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Unformatted text preview: Chapter 7: The Stock Market, the Theory of
Rational Expectations, and the Efﬁcient
' Market Hypothesis After this chapter you should have an
understanding of the following. 1. Computing the price of common stock by the OnePeriod Valuation Model, the
Generalized Dividend Valuation model, and
the Gordon Growth Model 2. How the market interacts to set stock prices
and the role of monetary policy in stock
price formation. 3. The theory of rational expectations 4. The efﬁcient market hypothesis and its
implications for stock prices 5. The role of behavioral ﬁnance in
determining stock prices Page 1 of 14 Computing the Price of Common Stock Recall that the fundamental principle of
determining the value of any asset is to determine
its present value of all cashmﬂovvs that asset will
generate over its lifetime. We will consider three models that follow this
principle to understand stock price values. 1) The OnePeriod Valuation Model Let, P0 = the current price of the stock Divl = the dividend paid at the end of year 1 k6 = the required return on investment in
equity P1 = the sale price of the stock at the end of
the ﬁrst period PD: D2121 + (1+ke) (1+ke) Page 2 of 14 2)_The Generalized Dividend Valuation Model The value of stock today, its price, is the present
value of all future cash ﬂows. This means the following, D1 D” DP? R?
PU: 1+ _j+...+_  j1+_ ﬂ
(HI:9) (l+]€e)_ (1+kg)* (1+ke) PI1 is far in the future, it will become insigniﬁcantly small and not affect today’s price. Therefore we would illuminate the last term.
:QJIIWI _.r_,.::_.. p Dr
0 (1+1ch The conclusion is that the price is determined
only by present value of future dividend streams. Page 3 ofl4 3) The Gordon Growth Model This model takes the generalized results and
includes a constant growth rate in dividends by
including the growth factor (1 + g)n in the
numerator of the generalized price formula. Dividends are assumed to continue growing at a
constant rate forever. The growth rate is assumed to be less than the
required return on equity. LetjéDo = the most recent diggendpgidf g = the expected constant growth rate in
dividends k6 = the required return on an asset Then, PZDD(l+g): D1
0 (kg—s) (lgs) Page40f14 How the Market Sets Stock Prices Information is important for individuals to value
each asset. When new information is released about a ﬁrm,
expectations and prices change. Market participants constantly receive
information and revise their expectations, so
stock prices change frequently. Using the Gordon model What happens to
stock prices during the growing phase of a
stock market bubble and the crash? Using the Gordon model What happens to
stock prices during periods of active
monetary policy? \ r.” ,r’  Page 5 of 14 r." l ' I: 9 hr! 3!. . r' I: Adaptive Expectations ( ) o Expectations are formed from past
experience only. 0 Changes in expectations will occur slowly
over time as data changes. 0 However, people use more than just past data
to form their expectations and sometimes
change their expectations quickly. How fast would your predictions for the future
change, if you form your expectations on
adaptive reasoning? “HERE!” /
Page 6 01°14 K The Theory of Rational Expectations  r’;'‘ I '. Expectations Will be identi_cal t0 Q‘ptimal
forecasts using all available information Even though a rational expectation equals the
optimal forecast using all available information,
a prediction based on it may not always be
perfectly accurate. 0 It takes too much effort to make the
expectation the best guess possible 0 Best guess Will not be accurate because
predictor is unaware of some relevant
information Formal Statement of the Theory: Xe = XOf Where, Xe = expectation of the variable that is
being forecasted X°f= optimal forecast using all available
information Page 7 of 14 Implications If there is a change in the way a variable moves,
the way in which expectations of the variable are
formed will change as well
0 Changes in the conduct of monetary policy
(e. g. target the federal funds rate) The forecast errors of expectations will, on
average, be zero and cannot be predicted ahead of time. Page 8 of 14 Efﬁcient Markets is an Application of
Rational Expectations Recall that the rate of return from holding a
security equals the sum of the capital gain on the
security, pliisgny cash. payments: Cliyidcd by the
ich of the security. Let, R = the rate of return on the security PM = price of the security at time t + 1, the end of
the holding period Pt = price of the security at time t, the beginning
of the holding period C = cash payment (coupon or dividend) made during the holding period
R : 13H] — I): + Ci
13 At the beginning of the period, we know Pt and
C. PHI is unknown and we must form an
expectation of it. Page 9 01°14 The expected return then is R9 : Prilﬂpr+C
P. I. Expectations of future prices are equal to optimal
forecasts using all currently available
information. Therefore, P9 = Pof :> R8 = Raf {+1 f+1 Supply and Demand analysis states Re will equal
the equilibrium return R*, so R0f = R* 0 Current prices in a ﬁnancial market will be
set so that the optimal forecast of a security’s
return using all available information equals
the security’s equilibrium return 0 In an efﬁcient market, a security’s price fully
reﬂects all available information But what is the rational that guarantees
this condition to hold? Page 10 ofl4 Remember that we are trading these stocks in a
market and we do not have the ability to prevent . . _ will move the
market to the equilibrium market price in our
supply and demand diagram. sf“ Rq>Kteﬂﬁqul
R‘sf < :> Pf $2 I?“ T until
agzﬁ In an efﬁcient market, all ' .   . proﬁt
opportunities will be eliminated. Page 11 of 14 The Efﬁcient Market Hypothesis (EMH): Rational Expectations in Financial Markets The EMH relies on the efﬁcient exploitation of
information by economic agents, which implies
that it would not be possible for a market agent to
earn abnormal proﬁts. EMH assumes that agents,
in forming their expectations in the period, are
rational in the sense that they do not make jg;  ; , and they know
expected market equilibrium prices or expected
equilibrium returns. Malkiel (2003, J EP) reviews the current evidence
and understanding of the market efﬁciency since
F ama’s (1970, JF) paper and concludes that the
evidence does support the claim of market
efﬁciency. Page 12 of14 Application Investing in the Stock Market 0 Recommendations from investment advisors
cannot help us outperform the market « A hot tip is probably information already
contained in the price of the stock 0 Stock prices respond to announcements only
when the information is new and unexpected o A “ uy and hold” strategy is the mostﬂsensiﬂe
strategy for the small investor Stranger Versiga of EfﬁsisaLMarlsst Hypprhsshiws
states that the price also reﬂectsthe true flindamental or intrinsic value of the securities at
MW ” _.— M/ CAI/Illa; ,  f . Page 13 of 14 The problems with the EMH assumptions are that
they apply to all agents at all times, and assume
that all agents have similar time constraints in their ability to hold assets. Research on behavioral ﬁnance, along with the
studies on anomalous behavior of markets,
suggests that there are various periods when the
market behaves in a manner that is
uncharacteristic for an efﬁcient market strictly
following the EMH assumptions, and suggests
that there is no reason why expectations of agents
cannot vary through time. Behavioral Finance 0 The lack of short selling (causing
overpriced stocks) may be explained byl_o_ss
Wu 0 The large trading volume may be explained
by investor overconﬁdence 0 Stock market bubbles may be explained by
overconﬁdence and social contagion  rage 14 ofl4 ...
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This note was uploaded on 12/21/2011 for the course BUS 100 taught by Professor Intro during the Fall '11 term at UCSB.
 Fall '11
 Intro

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