Ch. 7 (BUS G-345; Money, Banking; and Capital Markets; Self)

Ch. 7 (BUS G-345; Money, Banking; and Capital Markets;...

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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 One-Period 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 One-Period 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) (lg-s) 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‘s-f < :> 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 over-priced 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.

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Ch. 7 (BUS G-345; Money, Banking; and Capital Markets;...

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