Chapter 7 The Stock Market

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  • 1. Chapter 7 The Stock Market, The Theory of Rational Expectations, and the Efficient Market Hypothesis
  • 2. Computing the Price of Common Stock
    • Basic Principle of Finance
      • Value of Investment = Present Value of Future Cash Flows
    • One-Period Valuation Model
    (1)
  • 3. Generalized Dividend Valuation Model
    • Since last term of the equation is small, Equation 2 can be written as
    (3) (2)
  • 4. Gordon Growth Model
    • Assuming dividend growth is constant, Equation 3 can be written as
    • Assuming the growth rate is less than the required return on equity, Equation 4 can be written as
    (5) (4)
  • 5. How the Market Sets Prices
    • The price is set by the buyer willing to pay the highest price
    • The market price will be set by the buyer who can take best advantage of the asset
    • Superior information about an asset can increase its value by reducing its perceived risk
  • 6. How the Market Sets 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.
  • 7. Adaptive Expectations
    • Expectations are formed from past experience only.
    • Changes in expectations will occur slowly over time as data changes.
    • However, people use more than just past data to form their expectations and sometimes change their expectations quickly.
  • 8. Theory of Rational Expectations
    • Expectations will be identical to optimal 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
      • It takes too much effort to make the expectation the best guess possible
      • Best guess will not be accurate because predictor is unaware of some relevant information
  • 9. 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
      • 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.
  • 10. Efficient Markets
    • 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
    • In an efficient market, a security’s price fully reflects all available information
  • 11. Evidence on Efficient Markets Hypothesis
    • Favorable Evidence
    • 1. Stock prices reflect publicly available information: anticipated announcements don’t affect stock price
    • 2. Stock prices and exchange rates close to random walk
    • If predictions of  P big, R of > R*  predictions of  P small
    • Unfavorable Evidence
    • 1. Small-firm effect: small firms have abnormally high returns
    • 2. January effect: high returns in January
    • 3. Market overreaction
    • 4. New information is not always immediately incorporated into stock prices
    • Overview
    • Reasonable starting point but not whole story
  • 12. Application Investing in the Stock Market
    • Recommendations from investment advisors cannot help us outperform the market
    • A hot tip is probably information already contained in the price of the stock
    • Stock prices respond to announcements only when the information is new and unexpected
    • A “buy and hold” strategy is the most sensible strategy for the small investor
  • 13. Behavioral Finance
    • The lack of short selling (causing over-priced stocks) may be explained by loss aversion
    • The large trading volume may be explained by investor overconfidence
    • Stock market bubbles may be explained by overconfidence and social contagion