Chapter 7 The Stock Market, The Theory of Rational Expectations,  and the Efficient Market Hypothesis
Computing the Price of Common Stock <ul><li>Basic Principle of Finance </li></ul><ul><ul><li>Value of Investment = Present...
Generalized Dividend Valuation Model <ul><li>Since last term of the equation is small, Equation 2 can be written as </li><...
Gordon Growth Model <ul><li>Assuming dividend growth is constant, Equation 3 can be written as </li></ul><ul><li>Assuming ...
How the Market Sets Prices <ul><li>The price is set by the buyer willing to pay the highest price </li></ul><ul><li>The ma...
How the Market Sets Prices <ul><li>Information is important for individuals to value each asset. </li></ul><ul><li>When ne...
Adaptive  Expectations <ul><li>Expectations are formed from past experience only. </li></ul><ul><li>Changes in expectation...
Theory of Rational Expectations <ul><li>Expectations will be identical to optimal forecasts using all available informatio...
Implications <ul><li>If there is a change in the way a variable moves, the way in which expectations of the variable are f...
Efficient Markets <ul><li>Current prices in a financial market will be set so that the optimal forecast of a security’s re...
Evidence on Efficient Markets Hypothesis <ul><li>Favorable Evidence </li></ul><ul><li>1. Stock prices reflect publicly ava...
Application Investing in the Stock Market <ul><li>Recommendations from investment advisors cannot help us outperform the m...
Behavioral Finance <ul><li>The lack of short selling (causing  over-priced stocks) may be explained by loss aversion </li>...
Upcoming SlideShare
Loading in …5
×

Chapter 7 The Stock Market

436 views
376 views

Published on

Published in: Business, Economy & Finance
0 Comments
0 Likes
Statistics
Notes
  • Be the first to comment

  • Be the first to like this

No Downloads
Views
Total views
436
On SlideShare
0
From Embeds
0
Number of Embeds
0
Actions
Shares
0
Downloads
7
Comments
0
Likes
0
Embeds 0
No embeds

No notes for slide

Chapter 7 The Stock Market

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

×