Ch 7


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Ch 7

  1. 1. Chapter 7: The Stock Market, The Theory of Rational Expectations, and the Efficient Market Hypothesis <ul><li>Computing the Price of Common Stock </li></ul><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>e.g., One-Period Valuation Model </li></ul>Generalized Dividend Valuation Model Since last term of the equation is small (3) (2) (1)
  2. 2. 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) How the Fed’s monetary policies affect stock prices? Lower interest rate  (1) return on bonds declines  investors are likely accept a lower k e (2) stimulate the economy  g is likely to be higher  P 0 goes up.
  3. 3. Theory of Rational Expectations <ul><li>Rational expectation (RE) = expectation that is optimal forecast (best prediction of future) using all available information. </li></ul><ul><li>Rational expectation, although optimal prediction, may not be accurate </li></ul><ul><li>Implications: </li></ul><ul><li>1. If there is a change in the way a variable moves, there will be a change in the way expectations of this variable are formed as well </li></ul><ul><li>2. Forecast errors on average = 0 and are not predictable </li></ul>
  4. 4. Efficient Markets Hypothesis from Rational Expectation <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><ul><li>All unexploited profit opportunities eliminated </li></ul><ul><li>Efficient Market holds even if there are uninformed, irrational participants in market </li></ul>
  5. 5. Evidence in Favor of Market Efficiency <ul><li>Having performed well in the past does not indicate that an investment advisor or a mutual fund will perform well in the future </li></ul><ul><li>If information is already publicly available, a positive announcement does not, on average, cause stock prices to rise </li></ul><ul><li>Stock prices follow a random walk </li></ul><ul><li>Technical analysis cannot successfully predict changes in stock prices </li></ul>
  6. 6. Evidence Against Market Efficiency <ul><li>Small-firm effect </li></ul><ul><li>January Effect </li></ul><ul><li>Market Overreaction </li></ul><ul><li>Excessive Volatility </li></ul><ul><li>Mean Reversion </li></ul><ul><li>New information is not always immediately incorporated into stock prices </li></ul>
  7. 7. Implications for Investing <ul><li>1. Published reports of financial analysts not very valuable </li></ul><ul><li>2. Should be skeptical of hot tips </li></ul><ul><li>3. Stock prices may fall on good news </li></ul><ul><li>4. Prescription for investor </li></ul><ul><ul><li>1. Shouldn’t try to outguess market </li></ul></ul><ul><ul><li>2. Therefore, buy and hold </li></ul></ul><ul><ul><li>3. Diversify with no-load mutual fund </li></ul></ul>
  8. 8. Can smart money beat ordinary investors? ---Behavioral Finance <ul><li>The lack of short selling (causing over-priced stocks) may be explained by loss aversion (more unhappy in losses than happy in gains) </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>