the stock market, the theory of rational expectations, and the efficient markets hypothesis

Common stock is the principal way that corporations raise equity capital. Stockholders have the right to vote and be the residual claimants of all funds flowing to the firm. Dividends are payments made periodically, usually every quarter, to stockholders.

Chapter 7

The Stock Market, the Theory of

Rational Expectations, and the

Efficient Markets Hypothesis

Common Stock

• Common stock is the principal way that

corporations raise equity capital

• Stockholders have the right to vote and be the residual claimants of all funds flowing to the

firm

• Dividends are payments made periodically,

usually every quarter, to stockholders

One-Period Valuation Model

) k (1

P )

k (1

DIV P

e

1 e

1 0









PO = the current price of the stock

DIV1 = the dividend paid at the end of year 1

ke = the required return on investment in equity

P1 = the sale price of the stock at the end of the

first period

Generalized Dividend Valuation Model

The value of stock today is the present value of all future cash flows

n n

) k (1

P )

k (1

D

) k (1

D )

k (1

D P

e

n e

n 2

e

2 1

e

1 o

) k (1

D P

t

t

Gordon Growth Model

g g

k

D )

1 (

D P

D0 = the most recent dividend paid

g = the expected constant growth rate in dividends

ke = the required return on an investment in equity

Dividends are assumed to continue growing at a constant

rate forever.

The growth rate is assumed to be less than required return

on equity

Price Earnings Valuation Method I

The price earnings ratio (PE) represents how

much the market is willing to pay for $1 of earnings from the firm

1 A higher than average PE may mean the

market expects earnings to rise in the future

2 A high PE may also mean the market feels

the firm’s earnings are very low risk

Price Earnings Valuation Method II

value of a firm’s stock

expected earnings is the firm’s stock price

How the Market Sets Stock Prices I

• 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 risk

How the Market Sets Stock Prices II

Investor Discount Rate Stock Price

•Each investor has a different required return leading to

differing valuations of the stock.

•New information leads to changes in expectations and

therefore changes in price.

•Stock prices are constantly changing.

Monetary Policy and Stock Prices

• Monetary policy is an important determinant

of stock prices

• Gordon Growth model shows two ways in

which monetary policy affects stock prices

• ↓i lowers the return on bonds and this leads

Adaptive Expectations

• 1950s and 1960s economists believed in adaptive

expectations.

• Adaptive expectations means that expectations were

formed from past experience only

• Changes in expectations occur slowly over time

• Mathematical formation of hypothesis shows that

expected value at time t is a weighted average of

current and past values

• The smaller the weights the longer that past events affect current expectations

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

Formal Statement of the Theory

X e = expectation of the variable that is being forecast

X of = optimal forecast using all available information

Implications of the Theory

• 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

• The forecast errors of expectations will, on

average, be zero and cannot be predicted

ahead of time

Efficient Markets: Rational Expectations in

P

C P P

R    

R = the rate of return on the security

Pt+1 = price of the security at time t+1, the end of the holding

Efficient Markets: Rational Expectations in

Financial Markets II

At the beginning of the holding period, we know Pt and C

Pt+1 is unknown and we must form an expectation of it.

The expected return then is:

t

t

e 1 t e

P

C P

of 1 t

e 1

Efficient Markets: Rational Expectations in

Financial Markets III

• 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 and all profit opportunities will be eliminated.

• Caveat: Not everyone in an financial market must be well informed about a security or have rational

expectations for the efficient market condition to

hold

Rationale Behind the Theory

of

of t

* of

R P

R*

R

R P

R

Stronger Version of the Efficient Market

Hypothesis

• Efficient markets are rational (optimal

forecasts using all available information)

• Also requires prices to reflect true

fundamental (intrinsic) value of the securities

• In an efficient market prices are always

correct and reflect market fundamentals

Application: Practical Guide to 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

Behavioural 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