1、Copyright 2010 Pearson Addison-Wesley. All rights reserved.Chapter 7The Stock Market, the Theory of Rational Expectations, and the Efficient Market HypothesisCopyright 2010 Pearson Addison-Wesley. All rights reserved.7-27.1 Computing the Price of Common Stock Basic Principle of FinanceValue of Inves
2、tment = Present Value of Future Cash FlowsCopyright 2010 Pearson Addison-Wesley. All rights reserved.7-37.1.1 One-Period Valuation Model110011(1)(1)= the current price of the stock = the dividend paid at the end of year 1 = the required return on investment in equity = the sale price of the stock at
3、 the end of the eeeDivPPkkPDivkPfirst periodCopyright 2010 Pearson Addison-Wesley. All rights reserved.7-47.1.2 Generalized Dividend Valuation Model12012001The value of stock today is the present value of all future cash flows.(1)(1)(1)(1)If is far in the future, it will not affect (1)The price of t
4、he nnnneeeenttteDPDDPkkkkPPDPkstock is determined only by the present value ofthe future dividend streamCopyright 2010 Pearson Addison-Wesley. All rights reserved.7-57.1.3 Gordon Growth Model P0D0(1 g)(ke g)D1(ke g)D0= the most recent dividend paidg = the expected constant growth rate in dividendske
5、 = the required return on an investment in equityDividends are assumed to continue growing at a constant rate foreverThe growth rate is assumed to be less than the required return on equityCopyright 2010 Pearson Addison-Wesley. All rights reserved.7-67.2 How the Market Sets Prices Players in the mar
6、ket, bidding against one another, establish the market price. 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 riskCop
7、yright 2010 Pearson Addison-Wesley. All rights reserved.7-7How 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 expec
8、tations, so stock prices change frequently.Copyright 2010 Pearson Addison-Wesley. All rights reserved.7-87.3 Theory of Rational Expectations Adaptive Expectations Expectations are formed from past experience only. Changes in expectations will occur slowly over time as data changes. However, people u
9、se more than just past data to form their expectations and sometimes change their expectations quickly.Copyright 2010 Pearson Addison-Wesley. All rights reserved.7-9 Rational ExpectationsRational expectation = expectation that is optimal forecast (best prediction of future) using all available infor
10、mation: Rational expectation, although optimal prediction, may not be 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 informationCopyright 2010 Pearson Addison-Wesley. All rights reserved
11、.7-10Formal Statement of the Theory expectation of the variable that is being forecast = optimal forecast using all available informationeofeofXXXXCopyright 2010 Pearson Addison-Wesley. All rights reserved.7-11Implications 1. If there is a change in the way a variable moves, the way in which expecta
12、tions of the variable are formed will change as well 2. The forecast errors of expectations will, on average, be zero and cannot be predicted ahead of time. Copyright 2010 Pearson Addison-Wesley. All rights reserved.7-127.4 Efficient Markets: Application of Rational Expectations1RecallThe rate of re
13、turn from holding a security equals the sum of the capitalgain on the security, plus any cash payments divided by the initial purchase price of the security. = the rtttPPCRPR1ate of return on the security = price of the security at time + 1, the end of the holding period = price of the security at t
14、ime , the beginning of the holding period = cash payment (coupon ttPtPtCor dividend) made during the holding periodCopyright 2010 Pearson Addison-Wesley. All rights reserved.7-13Efficient Markets (contd)At the beginning of the period, we know Pt and C. Pt+1 is unknown and we must form an expectation
15、 of it.The expected return then isExpectations of future prices are equal to optimal forecasts using all currently available information soSupply and Demand analysis states Re will equal the equilibrium return R*, so Rof = R*ttetePCPPR1ofeoftetRRPP11Copyright 2010 Pearson Addison-Wesley. All rights
16、reserved.7-14Efficient Markets Current prices in a financial market will be set so that the optimal forecast of a securitys return using all available information equals the securitys equilibrium return In an efficient market, a securitys price fully reflects all available informationCopyright 2010
17、Pearson Addison-Wesley. All rights reserved.7-15Rationale Rof R* Pt RofRof R* Pt RofuntilRof R*In an efficient market, all unexploited profit opportunities willbe eliminatedEfficient Market holds even if are uninformed, irrational participants in marketCopyright 2010 Pearson Addison-Wesley. All righ
18、ts reserved.7-16Stronger Version of the EMH Add the condition that an efficient market is one in which prices reflect the true fundamental value of the securities. Thus, in an efficient market, all prices are always correct and reflect market fundamentals. Implications: 1. One investment is as good
19、as any other. 2. A securitys price reflects all available information about the intrinsic value of the security. 3. Security prices can be used to make correct decisions about whether a specific investment is worth making.Copyright 2010 Pearson Addison-Wesley. All rights reserved.7-17Evidence on Eff
20、icient Markets HypothesisFavorable Evidence1.Investment analysts and mutual funds dont beat the market2.Stock prices reflect publicly available information: anticipated announcements dont affect stock price3.Stock prices and exchange rates close to random walk4.Technical analysis does not outperform
21、 marketCopyright 2010 Pearson Addison-Wesley. All rights reserved.7-18Unfavorable Evidence1.Small-firm effect: small firms have abnormally high returns2.January effect: high returns in January3.Market overreaction4.Excessive volatility5.Mean reversion6.New information is not always immediately incor
22、porated into stock pricesOverviewReasonable starting point but not whole storyCopyright 2010 Pearson Addison-Wesley. All rights reserved.7-19Application Investing in the Stock Market Recommendations from investment advisors cannot help us outperform the market A hot tip is probably information alrea
23、dy 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 investorCopyright 2010 Pearson Addison-Wesley. All rights reserved.7-207.5 Behavioral Finance It applies
24、concepts from other social sciences to understand the behavior of securities prices. 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
