11

The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis

Chapter 7

22

Theory of Stock ValuationTheory of Stock Valuation

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One period stock valuation

Generalized dividend valuation

If n is fairly large, then

If the stock doesn’t pay dividends, t starts when dividends start.

33

Theory of Stock ValuationTheory of Stock Valuation

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Gordon Growth Model

To simplify, multiply both sides by

and subtract the original equation from both sides

44

Informed Buyer Bids Up the PriceInformed Buyer Bids Up the Price

If two people both knew next period’s If two people both knew next period’s dividend and the growth rate, but one has dividend and the growth rate, but one has more information about the future of the more information about the future of the firm, the knowledgeable one will require a firm, the knowledgeable one will require a smaller k and pay a higher price.smaller k and pay a higher price.

The uncertainty for the less informed The uncertainty for the less informed shows up as higher k.shows up as higher k.

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ExamplesExamples

Fed lowers interest rates => price of bonds Fed lowers interest rates => price of bonds rise => demand shifts to substitute: stocks rise => demand shifts to substitute: stocks => price of stocks rise=> price of stocks rise

Subprime crisis => g down, k up => PSubprime crisis => g down, k up => P00

downdown

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ExpectationsExpectations

Static: expectations don’t changeStatic: expectations don’t changePast has no trendPast has no trend

Adaptive: expectations are adjusted Adaptive: expectations are adjusted according to past with recent past having according to past with recent past having higher weighthigher weightSlope is smallSlope is small

Rational: expectations are forward lookingRational: expectations are forward lookingSlope is very discernableSlope is very discernable

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Rational ExpectationsRational Expectations

Approximate guesses impose high costsApproximate guesses impose high costsOptimal forecasts can reduce costsOptimal forecasts can reduce costs

Predictions are on average accuratePredictions are on average accurateErrors add up to zero: no trendErrors add up to zero: no trend

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Efficient Market HypothesisEfficient Market HypothesisRational Expectations in Financial MarketsRational Expectations in Financial Markets

Investors decide on stock purchases according Investors decide on stock purchases according to expected returns.to expected returns.

Expected returns rely on expected price in the Expected returns rely on expected price in the future.future.

Expected price is the optimal forecast price.Expected price is the optimal forecast price. Information on the variables affecting the supply Information on the variables affecting the supply

and demand allow optimal forecast of returns to and demand allow optimal forecast of returns to be the same as equilibrium return.be the same as equilibrium return.

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Efficient Markets HypothesisEfficient Markets Hypothesis

Markets with extreme price flexibility adjust Markets with extreme price flexibility adjust instantaneously to any shift in supply and instantaneously to any shift in supply and demand.demand.

Optimal forecast equals the equilibrium Optimal forecast equals the equilibrium value.value.

Any deviation will immediately be Any deviation will immediately be recognized and allow arbitrage.recognized and allow arbitrage.

There cannot be any profit opportunities.There cannot be any profit opportunities.

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Efficient Market HypothesisEfficient Market Hypothesis

Those who profit from the efficient market Those who profit from the efficient market are the smart ones because the “dumb” are the smart ones because the “dumb” ones make stupid choices.ones make stupid choices.

Prices are always right; they embody all Prices are always right; they embody all the relevant information.the relevant information.

Pangloss!Pangloss!

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Efficient Market HypothesisEfficient Market Hypothesis

Random walk, throwing darts do as well as Random walk, throwing darts do as well as professional picks.professional picks.

Hot tips are already passé.Hot tips are already passé.Beware of the managers with high fees.Beware of the managers with high fees.

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Efficient Market HypothesisEfficient Market Hypothesis

If there is market psychology, herd If there is market psychology, herd behavior, EMH is suspect.behavior, EMH is suspect.

Bubbles question EMH.Bubbles question EMH.Animal Spirits (R. Shiller and G. Akerlof) Animal Spirits (R. Shiller and G. Akerlof)

won the 2009 TIAA-CREF Samuelson won the 2009 TIAA-CREF Samuelson award.award.