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

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Pearson Canada Inc.
7- 1
Chapter 7
The Stock Market, the Theory of Rational
Expectations, and the
Efficient Markets Hypothesis
Copyright  2011
Pearson Canada Inc.
7- 2
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.
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Pearson Canada Inc.
7- 3
One-Period Valuation Model
)k(1
P
)k(1
DIV
P
e

1
e
1
0
+
+
+
=
P
O
= the current price of the stock
DIV
1
= the dividend paid at the end of year 1
k
e
= the required return on investment in equity
P
1
= the sale price of the stock at the end of the
first period
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Pearson Canada Inc.
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Generalized Dividend Valuation Model
The value of stock today is the present value of all future cash
flows
nn
)k(1
P

)k(1
D

)k(1
D
)k(1
D
P
e
n
e
n
2
e
2
1
e
1
o
+
+
+
++
+
+
+
=
If P
n
is far in the future, it will not affect P

0
∑
∞
=
+
=
1
e
t
0
)k(1
D
P
t
t
The price of the stock is determined only by the present
value of the future dividend stream
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Pearson Canada Inc.
7- 5
Gordon Growth Model
ggk
g
e
−
=
−
+
=
e

1
0
0
k
D
)1(D
P
D
0
= the most recent dividend paid
g = the expected constant growth rate in dividends
k
e
= 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
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Pearson Canada Inc.
7- 6
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.
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Pearson Canada Inc.
7- 7
Price Earnings Valuation Method II
•
The PE ratio can be used to estimate the
value of a firm’s stock.
•
The product of the PE ratio times the
expected earnings is the firm’s stock price.
•
(P/E) x E = P
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Pearson Canada Inc.
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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.
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How the Market Sets Stock Prices II
Investor Discount Rate Stock Price

You 15% $16.67
Jennifer 12% $22.22
Bud 10% $28.57
•
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.
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Pearson Canada Inc.
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10
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
to a ↓ in k
e
which leads to an ↑ stock prices
•

↓i stimulates economy leading to an ↑g leads

to an ↑ stock prices
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Pearson Canada Inc.
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11
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
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12
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 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 information.
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13
Formal Statement of the Theory
X
e
= X
of
X
e
= expectation of the variable that is being forecast
X
of
= optimal forecast using all available information
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14
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.
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Pearson Canada Inc.
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15
Efficient Markets: Rational Expectations in
Financial Markets I
Recall: The rate of return from holding a security equals the
sum of the capital gain on the security plus any cash payments
divided by the initial purchase price of the security
t
t1t
P
CPP
R
+−
=
+
R = the rate of return on the security
P
t+1
= price of the security at time t+1, the end of the holding
period

Pt = price of the security at time t, the beginning of the holding
period
C = cash payment (coupon or dividend) made during the holding
period
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16
Efficient Markets: Rational Expectations in
Financial Markets II
At the beginning of the holding period, we know P
t
and C
P
t+1
is unknown and we must form an expectation of it.
The expected return then is:
t
t
e
1t
e
P
CPP
R
++
=
+
Expectations of future prices are equal to optimal forecasts using all
currently available information so

ofeof
1t
e
1t
RRPP =⇒=
++
Supply and demand analysis states R
e
will equal the equilibrium
return R* so R
of
= R*
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Pearson Canada Inc.
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17
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.
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Pearson Canada Inc.
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18
Rationale Behind the Theory
↑⇒↓⇒<
↓⇒↑⇒>
of
t
of
of
t
*of
R PR* R
R P RR
until
R
of
= R*
In an efficient market all unexploited profit opportunities will be
eliminated
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Pearson Canada Inc.
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19
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
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Pearson Canada Inc.
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20
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
strategy for the small investor.
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Pearson Canada Inc.
7-
21

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.