the stock market, the theory of rational expectations, and the efficient market hypothesis
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The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis. Chapter 7. Theory of Stock Valuation. 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. - PowerPoint PPT PresentationTRANSCRIPT
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The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis
Chapter 7
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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.
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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
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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.