Chapter 7: The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis

-Theory of rational expectations; financial markets: efficient market hypothesis

Computing the price of common stock
1. the principal way to raise capital; right to vote and residual claimant of profits; dividends
2. Price equals the present value of all cash flows the investment will generate over its life.
3. one-period valuation model: to find price of stock; buy stock, hold it for one period to get dividend and sell it.

The one-period valuation model and The generalized dividend valuation model
1. Stocks that do not pay dividends: buyers of the stock expect that the firm will pay dividends someday.

The Gordon Growth Model
1. increase dividends at a constant rate each year.
2. assumptions:
-dividends are assumed to continue growing at a constant rate forever or at least for an extended period of time
-the growth rate is assumed to be less than the required return on equity, ke. If the growth rate were faster than the rate required, the firm would grow impossibly large.

How the market sets stock prices
1. the price is set by the buyer willing to pay the highest price.
2. the market price will be set by buyer who can take advantage of the asset
3. superior information can increase value by reducing risk
4. market price is set by buyers bidding against each other; new information causes change in expectations and change in stock prices.

Application: monetary policy and stock prices
1. Monetary policy affect stock prices in two ways
-Fed lowers interest rates, the return on bonds dclins and investors are likely to accept a lower required rate of retrun on an investment in equity (ke) --> raise stock prices
-Lower interest rate --> stimulate economy --> rise in g --> rise in stock prices

Application: the 911 terrorist attacks, the Enron Scandal, and the stock market
1. 911: raised possibility that terrorism would paralyze the country; expect lower growth --> decrease in g --> decline in stock prices
2. increased uncertainty would raise the ke --> decline in stock prices
3. the Enron scandal and overstated earnings cause doubt and uncertainty --> decrease in g and rise in ke --> decline in stock prices

The theory of rational expectations
1. Adaptive expectations: the changes in expectations will occur slowly over time as past data change.
2. people use more than just past information; people change expectations to new info
3. Rational expectations: expectations will be identical to optimal forecasts using all available information
-does not have to be perfectly accurate; only needs to be the best possible given the 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
4. Two reasons why an expectation may fail to be rational
-people might be aware of all available information but find it takes too much effort to make their expectation the best guess possible
-people might be unaware of some available relevant information, so their best guess of the future will not be accurate
5. If an additional factor is important but not available, the expectation is still rational

Rationale behind the theory
1. people make their expectations match their best possible guess using all available information because it is costly for people not to do so.

Implications of the theory
1. if there is a change in the way a variable moves, the way in which expectations of this 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; forecast errors of expectations cannot be predicted

The efficient market hypothesis: rational expectations in financial markets
1. application of rational expectations to the pricing of stocks
2. assumption that prices of securities in financial markets fully reflect all available information
3. R(of)=R* - 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.
4. a security's price fully reflects all available information

Rationale behind the hypothesis
1. Unexploited profit opportunity: people earning more than they should; R(of) > R* driving up P(of)t+1 lowering R(of) --> unexploited profit opportunity disappeared
2. In an efficient market, all unexploited profit opportunities will be eliminated
3. Not everyone in a financial market must be well informed about a security or have rational expectations for its price to be driven to the point at which the efficient market condition holds; as long as a few keep their eyes open for unexploited profit opportunities, they will eliminate the profit opportunities

Stronger version of the efficient market hypothesis:
1. not only does optimal forecasts using all available information but also in an efficient market is one in which prices reflect the true fundamental (intrinsic) value of the securities.
2. implies that one investment is as good as any other because the securities' prices are correct
3. implies that a security's price reflect all available information about the intrinsic value of the security
4. implies that security prices can be used by managers of both financial and nonfinancial firms to asses their cost of capital accurately and hence that security prices can be used to help make the correct decisions about whether the investment is worth making.

Evidence on the efficient market hypothesis
1. in favor
-having performed well in the past does not indicate that an investment adviser or a mutual fund will perform well in the future.
-stock prices reflect publicly available information
-random walk: future changes cannot be predicted; EMH states that stock prices should follow random walk - future changes in stock prices should, for all practical purposes, be unpredictable
-technical analysis: study past stock price data and search for patterns such as trends on regular cycles; waste of time

2. against
-small-firm effect: small firms have earned abnormally high returns over long periods of time even when the risk of these firms are taken into account; may be due to rebalancing of portfolios by institutional investors, tax issues, low liq of stocks, large info costs in eval small firms, inappropriate measurement of risk
-January effect: abnormal price rise from dec to jan that is predictable and inconsistent with random-walk behavior; decresed for large companies; due to tax issues --> incentive to sell sotcks before the end of year to reduce liabilities
-market overreaction: stock prices overreact to news announcements and pricing errors are correctly only slowly.
-excess volatility: related to market overreaction; fluct in prices greater than are warranted by fluct in fundamental value; prices driven by other factors
-mean reversion: stocks with low returns today have high returns in the future; predicatable positive change in the future price
-new information is not always immediately incorporated into stock prices: stock prices continue to rise after announcement of high profits

Application: practical guide to investing in the stock market
1. stock prices will respond to announcements only when the information is new and unexpected

Summary
1. Stocks are valued as sthe present value of future dividens. Unfortunately, we do not know very precisely what these dividens will be. This uncertainty introduced a great deal of error inot the valuation process. The gordon gorwth model is a simplified method of computing stock value that depends on the assumption that the dividends arer growing at a constant rate forevr. Given our uncertainty regarding future dividends, this assumption is often the best we can do.
2. The interaction among traders in the market is what actually sets prices on a day-to-day basis. The trader who values the security the most (either because of less uncertainty about the cash flows or because of greater estimated cash flows) will be willing to pay the most. As new information is released, investors will revise their estimates of the true value of the security and will either buy or sell it depending on how the market price compares to their estimated valuation. Becasuse small changes in estimated growth rates or required return result in large changes in price, it is not surprising that the markets are often volatile.
3. The efficient market hypothesis states that current security prices will fully reflect all available information, because in an efficient market, all unexploited profit opport are eliminated. The elimination of unexp prof opport necess for a financial market to be efficient does not require that all market parti be well informed.
4. The evidence on the EMH is mixed. Early evidence are quite favorable.