Chapter 7

The Stock Market, The Theory of Rational Expectations,

and the Efficient Markets Hypothesis

© 2005 Pearson Education Canada Inc.

© 2005 Pearson Education Canada Inc. 7-2

1 10 (1 ) (1 )e e

Div PP

k k

(1)

Computing the Price of Common Stock

• Basic Principle of FinanceValue of Investment = Present Value of Future Cash Flows

• One-Period Valuation Model

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Generalized Dividend Valuation Model

• Since last term of the equation is small, Equation 2 can be written as

1 20 1 2(1 ) (1 ) (1 ) (1 )

n nn n

e e e e

D PD DP

k k k k

01 (1 )

tt

t e

DP

k

(3)

(2)

© 2005 Pearson Education Canada Inc. 7-4

Gordon Growth Model

• Assuming dividend growth is constant, Equation 3 can be written as

• Assuming the growth rate is less than the required return on equity, Equation 4 can be written as

1 20 0 0

0 1 2

(1 ) (1 ) (1 )

(1 ) (1 ) (1 )e e e

D g D g D gP

k k k

0 10

(1 )

( ) ( )e e

D g DP

k g k g

(5)

(4)

© 2005 Pearson Education Canada Inc. 7-5

Theory of Rational Expectations

Rational expectation (RE) = expectation that is optimal forecast (best prediction of future) using all available information: i.e., RE

Xe = Xof

2 reasons expectation may not be rational

1. Not best prediction

2. Not using available information

Rational expectation, although optimal prediction, may not be accurate

Rational expectations makes sense because is costly not to have optimal forecast

Implications:

1. Change in way variable moves, way expectations are formed changes

2. Forecast errors on average = 0 and are not predictable

© 2005 Pearson Education Canada Inc. 7-6

Efficient Markets HypothesisP

t+1 – P

t + C

RET =P

t

Pet+1

– Pt + C

RETe =P

t

Rational Expectations implies:

Pet+1

= Poft+1

RETe = RETof (1)

Market equilibriumRETe = RET* (2)

Put (1) and (2) together: Efficient Markets HypothesisRETof = RET*

Why the Efficient Markets Hypothesis makes sense

If RETof > RET* Pt , RETof

If RETof < RET* Pt , RETof

until RETof = RET* 1. All unexploited profit opportunities eliminated 2. Efficient Market holds even if are uninformed, irrational participants in market

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Evidence on Efficient Markets Hypothesis

Favorable Evidence1. Investment analysts and mutual funds don’t beat the market2. Stock prices reflect publicly available information: anticipated

announcements don’t affect stock price3. Stock prices and exchange rates close to random walk

If predictions of P big, Rof > R* predictions of P small4. Technical analysis does not outperform market

Unfavorable 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 incorporated into stock prices

OverviewReasonable starting point but not whole story

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Implications for Investing

1. Published reports of financial analysts not very valuable2. Should be skeptical of hot tips3. Stock prices may fall on good news4. Prescription for investor

1. Shouldn’t try to outguess market2. Therefore, buy and hold3. Diversify with no-load mutual fund

Evidence on Rational Expectations in Other Markets1. Bond markets appear efficient2. Evidence with survey data is mixed

Skepticism about quality of data3. Following implication is supported: change in way variable moves, way

expectations are formed changes