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Transcript of Lecture06
Topic 6
The Stock Market
Topic 6, page 1
ECO 350 • Money and Banking
The Stock Market
Department of Economics, SUNY
[Background]
A. Common Stock and Stockholders
i. Equity capital, dividends
ii. Residual claimant
Topic 6, page 2
ECO350 • Money and BankingDepartment of Economics, SUNY
[Background]
A. Common Stock and Stockholders
i. Equity capital, dividends
ii. Residual claimant
B. Basic Principle of Finance
Topic 6, page 3
ECO350 • Money and Banking
o The value of any investment is found by computing
the present value of all cash flows the investment
will generate over its life.
Department of Economics, SUNY
[Background]
A. Common Stock and Stockholders
i. Equity capital, dividends
ii. Residual claimant
B. Basic Principle of Finance
Topic 6, page 4
ECO350 • Money and Banking
o The value of any investment is found by computing
the present value of all cash flows the investment
will generate over its life.
C. Common stock is valued as the value in today’s dollars of
all future cash flows
o The cash flows a stockholder might earn from stock
are---Department of Economics, SUNY
[Background]
A. Common Stock and Stockholders
i. Equity capital, dividends
ii. Residual claimant
B. Basic Principle of Finance
Topic 6, page 5
ECO350 • Money and Banking
o The value of any investment is found by computing
the present value of all cash flows the investment
will generate over its life.
C. Common stock is valued as the value in today’s dollars of
all future cash flows
o The cash flows a stockholder might earn from stock
are---dividends, the sales price, or both.Department of Economics, SUNY
1. Fundamental Stock Price
A. Fundamental stock price = discounted sum of expected
dividends:
Topic 6, page 6
1+i (1+i)2+ + + …
(1+i)3div2
e div3e
div1e
PSF =
ECO350 • Money and BankingDepartment of Economics, SUNY
1. Fundamental Stock Price
A. Fundamental stock price = discounted sum of expected
dividends:
B. Gordon Growth model
i. Constant dividend growth:
Topic 6, page 7
1+i (1+i)2+ + + …
(1+i)3div2
e div3e
div1e
PSF =
ECO350 • Money and Banking
i. Constant dividend growth:
ii. If i > g,
iii. If i ≤ g, PSF = ∞.
Department of Economics, SUNY
div2 = (1+g)div1;e e
div3 = (1+g)div2 = (1+g)2div1
e e e
div1i – g
e
PSF =
1. Fundamental Stock Price (continued)
[Example] D1 = $2, g = 3%
Topic 6, page 8
Investor Discount Rate Stock Price
You 15% $16.67
Jennifer 12% $22.22
ECO350 • Money and BankingDepartment of Economics, SUNY
Jennifer 12% $22.22
Bud 10% $28.57
1. Fundamental Stock Price (continued)
C. How the market sets stock prices
i. The price is set by the buyer willing to pay the
highest price.
• The price is not necessarily the highest price the
asset could fetch. It is incrementally greater than
what any other buyer is willing to pay.
Topic 6, page 9
ECO350 • Money and Banking
what any other buyer is willing to pay.
ii. The market price will be set by the buyer who can
take best advantage of the asset.
Department of Economics, SUNY
1. Fundamental Stock Price (continued)
C. How the market sets stock prices
iii. Superior information about an asset can increase its
value by reducing its risk.
• The buyers who has the best information about
the future cash flows will discount them at a
lower interest rate than will a buyer who is very
Topic 6, page 10
ECO350 • Money and Banking
lower interest rate than will a buyer who is very
uncertain.
D. An Application---Monetary Policy and Stock Prices
i. lower interest rate → lower required rate of return
on equity
ii. lower interest rate → higher g
Department of Economics, SUNY
2. Rational Expectations
A. Rational expectations: Expectations (predictions) are
statistically optimal forecasts using all available
information.
Topic 6, page 11
ECO350 • Money and BankingDepartment of Economics, SUNY
2. Rational Expectations
A. Rational expectations: Expectations (predictions) are
statistically optimal forecasts using all available
information.
• Best possible given the available information
• The forecast does not have to be perfectly
accurate to be rational.
Topic 6, page 12
ECO350 • Money and Banking
accurate to be rational.
Department of Economics, SUNY
2. Rational Expectations (continued)
[Example] Best possible given the available information
o If a forecaster spends hours every day studying data
to forecast interest rates but his expectations are
not as accurate as predicting that tomorrow’s
interest rates will be identical to today’s interest rate,
Topic 6, page 13
ECO350 • Money and Banking
are his expectations rational?
Department of Economics, SUNY
2. Rational Expectations (continued)
[Example] Best possible given the available information
o If a forecaster spends hours every day studying data
to forecast interest rates but his expectations are
not as accurate as predicting that tomorrow’s
interest rates will be identical to today’s interest rate,
Topic 6, page 14
ECO350 • Money and Banking
are his expectations rational?
o No. Because he could improve the accuracy of his
forecasts, his forecast is not optimal.
Department of Economics, SUNY
2. Rational Expectations (continued)
[Example] Best possible given the available information
o Whenever it is snowing when Joe Commuter gets up
in the morning, he misjudges how long it will take
him to drive to work. Otherwise, his expectations of
the driving time are perfectly accurate. Considering
Topic 6, page 15
ECO350 • Money and Banking
that it snows only once every ten years where Joe
lives, Joe’s expectations are almost always perfectly
accurate. Are Joe’s expectations rational?
Department of Economics, SUNY
2. Rational Expectations (continued)
[Example] Best possible given the available information
o Whenever it is snowing when Joe Commuter gets up
in the morning, he misjudges how long it will take
him to drive to work. Otherwise, his expectations of
the driving time are perfectly accurate. Considering
Topic 6, page 16
ECO350 • Money and Banking
that it snows only once every then years where Joe
lives, Joe’s expectations are almost always perfectly
accurate. Are Joe’s expectations rational?
o No. He doesn’t take account of a snowfall in his
forecasts.
Department of Economics, SUNY
2. Rational Expectations (continued)
[Example] The forecast does not have to be perfectly
accurate to be rational.
o “Forecasters’ predictions of inflation are notoriously
inaccurate, so their expectations of inflation cannot
be rational.” Is this statement true, false, or
uncertain?
Topic 6, page 17
ECO350 • Money and Banking
uncertain?
Department of Economics, SUNY
2. Rational Expectations (continued)
[Example] The forecast does not have to be perfectly
accurate to be rational.
o “Forecasters’ predictions of inflation are notoriously
inaccurate, so their expectations of inflation cannot
be rational.” Is this statement true, false, or
uncertain?
Topic 6, page 18
ECO350 • Money and Banking
uncertain?
o False. A forecast is optimal if it is the best possible
even if the forecast errors are large.
Department of Economics, SUNY
2. Rational Expectations (continued)
B. Implication: The forecast errors of expectations will, on
average, be zero and cannot be predicted ahead of time.
Topic 6, page 19
ECO350 • Money and BankingDepartment of Economics, SUNY
2. Rational Expectations (continued)
B. Implication: The forecast errors of expectations will, on
average, be zero and cannot be predicted ahead of time.
C. Justification: Suboptimal forecasts are costly.
• How much inventory should Wal-Mart keep?
• In financial markets, people loss money if their
Topic 6, page 20
ECO350 • Money and Banking
• In financial markets, people loss money if their
expectations are not rational.
Department of Economics, SUNY
3. The Efficient Market Hypothesis
A. Efficient Market Hypothesis
i. Rational expectations applied to the pricing of stocks
and other securities
ii. The hypothesis says that: In an efficient market, a
security’s price fully reflects all publicly available
Topic 6, page 21
ECO350 • Money and Banking
security’s price fully reflects all publicly available
information and all unexpected profit opportunities
will be eliminated.
Department of Economics, SUNY
3. The Efficient Market Hypothesis
A. Efficient Market Hypothesis
i. Rational expectations applied to the pricing of stocks
and other securities
ii. The hypothesis says that: In an efficient market, a
security’s price fully reflects all publicly available
Topic 6, page 22
ECO350 • Money and Banking
security’s price fully reflects all publicly available
information and all unexpected profit opportunities
will be eliminated.
iii. Justification: if prices are not rational, there are
unexploited profit opportunities. Ex.
Department of Economics, SUNY
*RRof >
3. The Efficient Market Hypothesis
A. Efficient Market Hypothesis
i. Rational expectations applied to the pricing of stocks
and other securities
ii. The hypothesis says that: In an efficient market, a
security’s price fully reflects all publicly available
Topic 6, page 23
ECO350 • Money and Banking
security’s price fully reflects all publicly available
information and all unexpected profit opportunities
will be eliminated.
iii. Justification: if prices are not rational, there are
unexploited profit opportunities. Ex.
⇒ profits available to investors who buy ⇒ Pt bid up
until .
Department of Economics, SUNY
*RRof >
*RRof =
3. The Efficient Market Hypothesis (continued)
B. Implications of RE/EMH
i. Past values of ret do not predict future values.
ii. Events that were predicted should not affect stock
prices.
iii. Future changes in stock prices should be
Topic 6, page 24
ECO350 • Money and Banking
iii. Future changes in stock prices should be
unpredictable: Random Walk Hypothesis
Department of Economics, SUNY
3. The Efficient Market Hypothesis (continued)
[Example] Implications of RE/EMH
o If you read in the Wall Street Journal that the “smart
money” on Wall Street expects stock prices to fall,
should you follow that lead and sell all your stocks?
Topic 6, page 25
ECO350 • Money and BankingDepartment of Economics, SUNY
3. The Efficient Market Hypothesis (continued)
[Example] Implications of RE/EMH
o If you read in the Wall Street Journal that the “smart
money” on Wall Street expects stock prices to fall,
should you follow that lead and sell all your stocks?
o No, because this is publicly available information and
Topic 6, page 26
ECO350 • Money and Banking
o No, because this is publicly available information and
is already incorporated into stock prices. The optimal
forecast of stock returns will equal the equilibrium
return. Therefore, there is no benefit from selling
your stocks.
Department of Economics, SUNY
3. The Efficient Market Hypothesis (continued)
[Example] Implications of RE/EMH
o If the public expects a corporation to lose $5 per
share this quarter and it actually loses $4, which is
still the largest loss in the history of the company,
what does the efficient market hypothesis say will
Topic 6, page 27
ECO350 • Money and Banking
happen to the price of the stock when the $4 loss is
announced?
Department of Economics, SUNY
3. The Efficient Market Hypothesis (continued)
[Example] Implications of RE/EMH
o If the public expects a corporation to lose $5 per
share this quarter and it actually loses $4, which is
still the largest loss in the history of the company,
what does the efficient market hypothesis say will
Topic 6, page 28
ECO350 • Money and Banking
happen to the price of the stock when the $4 loss is
announced?
o The stock price will rise. The price of the stock
reflects an even larger expected loss.
Department of Economics, SUNY
3. The Efficient Market Hypothesis (continued)
B. Empirical Evidence
i. Generally favorable
• Performance of Investment Analysts and Mutual
Funds
• Stock prices reflect publicly available information.
• Stock prices follow random-walk.
Topic 6, page 29
ECO350 • Money and Banking
• Stock prices follow random-walk.
Department of Economics, SUNY
3. The Efficient Market Hypothesis (continued)
B. Empirical Evidence
i. Generally favorable
• Performance of Investment Analysts and Mutual
Funds
• Stock prices reflect publicly available information.
• Stock prices follow random-walk.
Topic 6, page 30
ECO350 • Money and Banking
• Stock prices follow random-walk.
ii. Anomalies
• Small-Firm Effect
• January Effect
• Market Overreaction
• Excessive Volatility
• Mean Reversion
Department of Economics, SUNY
4. Speculative Bubbles
A. Speculative Bubble: the price of an asset differs from its
fundamental (intrinsic) market value.
i. Prices rise today because investors expect them to
rise tomorrow, regardless of fundamentals.
(overconfidence and social contagion)
• P is high because investors expect P to be even
Topic 6, page 31
ECO350 • Money and Banking
• Pt is high because investors expect Pt+1 to be even
higher.
• Pt+1 is expected to be high because investors
expect Pt+2 to be even higher.
Department of Economics, SUNY
4. Speculative Bubbles (continued)
B. Speculative bubbles can be consistent with rational
expectations.
• Stock market crashes (or the bursting of the bubble)
are unpredictable and so there are no unexploited
profit opportunities.
Topic 6, page 32
ECO350 • Money and BankingDepartment of Economics, SUNY
4. Speculative Bubbles (continued)
B. Speculative bubbles can be consistent with rational
expectations.
• Stock market crashes (or the bursting of the bubble)
are unpredictable and so there are no unexploited
profit opportunities.
C. Strong version of efficient market hypothesis: Forecasts
Topic 6, page 33
ECO350 • Money and Banking
C. Strong version of efficient market hypothesis: Forecasts
are rational, and there are no speculative bubbles.
Department of Economics, SUNY
Topic 6, page 34
Was there a speculative bubble in housing in the early 2000s?
S&P/Case-Shiller Housing Price Index
225.54
150
200
250
ECO350 • Money and BankingDepartment of Economics, SUNY
http://www2.standardandpoors.com/spf/pdf/index/CSHomePrice_History_122622.xls
123.93
62.82
0
50
100
Jan-
87
Jan-
89
Jan-
91
Jan-
93
Jan-
95
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97
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99
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01
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03
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05
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07