Stock Markets, Rational expectations and Efficient Market Hypothesis Chap 7, Mishkin 1

2 Chap discusses the Generalized Dividend Valuation Model of pricing stocks the Gordon Growth Model of pricing stocks the theory of Rational Expectations the Efficient Market Hypothesis implications

Mathematical digression The chapter assumes familiarity with infinite geometric series. Hence we begin by revisiting that formula. We used the formula to find the YTM of a consol in Chap 4. The formula is discussed in footnote 3 in Chap 4. It is better for you in this chapter to try and understand where that formula is coming from, mathematically. 3

4 Example: Calculating the YTM on consols using the formula on the previous slide:

5 I. Pricing common stocks: the Generalized Dividend Valuation Model Uses the fundamental theorem of finance:

6 By the fundamental theorem of finance, the price of the stock at date n equals Hence stock price at date 0 equals Conclusion:

7 II. Pricing common stocks: the Gordon Growth Model Assumes dividends to Dividend streams are given by Substituting into the expression for stock price Using geometric series formula Assumption needed for this model to work:

8 Role of information in forming expectations and pricing stocks Under competitive markets, market prices are set by In the stock pricing formulas on the previous slide, the market price will be determined by Who are these people? more information = If more information works in favor of a specific stock,

9 III. How do people process information? The rival theories of Adaptive and Rational expectations The theory of Adaptive Expectations: The theory of Rational Expectations:

10 Implications of Rational Expectations theory Can forecasts go wrong? way in which expectations of the variable are formed will change if forecast errors of expectations on average

11 IV. The Efficient Market Hypothesis: Rational Expectations theory in practice The Efficient Market Hypothesis in brief: Understanding the efficient market hypothesis with the one period rate of return on bonds (stocks)

12 Arbitrage and market efficiency: the rationale behind the Efficient Market Hypothesis arbitrage = arbitrage and the market mechanism

13 A practitioner’s dictionary: market fundamentals speculative bubbles short sales

14 V. Implications of the Efficient Market Hypothesis (some practical tips for you!): 1.Should you listen to investment advisors? 2.Should you be skeptical of hot tips? 3.What is a “smart” strategy to make money?