1. Mishkin/Serletis
The Economics of Money, Banking, and Financial Markets Sixth Canadian Edition
Chapter 7
The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis

2. Learning Objectives
Calculate the price of common stock and recognize the impact of new information on stock prices
Distinguish adaptive and rational expectations
Explain why arbitrage opportunities imply the efficient market hypothesis holds
Identify and explain the implications of the efficient market hypothesis for financial markets

3. Common Stock
Common stock is the principal way that corporations raise equity capital
Stockholders have the right to vote and be the residual claimants of all funds flowing to the firm
Receives whatever remains after all other claims against the firm’s assets have been satisfied
Dividends are payments made periodically, usually every quarter, to stockholders
Set by board of directors

4. Stock Indexes TSX (Toronto Stock Exchange) 2nd most listings worldwide
12th largest in world by capitalization
Has heavy emphasis on mining and oil & gas companies than any other exchange
NASDAQ (National Association of Securities Dealers Automated Quotations)
2nd largest in world by market capitalization and volume
Was world’s first electronic stock market (reflecting over-the-counter sales)

5. Stock Indexes Dow Jones Industrial Average (US)
Includes 30 major US corporations
Does not reflect market capitalization but rather the sum of the price of one share for each of the 30 firms
Index= sum of prices/ DJ ‘divisor’ (value changes when stocks split or stock dividend)
S & P 500
Includes 500 large companies in US and is based on market capitalization
Link to explain calculation of DJIA and S&P 500 Indexes

6. Stock Valuation: One-Period Valuation Model
PO = the current price of the stock
DIV1 = the dividend paid at the end of year 1
ke = the required return on investment in equity
P1 = the sale price of the stock at the end of the first period

7. Practice Question
A friend recommends purchasing shares in XYZ Corporation because it is ‘a good deal’ at $43/share. The stock pays a dividend of $2.50/share per year and analysts predict the stock price will be $46/share next year.
Questions:
1) If your required return on equity is 15%, what is your valuation of the value of the stock?
2) Do you buy the stock?
3) Why would your friend view the stock price as ’a good deal’?

8. Generalized Dividend Valuation Model
The value of stock today is the present value of all future cash flows
If Pn is far in the future, it will not affect P0
The price of the stock is determined only by the present value of the future dividend stream

9. Practice Question: Generalized Dividend Valuation Model
Consider company XYZ, it is expected to pay dividends of $10/share, $12/share, $14/share, $17/share and $20/share in the next five years. What would be the price you would be willing to pay for stock of XYZ company if your discount rate is 15%?

10. Gordon Growth Model D0 = the most recent dividend paid
g = the expected constant growth rate in dividends
ke = the required return on an investment in equity
Dividends are assumed to continue growing at a constant rate forever
The growth rate is assumed to be less than required return on equity

11. Application: The Global Financial Crisis and the Stock Market
Financial crisis that started in August 2007 led to one of the worst bear markets in 50 years
Downward revision of growth prospects: ↓g
Increased uncertainty: ↑ke
Gordon model predicts a drop in stock prices

12. Practice Question:
Calculate the current market price of shares in XYZ Corporation assuming dividends grow at 8% per year, the last dividend paid was $1.50/share and the desired return on equity is 15%.

13. How the Market Sets Prices
Price is set by the buyer with highest willingness to pay
Typically the buyer who can take best advantage of the asset
The role of information
Superior information about an asset can increase its value by reducing its perceived risk
When new information is released about a firm, expectations and prices change
Market participants constantly receive information and revise their expectations, so stock prices change frequently

14. How the Market Sets Stock Prices
Suppose a firm is expecting to pay $2 dividend/share next year. Analysts expect the firm’s dividends to grow at 3% per year.
Calculate the price each individual is willing to pay for these shares IF: i) individual 1 has a required return on equity of 15%, ii) individual 2’s required return on equity is 12%, and iii) individual 3 has a required return on equity of 10%.
What will the stock price sell for?

15. The Theory of Rational Expectations
Adaptive Expectations:
expectations are formed from past experience only
expectations change slowly over time as data changes
However, people use more than just past data to form their expectations and sometimes change their expectations quickly

16. The Theory of Rational Expectations (cont’d)
Expectations will be identical to optimal forecasts using all 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

17. Formal Statement of the Theory

18. Rationale Behind the Theory
The incentives for equating expectations with optimal forecasts are strong in financial markets
In these markets people with better forecasts of the future get rich
The application of the theory of rational expectations to financial markets (where it is called the efficient market hypothesis or the theory of efficient capital markets) is thus particularly useful

19. Implications of the Theory
Rational expectations theory leads to two implications:
If there is a change in the way a variable moves, the way in which expectations of the variable are formed will change as well
i.e., changes in the conduct of monetary policy
The forecast errors of expectations will, on average, be zero and cannot be predicted ahead of time
Forecast error is X - Xe

20. The Efficient Market Hypothesis: Rational Expectations in Financial Markets
Recall: The rate of return from holding a security equals the sum of the capital gain on the security plus any cash payments divided by the initial purchase price of the security
R = the rate of return on the security
Pt+1 = price at time t+1 (end of the holding period)
Pt = price at time t (beginning of the holding period)
C = cash payment (coupon or dividend) made during the holding period

21. The Efficient Market Hypothesis: Rational Expectations in Financial Markets (cont’d)
At the beginning of the period, we know Pt and C
Pt+1 is unknown and we must form an expectation of it
The expected return then is
Expectations of future prices are equal to optimal forecasts using all currently available information so
Supply and demand analysis states Re will equal the equilibrium return R* so Rof = R*

22. The Efficient Market Hypothesis: Rational Expectations in Financial Markets (cont’d)
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
In an efficient market, a security’s price fully reflects all available information

23. Rationale Behind the Hypothesis
until Rof = R*
In an efficient market all unexploited profit opportunities will be eliminated by arbitrage
Not everyone in a financial market must be well informed or have rational expectations for its price to be driven to the point at which the efficient market condition holds

24. Efficient Market Hypothesis:
Suppose Microsoft closing price yesterday was $90/share but new information was announced after the market was closed that suggests the price forecast for next year will be $120/share. If the annual equilibrium ROR on Microsoft is 15% and Microsoft pays no dividends, the what does the efficient market hypothesis suggest will be the price of Microsoft shares when the market opens today?

25. Random-Walk Behaviour of Stock Prices
Random Walk: the movements of a variable whose future values cannot be predicted
Given today’s value, the value of the variable is just as likely to fall as it is to rise
Important implication of the efficient market hypothesis is that stock prices should approximate a random walk
Future changes in stock prices should, for all practical purposes, be unpredictable

26. How Valuable are Published Reports by Investment Advisors?
Information in newspapers and in the published reports of investment advisers is already reflected in market prices
Acting on this information will not yield abnormally high returns
The empirical evidence confirms that recommendations from investment advisers cannot help us outperform the general market

27. Efficient Market Prescription for the Investor
Recommendations from investment advisors cannot help us outperform the market
A hot tip is probably information already contained in the price of the stock
Stock prices respond to announcements only when the information is new and unexpected
A “buy and hold” strategy is the most sensible strategy for the small investor

28. Why the Efficient Market Hypothesis Does Not Imply that Financial Markets are Efficient
Some financial economists believe all prices are always correct and reflect market fundamentals and so financial markets are efficient
One investment is as good as any other
Prices reflect all information about intrinsic value of security
Prices can be used to assess cost financing real investments
The efficient market hypothesis may be misname, however. Only implies prices are unpredictable, not that they are efficient.