7 Flashcards
What is common stock?
Common stock is the primary way to raise equity capital
what 3 rights to stockholders have
voting rights
right to residual claims on cash flows
right to receive dividends.
What are the three models for computing stock prices?
One-Period Valuation Model
Generalized Dividend Valuation Model
Gordon Growth Model
What gives stocks their value?
Stocks have value because they pay dividends and can increase in price, generating capital gains.
What is the One-Period Valuation Model formula?
P0=DI/(1+ke)+ P1/(1+ke)
P0 = Current stock price
π·1 = Dividend at the end of period 1
π1= Stock price at end of period 1
ππ= Required return on equity
How do you interpret the One-Period Valuation Model result?
If the computed stock price is greater than the market price, the stock is undervalued, and you should buy.
What is the Generalized Dividend Valuation Model?
It extends the One-Period Model to multiple periods:
π0=ββ π·π‘ / (1+ππ)^π‘
this model assumes stock value is based only on future dividends.
What is the main criticism of the Generalized Dividend Valuation Model?
Many stocks, especially growth stocks, do not pay dividends.
What assumptions does the Gordon Growth Model make?
Dividends grow at a constant rate π.
The growth rate π is less than the required return ππ
What is the Gordon Growth Model?
A simplification of the Generalized Dividend Model assuming dividends grow at a constant rate:
π0=D1 / (ππβπ)
g = constant dividend growth rate
ππ>π to ensure realistic growth assumptionsβ
How are stock prices set in the market?
Stock prices are determined by interaction among buyers and sellers, specifically by:
The buyer willing to pay the highest price (auction).
The buyer who can best utilize the asset (information advantage).
Why is information important in stock pricing?
Superior information reduces uncertainty about future cash flows, leading to lower perceived risk and higher stock value.
How does monetary policy affect stock prices?
Lower interest rates β Lower return on bonds β Lower required return on equity β Higher stock prices.
Lower interest rates β Economic stimulus β Higher dividend growth rate (g) β Higher stock prices.
How did the Global Financial Crisis (2007-08) affect stock prices?
Decreased growth prospects β Lower π.
Increased uncertainty β Higher ππ
According to the Gordon Model, this led to lower stock prices.
What are the two types of expectations in economic theory?
Adaptive Expectations β Formed using past data, changing slowly over time.
Rational Expectations β Formed using all available information, aiming for the best possible forecast.
What is the Rational Expectations Hypothesis (REH)?
It states that individuals use all available information to make the best possible forecast, but forecasts may not always be accurate.
Why might rational expectations be inaccurate?(3)
High effort required to use all information.
Lack of awareness of available information.
Some information may not be available at all.
what is the formal statement of the rational expectation theory
Xe = Xof
Xe = expectation of variable X
Xof = optimal forecast using all available information
What is the Efficient Market Hypothesis (EMH)?
It states that security prices fully reflect all available information, meaning no investor can consistently achieve above-average returns using public data.
How is the rate of return (π ) on a security calculated?
R= (Pt+1 - Pt +C)/Pt
Pt = price at time t
Pt+1 = price at time t+1
C=cash payment (dividend/coupon)
β
What are the implications of the Efficient Market Hypothesis (EMH)? (3)
Prices adjust quickly to new information.
Changes in stock prices are unpredictable (random walk).
Investors cannot consistently outperform the market using public information.
How is the equilibrium return π β in financial markets determined?
Expected return = Equilibrium return β π π=π β
Rational expectations β π π=π ππ
Efficient market β π ππ=π β
In an efficient market, security prices fully reflect all available information.
What is arbitrage in financial markets?
Arbitrage is the process of eliminating unexploited profit opportunities.
Pure arbitrage (riskless) and risk-bearing arbitrage exist.
Efficient markets eliminate arbitrage opportunities.
What happens when arbitrageurs exploit profit opportunities?
If π ππ>π β β Demand increases β Price ππ‘ rises β π ππ falls.
If π ππ<π β β Demand decreases β Price ππ‘ falls β π ππ rises.
Arbitrage continues until π ππ=π β
What evidence supports market efficiency?
Investment analysts & mutual funds do not consistently outperform the market.
Publicly available information is already reflected in stock prices.
Stock prices follow a random walk, making future prices unpredictable.
Technical analysis is ineffective at predicting price changes.
What are some arguments against market efficiency (5)
Small-firm effect: Small stocks tend to outperform large ones.
January effect: Stock prices tend to rise in January.
Market crashes & bubbles: Prices deviate significantly from fundamental values.
Excessive volatility: Prices fluctuate more than justified by fundamentals.
Delayed incorporation of information into stock prices.
What is behavioral finance?
Behavioral finance applies psychology to financial markets, explaining irrational investor behavior.
How do psychological biases impact market efficiency?
Loss aversion: Investors fear losses more than they desire gains β reluctant to short stocks.
Overconfidence: Investors believe they have superior knowledge β excessive trading.
Contagion: Herd behavior leads to speculative bubbles
