Ch 7 Flashcards
The theory of rational expectations
When this theory is applied to financial markets, the outcome is the efficient market hypothesis, which has some general implications for how markets in other securities besides stocks operate.
Stockholders
those who hold stock in a corporation own an interest in the corporation equal to the percentage of outstanding shares they own .
residual claimant
the right to vote and to claim all funds flowing in to the firm (cash flows) meaning that the stockholder receives whatever remains after all other claims agains the firm’s assets have been satisfied.
Dividends
are payments made periodically, usually every quarter, to stock holders. The board of directors of the firm sets the level of the dividend, usually based on the recommendation of management. Stockholders has the right to sell the stock.
one-period valuation model
You buy the stock, hold it for one period to get a dividend, then sell the stock.
The generalized dividend valuation model
Using the present value concept we can extend the one-period concept to any number of periods.
The gordon growth model
A simplified model to make the calculations easier and assumes constant dividend growth.
how does monetary policy affect stock prices?
The gordon growth model in equation 5 explains this relationship. Monetary policy can affect stock prices in two ways: First when the Fed lowers interest rates, the return on bonds (an alternative asset to stocks) declines, and investors are likely to accept a lower required rate of return on an investment in equity (ke). The resulting decline in ke lowers the denominator in the Gordon growth model , leads to a higher value of P0 and the rise in stock prices.
Adaptive expectations
The view of expectation formation, suggests that changes in expectations will occur slowly over time, as data for a variable evolve. So, if inflation had formerly been steady at a 5% rate expectations of future inflation would be 5 % also. If inflation rose to a steady rate of 10%, expectations of future inflation would rise toward 10% but slowly; in the first year, expected inflation might rise only to 6%; in the second year to 7% and so on.
Rational expectations
Expectations will be identical to optimal forecasts (the best guess of the future) using all available information.
How expectations are formed in a situation that most of us will encounter at some point.
Our drive to work., Suppose that if Joe Commuter travels when it is not rush hour, his trip takes an average of 30 min. Sometimes his trip takes 35mins; other times, 25 minutes; but the average, non-rush-hour driving time is 30mins. If, however, Joe leaves for work during the rush hour, it takes him, on average, an additional 10 minutes to get to work. . Given that he leaves for work during the rush hour, the best guess of his driving time- the optimal forecast is 40 mins.
Important point about rational expectations
Even though a rational expectation equals the optimal forecast using all available information, a prediction based on it may not always be perfectly accurate.
Accordingly, an expectation may fail to be rational for two reasons:
- People might be aware of all available information but find it takes too much effort to make their expectations the best guess possible.
- People might be unaware of some available relevant information, so their best guess of the future will not be accurate.
