Chapter 7: The Stock Market, the Theory of Rational Expectations and Efficient Market Hypothesis Flashcards
The Dividend-Discount Model
- A One-Year Investor
- A Multi-Year Investor
Constant Dividend Growth
• The simplest forecast for the firm’s future dividends states that they will grow at a constant rate, g, forever
Limitations of the Dividend-Discount Model
- There is a tremendous amount of uncertainty associated with forecasting a firm’s dividend growth rate and future dividends.
- Small changes in the assumed dividend growth rate can lead to large changes in the estimated stock price.
• Information in Stock Prices
Our valuation model links the firm’s future cash flows, its cost of capital, and its share price. Given accurate information about any two of these variables, a valuation model allows us to make inferences about the third variable.
Information in Stock Prices (accurate?)
For a publicly traded firm, its current stock price should
already provide very accurate information, aggregated from a multitude of investors, regarding the true value of its shares.
• Based on its current stock price, a valuation model will tell us something about the firm’s future cash flows or cost of capital.
How the Market Sets Stock Prices
- The price is set by the buyer willing to pay the highest price.
- The market price will be set by the buyer who can take best advantage of the asset.
- Superior information about an asset can increase its value by reducing its perceived risk.
- Information is important for individuals to value each asset.
- 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
Adaptive expectations:
- Expectations are formed from past experience only.
- Changes in expectations will occur slowly over time as data changes.
• However, people use more than just past data to form
their expectations and sometimes change their
expectations quickly.
The Theory of Rational Expectations
• 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.
The Efficient Market Hypothesis: Rational Expectations in Financial Markets
• 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.
How Valuable are Published Reports by Investment Advisors?
- Information in newspapers and in the published reports of investment advisers is readily available to many market participants and is already reflected in market prices.
- Acting on this information will not yield abnormally high returns, on average.
• The empirical evidence for the most part confirms that recommendations from
investment advisers cannot help us outperform the general market.
market fundamentals
items that have a direct impact on future income
streams of the securities
Behavioral Finance
- What is it?
Study that seeks to combine psychology, sociology and traditional finance
- Acknowledges that investors are not perfectly rational
- Allows for psychological factors of behavior
- Applies results from experiments on risk taking
Helps explain why people make irrational financial decisions
