Stock Market and Rational Expectation Flashcards
Week 5
What is Common Stock? What does holding common stock mean for investors?
- Common stock is the principal way to raise capital
- Gives the stock holder an opportunity to own part of the company
What do stock holders have the right to?
- Stockholders have the right to vote on company ideas in an AGM
- Stockholders have the right to receive dividends
- Stockholders have the right to receive earnings after claimants are satisfied
What are the three computations of a stock price?
- One-Period Valuation Model
- Generalised Dividend Value Model
- Gordon Growth Model
What two principals gives stocks value?
- They pay dividends
- Their value may rise in value, which could generate gains
What is the equation for a One-Period Valuation Model? When would you buy/sell a stock?
- P0 = [Div1] / 1 + Ke + [P1] / 1 + Ke
- Where Ke is the required return on equity and x0/x1 is anything at the start/end of the period
- If the cashflow > price to buy, then you should buy the stock
- However, risk is associated due to the different level of investor’s risk appetite
What is the equation for a Generalised dividend value Model? Give economic intuition
- P0 = Σ[Divn] / (1+Ke)^n + “Pn / (1+Ke)^n”
- If n is large, Pn won’t affect P0
- The price of a stock will only be determined by the present values of the dividends- as some don’t pay dividends
- The model argues that all stocks will eventually pay dividends
What is the equation for a Gordon Growth Model? What are some of the assumptions of the model?
- Assumptions: Dividends continue growing at rate g forever and g<Ke
- P0 = Div1 / (Ke - g)
What happens when the Central Bank Raises the base rate?
- If C.B raises the interest rate, this lowers the return on bonds and therefore the demand and the price for stocks increase
- Similarly, if C.B raises the interest rate, economic growth also increases, which causes g to rise and the price for the stocks also increase
How do markets set prices
- Prices are set by interactions between buyers and sellers
- This can either be by what the maximum that a buyer is willing to pay or by the buyer who takes the best advantage of the assets
How does risk and market price interact?
- Superior information about an asset can increase its value by decreasing its risk
- Buyers with better information of a stock will discount cash-flows at lower interest rates
What is the theory of rational expectations?
- All decisions are based on present values and predictions for future values
What are adaptive expectations? What can be an issue with this policy?
- Changes in expectation occur every time as past data changes
- E.g. inflation rate
- However, other things are used to make predictions
What are rational expectations? What can be an issue with this policy?
- Expectations are identical to the most optimal forecast
- Forecast error (Eπ - OFπ) is on average 0
- However, forecasts aren’t always perfectly accurate
- It can also be tough to obtain this information
What is the Efficient Market Hypothesis? What is the formula for EMH?
- EMH assumes expectations of future prices are equal to optimal forecasts, so is an application of this
- This shows that:
R(e) = [P(et+1) - P(et) + c] / Pt
What is Arbitrage? How does it work?
- Arbitrage is a market mechanism where participants eliminate unexploited profit opportunity
- This is an issue, as it is riskless
- Efficient makrets have no arbitrage
- If the optimal forecast returns more than R, Pt rises and return optimal forecast falls until = R
