Chapter 6
The Stock Market, the Theory of Rational Expectations,
and the Efficient Market Hypothesis
The economics of money, banking, and financial
markets, business school edition (4th edition)
Instructor: Aria Liu
Common Stock Price
Value of stock
Stock
&
Common stock cash flow
Dividend
Sell price
Computing the Price of Common
Stock
The One-Period Valuation Model:
Div1 P1
P0
(1 ke ) (1 ke )
P0 = 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
Q1
Assuming a year-end dividend of $0.11, an expected
sales price of $110, and a required rate of return of
10%, the current price of the stock would be?
• A) $110.11.
• B) $121.12.
• C) $100.10.
• D) $100.11 Answer: C
Computing the Price of Common
Stock
The Generalized Dividend Valuation Model:
The value of stock today is the present value of all future cash flows
D1 D2 Dn Pn
P0 ...
(1 ke )1 (1 ke ) 2 (1 ke ) n (1 ke ) n
If Pn is far in the future, it will not affect P0
Dt
P0
t 1 (1 ke )t
The price of the stock is determined only by the present value of
the future dividend stream
Think~
Coupon bond
Usingdoes
What the same
The strategy used for
Generalized the fixed-payment
Dividend loan:
Valuation Model
looks like? P = price of coupon bond
C = yearly coupon payment
F = face value of the bond
n = years to maturity date
C C C C F
P= . . . +
1+i (1+i) 2 (1+i )3 (1+i ) n (1+i ) n
A future sales price far in the future does not affect the current
stock price because the present value is almost zero
Computing the Price of Common
Stock
The Gordon Growth Model:
D0 (1 g) D1
P0
(ke g) (ke g)
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 the required return on equity
Q2
• Suppose you are thinking about to buy a stock
• Expect to pay $2 next year; market expect firm
growth rate 3%
• You expected a return from this stock for 15%
How much are you willing to pay?
Willing to
Expected
Info known Uncertainty pay
return
Public info: The
You market expect firm High 15% 16.67
growth rate 3%
Investor 1
Father of Insider info Medium 12% 22.22
insider
Investor 2
Much more insider
Insider Low 10% 28.57
info
himself
Investor 2 bid against other investors because of the
highest bid price!
Current market price= 28.57
How the Market Sets Stock Prices
-buyer’s demand
• The price is set by the buyer willing to pay the
highest price.
• Superior information about an asset can increase its
value by reducing its perceived risk (uncertainty).
What will happen to the stock price, if a credit
rating institution released an info that it
downgrading the company because of the
company’s poor ability on pay back its debt?
Negative info
Pessimistic expectation
Current market price change
28.75↓
How the Market Sets Stock Prices
- information
• 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.
Case 1: The Monetary Policy and the
Stock Market
The Gordon Growth Model suggested that:
D0 (1 g) D1
P0
(ke g) (ke g)
D0 = the most recent dividend paid
Return on bond ↓ Supply &
g = the expected constant
investor’s growth rate in dividends
required demand
returnreturn
ke = the required (k) ↓onP an
↑ investment in equity
perspective
When i How will P change if i decrease?
Dividends are assumed to continue growing at a constant rate forever
↓
Stimulate
The growth rate is assumed economy
to be less than the required(low
return on equity
borrowing cost), growth rate in
dividend (g) ↑ P ↑
Case 2: The Global Financial Crisis
and the Stock Market
The financial crisis that started in August 2007
↓
Downward revision of growth prospects: ↓g
Increased uncertainty: ↑ke
↓
Gordon model predicts a decrease stock prices.
Theory of Rational Expectations
Adaptive expectations
Adaptive expectations (1950s and 1960s)
Most widely used theory to describe the information of business and consumer
expectations
• Expectations = experience only.
• Data changes→ Changes in expectations will occur
slowly over time.
Limitations:
However, people use more than just past data to form
their expectations and change their expectations quickly.
Case 3: U.S. housing bubble
What would people
expect about the P
under the adaptive
theory?
P
Now
本人在房地产行业
卧底多年，深知行
业内幕。现在不买
无所谓，之后涨了
别后悔~
T
The Theory of Rational Expectations
Rational Expectations
• Expectations= optimal forecasts using all
available info.
• prediction based on rational expectation may
not always be perfectly accurate.
Case 4: Joe the commuter
- leave for work during rush hours
Less Average Heavy Rush Unpredictable
Conditions
traffic traffic traffic Hour event- accident
Travel time 25mins 30mins 35mins 40mins 2h + 40mins
Optimal Rational: Does this make
forecast √
Accurate
on average joe’s forecast
irrational?
What makes it irrational:
Under what
Not part of the all available info condition does
It takes too much effort to make their expectation the it make 40mins
best guess. & 2h + 40mins
rational?
Formal Statement of the Theory
X e X of
X e expectation of the variable that is being forecast
of
X = optimal forecast using all available information
Rationale Behind the Theory
• The incentives for are especially 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
↓
The efficient market hypothesis
or The theory of efficient capital markets
Implications of the Theory
1. 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.
• Changes in the conduct of monetary policy
2. The forecast errors of expectations will, on
average, be zero and cannot be predicted ahead of
time.
