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1、Chapter 7The Stock Market,The Theory of Rational Expectations,and the Efficient Markets Hypothesis 2005 Pearson Education Canada Inc.(1)Computing the Price of Common StockBasic Principle of FinanceValue of Investment=Present Value of Future Cash FlowsOne-Period Valuation Model 2 2005 Pearson Educati
2、on Canada Inc.Generalized Dividend Valuation ModelSince last term of the equation is small,Equation 2 can be written as(3)(2)3 2005 Pearson Education Canada Inc.Gordon Growth ModelAssuming dividend growth is constant,Equation 3 can be written asAssuming the growth rate is less than the required retu
3、rn on equity,Equation 4 can be written as(5)(4)4 2005 Pearson Education Canada Inc.Theory of Rational ExpectationsRational expectation(RE)=expectation that is optimal forecast(best prediction of future)using all available information:i.e.,RE Xe=Xof2 reasons expectation may not be rational1.Not best
4、prediction2.Not using available informationRational expectation,although optimal prediction,may not be accurateRational expectations makes sense because is costly not to have optimal forecastImplications:1.Change in way variable moves,way expectations are formed changes2.Forecast errors on average=0
5、 and are not predictable5 2005 Pearson Education Canada Inc.Efficient Markets HypothesisPt+1 Pt+CRET=Pt Pet+1 Pt+CRETe=PtRational Expectations implies:Pet+1=Poft+1 RETe=RETof(1)Market equilibriumRETe=RET*(2)Put(1)and(2)together:Efficient Markets HypothesisRETof=RET*Why the Efficient Markets Hypothes
6、is makes senseIf RETof RET*Pt,RETof If RETof R*predictions of P small4.Technical analysis does not outperform marketUnfavorable Evidence1.Small-firm effect:small firms have abnormally high returns2.January effect:high returns in January3.Market overreaction4.Excessive volatility5.Mean reversion6.New
7、 information is not always immediately incorporated into stock pricesOverviewReasonable starting point but not whole story7 2005 Pearson Education Canada Inc.Implications for Investing1.Published reports of financial analysts not very valuable2.Should be skeptical of hot tips3.Stock prices may fall
8、on good news4.Prescription for investor1.Shouldnt try to outguess market2.Therefore,buy and hold3.Diversify with no-load mutual fundEvidence on Rational Expectations in Other Markets1.Bond markets appear efficient2.Evidence with survey data is mixedSkepticism about quality of data3.Following implication is supported:change in way variable moves,way expectations are formed changes8 2005 Pearson Education Canada Inc.