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1、Chapter 7,The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis,7.1 Computing the Price of Common Stock,Basic Principle of Finance Value of Investment = Present Value of Future Cash Flows,7.1.1 One-Period Valuation Model,7.1.2 Generalized Dividend Valuation Model
2、,7.1.3 Gordon Growth Model,7.2 How the Market Sets Prices,Players in the market, bidding against one another, establish the market price. 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 informa
3、tion about an asset can increase its value by reducing its perceived risk,How the Market Sets Prices,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 rev
4、ise their expectations, so stock prices change frequently.,7.3 Theory of Rational Expectations,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 expe
5、ctations and sometimes change their expectations quickly.,Rational Expectations,Rational expectation = expectation that is optimal forecast (best prediction of future) using all available information: Rational expectation, although optimal prediction, may not be accurate. It takes too much effort to
6、 make the expectation the best guess possible Best guess will not be accurate because predictor is unaware of some relevant information,Formal Statement of the Theory,Implications,1. If there is a change in the way a variable moves, the way in which expectations of the variable are formed will chang
7、e as well 2. The forecast errors of expectations will, on average, be zero and cannot be predicted ahead of time.,7.4 Efficient Markets: Application of Rational Expectations,Efficient Markets (contd),At the beginning of the period, we know Pt and C. Pt+1 is unknown and we must form an expectation of
8、 it. The expected return then is Expectations of future prices are equal to optimal forecasts using all currently available information so Supply and Demand analysis states Re will equal the equilibrium return R*, so Rof = R*,Efficient Markets,Current prices in a financial market will be set so that
9、 the optimal forecast of a securitys return using all available information equals the securitys equilibrium return In an efficient market, a securitys price fully reflects all available information,Rationale,Efficient Market holds even if are uninformed, irrational participants in market,Stronger V
10、ersion of the EMH,Add the condition that an efficient market is one in which prices reflect the true fundamental value of the securities. Thus, in an efficient market, all prices are always correct and reflect market fundamentals. Implications: 1. One investment is as good as any other. 2. A securit
11、ys price reflects all available information about the intrinsic value of the security. 3. Security prices can be used to make correct decisions about whether a specific investment is worth making.,Evidence on Efficient Markets Hypothesis,Favorable Evidence 1. Investment analysts and mutual funds don
12、t beat the market 2. Stock prices reflect publicly available information: anticipated announcements dont affect stock price 3. Stock prices and exchange rates close to random walk 4. Technical analysis does not outperform market,Unfavorable Evidence,1. Small-firm effect: small firms have abnormally
13、high returns 2. January effect: high returns in January 3. Market overreaction 4. Excessive volatility 5. Mean reversion 6. New information is not always immediately incorporated into stock prices Overview Reasonable starting point but not whole story,Application Investing in the Stock Market,Recomm
14、endations from investment advisors cannot help us outperform the market A hot tip is probably information already contained in the price of the stock Stock prices respond to announcements only when the information is new and unexpected A “buy and hold” strategy is the most sensible strategy for the
15、small investor,7.5 Behavioral Finance,It applies concepts from other social sciences to understand the behavior of securities prices. The lack of short selling (causing over-priced stocks) may be explained by loss aversion The large trading volume may be explained by investor overconfidence Stock market bubbles may be explained by overconfidence and social contagion,
