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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 FinanceValue 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 priceThe market price will be set by the buyer who can take best advantage of the assetSuperior informatio
3、n 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 revise t
4、heir 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 expectation
5、s 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 make th
6、e expectation the best guess possibleBest 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 change as well
7、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 it.The ex
8、pected return then isExpectations of future prices are equal to optimal forecasts using all currently available information soSupply 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 the optimal
9、forecast of a securitys return using all available information equals the securitys equilibrium returnIn an efficient market, a securitys price fully reflects all available information,Rationale,Efficient Market holds even if are uninformed, irrational participants in market,Stronger Version of the
10、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 securitys price reflects
11、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 Evidence1.Investment analysts and mutual funds dont beat the market2.St
12、ock prices reflect publicly available information: anticipated announcements dont affect stock price3.Stock prices and exchange rates close to random walk4.Technical analysis does not outperform market,Unfavorable Evidence,1.Small-firm effect: small firms have abnormally high returns2.January effect
13、: high returns in January3.Market overreaction4.Excessive volatility5.Mean reversion6.New information is not always immediately incorporated into stock pricesOverviewReasonable starting point but not whole story,Application Investing in the Stock Market,Recommendations from investment advisors canno
14、t help us outperform the marketA hot tip is probably information already contained in the price of the stockStock prices respond to announcements only when the information is new and unexpectedA “buy and hold” strategy is the most sensible strategy for the small investor,7.5 Behavioral Finance,It ap
15、plies 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 aversionThe large trading volume may be explained by investor overconfidenceStock market bubbles may be explained by overconfidence and social contagion,
