Professional Documents
Culture Documents
The Stock
Market, the
Theory of
Rational
Expectations,
and the Efficient
Market
Hypothesis
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
Example:
Compute the price of the Intel stock if, after a
careful consideration, you decide that you
would be satisfied to earn 12% return on
investment. You are also told that Intel pays
$0.16 per year in dividends and forecast the
share price of $60 for next year.
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
Example:
Find the value of the stock that sells for $50
seventy-five years from now using a 12%
discount rate. Assuming the stock pays no
dividend.
Multiply both sides of the equation with (1+ke)/ (1+g) and subtract from the
original equation
ke > g
• 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 expectations and
sometimes change their expectations
quickly.
X e X of
X e expectation of the variable that is being forecast
X of = optimal forecast using all available information
Recall
The rate of return from holding a security equals the sum of the capital
gain on the security, plus any cash payments divided by the
initial purchase price of the security.
Pt 1 Pt C
R
Pt
R = the rate of return on the security
Pt 1 = price of the security at time t + 1, the end of the holding period
Pt = price of the security at time t , the beginning of the holding period
C = cash payment (coupon or dividend) made during the holding period
P Pt C e
R e t 1
Pt
Expectations of future prices are equal to optimal forecasts using all
currently available information so
P P R R
e
t 1
of
t 1
e of
R of R* Pt R of
R of R* Pt R of
until
R of R*
In an efficient market, all unexploited profit opportunities will
be eliminated