The Economics of Money, Banking, and
Financial Markets
Twelfth Edition
Chapter 7 – REVIEW
The Stock Market, the
Theory of Rational
Expectations,
and the Efficient Market
Hypothesis
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Common Stock
• A stockholder's ownership of a company's stock gives her
the right to vote and be the residual claimant of all cash
flows.
• Stockholders are residual claimants, meaning that they
receive the remaining cash flow after all other claims are
paid.
• Periodic payments of net earnings to shareholders are
known as dividends. A corporation's dividend payment is
set by its board of directors.
• The value of any investment is found by computing the
present value of all future cash flows.
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Computing the Price of Common Stock (1 of 3)
The One-Period Valuation Model: the value of a share of
stock today depends upon the present value of both the
dividends and the expected sales price.
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
In a one-period valuation model, a decrease in the required
return on investments in equity causes an increase in the
current price of a stock.
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Computing the Price of Common Stock (2 of 3)
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
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Computing the Price of Common Stock (3 of 3)
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
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How the Market Sets Stock Prices (1 of 2)
• 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 information about an asset can increase its value
by reducing its perceived risk.
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How the Market Sets Stock Prices (2 of 2)
• Information is important for individuals to value each asset.
Information plays an important role in asset pricing
because it allows the buyer to more accurately judge risk.
• 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.
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The Theory of Rational Expectations (1 of 2)
• The theory of rational expectations, when applied to
financial markets, is known as the efficient markets
hypothesis. The efficient market hypothesis implies that the
average investor should not expect to receive abnormally
high returns on a consistent basis.
• If a market participant believes that a stock price is
irrationally high, they may try to borrow stock from brokers
to sell in the market and then make a profit by buying the
stock back again after the stock falls in price. This practice
is called short selling.
• Investors tend to trade on their beliefs rather than on pure
facts. This statement might explain why securities markets
have such a large trading volume that the efficient market
hypothesis does not predict.
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The Theory of Rational Expectations (2 of 2)
• Arbitrage occurs when market participants observe returns
on a security that are larger than what is justified by the
characteristics of that security and take action to quickly
eliminate the unexploited profit opportunity.
• The global financial crisis lead to a decline in stock prices
because of a lowered expected dividend growth rate.
• Overconfidence and social contagion may provide an
explanation for stock market bubbles.
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Copyright
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved.
