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Lecture 10

# Economics 2154A/B Lecture 10: Econ 2154 – Textbook Notes – Midterm 2

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Department
Economics
Course Code
Economics 2154A/B
Professor
Desmond Mc Keon

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Econ 2154 – Textbook Notes – Midterm 2
Chapter 7
Computing the price of a common stock
Shareholder
Those who hold stock in a corporation
Residual claim: receive whatever remains after all other claims of the firms
assets have been satisfied
Dividends: payments made periodically, upon the recommendation of
management
One Period Valuation Model:
P0 = Div1/(1+K) + P1/(1+K)
Generalize Dividend Valuation Model:
P0 = D1/(1+k1) + D2/(1+k2) + … + Dn/(1+kn) + Pn/(1+kn)
Gordon Growth Model:
P0 = D1/(k-g)
1. Dividends are assumed to continue growing at a constant rate forever
2. The growth rate is assumed to be less than the required return on equity
Price-Earnings Valuation Method
1. How much the market is willing to pay for \$1 of earnings from a firm
2. A higher than average PE may meant that the market expects earnings to rise in
the future. This would return the PE to a more normal level
3. A high PE may alternatively indicate that the market feels the firm’s earnings are
very low risk and is therefore willing to pay a premium for them
P/E x E = P
How the market sets the Stock 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 information about an asset can increase its value by reducing its risk
Each investor has a different required return leading to differing valuations of the stock
New information leads to changes in expectations and therefore changes in price
Stock prices are constantly changing
Monetary Policy and Stock Prices
Monetary policy is an important determinant of stock prices
Gordon Growth model shows two ways in which monetary policy affects stock prices
A decrease in interest rates lowers the return on bonds and this leads to a decrease in
required rate of return on an investment in equity leads to an increase in stock prices
A decrease in interest rates stimulates economy leading to an increase in the growth
rate leads to an increase in stock prices
1950s and 1960s economists believed in adaptive expectations
Adaptive expectations mean that expectations were formed from past experience only
Changes in expectations occur slowly over time
Mathematical formation of hypothesis shows that expected value at time “t” is weighted
average of current and past values
The smaller the weights the longer that past events affect current expectations
Theory of Rational Expectations
Expectations will be identical to optimal forecast using all available information
Even though a rational expectation equals the optimal forecast using all available
information, a prediction based on it may not always be perfectly accurate
It takes too much effort to make the expectation the best guess possible
Best guess will not be accurate because predicator is unaware of some relevant
information
Xe (expectation of the variable that is being forecast) = Xof (Optimal forecast using all
available information)
Implications
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
The forecast errors of expectations will, on average, be zero and cannot be
Efficient Markets: Rational Expectations in Financial Markets
Current prices in a financial market will be set so that the optimal forecast of security’s
return using all available information equals the security’s equilibrium return
In an efficient market, a security’s price fully reflects all available information and all
profit opportunities will be eliminated
Caveat: Not everyone in an financial market must be well informed about a security or
have rational expectations for the efficient market condition to hold
Stronger Version of the Efficient Market Hypothesis
Efficient markets are rational (optimal forecasts using all available information)
Also requires prices to reflect true fundamental (Intrinsic) value of the securities
In an efficient market prices are always correct and reflect market fundamentals
Application: Practical guide to investing in the Stock Market
Recommendations from investment advisors cannot help us outperform the market
A hot tip is probably information already contained in the stock price
Stock prices respond to announcements only when the information is new and
unexpected
A “buy and hold” strategy is the most sensible strategy for a small investor
Behavioural Finance
The lack of short selling (causing over-priced stocks) may be explained by loss aversion
The large trading volume may be explained by investor confidence
Stock market bubbles may be explained by overconfidence and social contagion
Forms of market efficiency
Efficient Markets Hypothesis
Weak Form:
Investors have an “Information” set on which “expectations” of future stock prices
are formed
Semi-Strong:
Form expands the information set to include other fundamental macroeconomic
variables such as interest rates, inflation, money, growth… etc.
Strong-From:
Incorporate private of insider information. Would severely limit the profitable
opportunities from changes in stock behaviour
What Causes “Noise” In stock markets?
Case 1: Market dominated by informed traders = Low volatility
Case 2: Market dominated by noisy traders = High Volatility
Chapter 8
1. Stocks are not the most important sources of external financing for businesses
2. Issuing marketable debt and equity securities is not the primary way in which
3. Indirect finance is many times more important than direct finance
4. Financial intermediaries are the most important source of external funds
5. The financial system is among the most heavily regulated sectors of the
economy
to finance their activities
7. Collateral is a prevalent feature of debt contracts
8. Debt contracts are extremely complicated legal documents that place substantial
restrictive covenants on borrowers

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