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Lecture 10

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

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Economics 2154A/B
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: 1 P0 = Div(1+K) + P1(1+K) Generalize Dividend Valuation Model: 1122nnnn P0 = D(1+k) + D(1+k) + + D(1+k) + P(1+k) Gordon Growth Model: P0 = D1(kg) 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 PriceEarnings 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 firms earnings are very low risk and is therefore willing to pay a premium for them PE 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 pricesGordon 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 Adaptive Expectations 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 e of X(expectation of the variable that is being forecast) = X(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 predicted ahead of time Efficient Markets: Rational Expectations in Financial Markets Current prices in a financial market will be set so that the optimal forecast of securitys return using all available information equals the securitys equilibrium return In an efficient market, a securitys 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
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