Stock Markets, Rational expectations and Efficient Market Hypothesis
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Stock Markets, Rational expectations and Efficient Market Hypothesis Chap 7, Mishkin. Chap discusses the Generalized Dividend Valuation Model of pricing stocks the Gordon Growth Model of pricing stocks the theory of Rational Expectations the Efficient Market Hypothesis implications .

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Presentation Transcript

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  • Chap discusses Hypothesis

  • the Generalized Dividend Valuation Model of pricing stocks

  • the Gordon Growth Model of pricing stocks

  • the theory of Rational Expectations

  • the Efficient Market Hypothesis

  • implications


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Mathematical digression Hypothesis

The chapter assumes familiarity with infinite geometric series. Hence we begin by revisiting that formula. We used the formula to find the YTM of a consol in Chap 4. The formula is discussed in footnote 3 in Chap 4. It is better for you in this chapter to try and understand where that formula is coming from, mathematically.


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Example: HypothesisCalculating the YTM on consols using the formula on the previous slide:


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I. Pricing common stocks Hypothesis: the Generalized Dividend Valuation Model

Uses the fundamental theorem of finance:


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By the fundamental theorem of finance, the price of the stock at date n equals

Hence stock price at date 0 equals

Conclusion:


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II. Pricing common stocks stock at date : the Gordon Growth Model

Assumes dividends to

Dividend streams are given by

Substituting into the expression for stock price

Using geometric series formula

Assumption needed for this model to work:


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Role of information in forming expectations and pricing stocks

Under competitive markets, market prices are set by

In the stock pricing formulas on the previous slide, the market price will be determined by

Who are these people?

more information =

If more information works in favor of a specific stock,


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III. How do people process information? The rival theories of Adaptive and Rational expectations

The theory of Adaptive Expectations:

The theory of Rational Expectations:


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IV. The Efficient Market Hypothesis: Rational Expectations theory in practice

The Efficient Market Hypothesis in brief:

Understanding the efficient market hypothesis with the one period rate of return on bonds (stocks)


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Arbitrage and market efficiency: the rationale behind the Efficient Market Hypothesis

arbitrage =

arbitrage and the market mechanism


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A practitioner’s dictionary: Efficient Market Hypothesis

market fundamentals

speculative bubbles

short sales


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