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Reading: Siklos Chapter 14 The Stock Market and Stock Prices Overview Basics of Stock Markets Explaining Stock Price Behaviour: Efficient Markets & Fundamentalists Stock Market Volatility The Home-bias in Stock Purchases International Stock Price Linkages Notation

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Reading: Siklos Chapter 14

The Stock Market and Stock Prices


Overview l.jpg
Overview

  • Basics of Stock Markets

  • Explaining Stock Price Behaviour:

    • Efficient Markets & Fundamentalists

  • Stock Market Volatility

  • The Home-bias in Stock Purchases

  • International Stock Price Linkages


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Notation

Note that many stocks do not pay dividends. Buyers of the stock expect that the firm will pay dividends some day.


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Computing the Price of Common Stock

  • Basic Principle of Finance

    Value of Investment = Present Value of Future Cash Flows

  • One-Period Valuation Model

(1)


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Exercise 1

Intel Share Price

12% return is required on equity

16 cent dividend to be paid next year.

$10 share price forecasted for next year


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Generalized Dividend Valuation Model

  • Since last term of the equation is small, Equation 2 can be written as

(2)

(3)


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Theory of Rational Expectations

Rational expectation (RE) = expectation that is optimal forecast (best prediction of future) using all available information: i.e., RE 

Xe = Xof

2 reasons an expectation may not be rational

1. Not best prediction

2. Not using available information


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  • Rational expectation, although optimal prediction, may not be accurate

  • Rational expectations makes sense because it is costly not to have optimal forecast

    Implications:

    1. Change in way variable moves, changes the way expectations are formed

    2. Forecast errors on average = 0 and are not predictable (i.e. forecasters do not make persistent mistakes and they learn from previous mistakes immediately)


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Theories of Stock Price Determination be accurate

  • Efficient Markets Hypothesis – an application of rational expectations theory.

  • Expectations about stock prices will be identical to optimal forecast using all available information.

  • Three forms (vary based on definition of “all available information”):

    • weak form, semi-strong form, strong form


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Notation be accurate


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Efficient Markets Hypothesis: be accurateWeak form

Investors have an “information set” on which

“expectations” of future stock prices are formed

E(Pt+1| Pt, Pt-1,…)=Pt

If the past history of stock prices is known then

E(Pt+1) = Pt so that Pt+1=Pt+Ut giving rise to the random

walk of stock prices




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Efficient Markets Hypothesis (cont’d) be accurate

  • Semi-strong form expands the Information set to include other fundamental macroeconomic variables such as interest rates, inflation, money growth,….)

  • The strong form would incorporate private or insider information. This would most severely limit the profitable opportunities from changes in stock price behaviour


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Interest Rates and Stock Prices be accurate

R

R

LF1

LFs

R P

LF0

LF 2

Stock Price

LF


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Efficient Markets Hypothesis be accurate

Pt+1 – Pt + C

RET =

Pt

Pet+1 – Pt + C

RETe =

Pt

Rational Expectations implies:

Pet+1 = Poft+1RETe = RETof (1)

Market equilibrium

RETe = RET* (2)

Put (1) and (2) together: Efficient Markets Hypothesis

RETof = RET*


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Why the Efficient Markets Hypothesis makes sense be accurate

If RETof > RET* Pt, RETof

If RETof < RET* Pt, RETof

until RETof = RET*

1. All unexploited profit opportunities eliminated

2. Efficient Market holds even if there are uninformed, irrational participants in the market


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Evidence on Efficient Markets Hypothesis be accurate

Favorable Evidence

1. Investment analysts and mutual funds don’t beat the market

2. Stock prices reflect publicly available information: anticipated announcements don’t affect stock price

3. Stock prices and exchange rates close to random walk

4. Technical analysis does not outperform market


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Unfavorable Evidence be accurate

1. Small-firm effect: small firms have abnormally high returns

2. January effect: high returns in January

3. Market overreaction

4. Excessive volatility

5. Mean reversion

6. New information is not always immediately incorporated into stock prices

Overview

Reasonable starting point but not whole story


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Implications for Investing be accurate

1. Published reports of financial analysts not very valuable

2. Should be skeptical of hot tips

3. Stock prices may fall on good news

4. Prescription for investor

1. Shouldn’t try to outguess market

2. Therefore, buy and hold

3. Diversify with no-load mutual fund


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A Different but Compatible View: be accurateThe Fundamentalist Approach

  • Related to Gordon Growth Model

  • Stock prices should reflect expectations about the flow of future dividends

  • Assume that dividends reflect profits of the firm

  • Assume a constant opportunity cost of holding money, R.

  • Assume a constant growth rate of dividends, g

  • Assume that dividends paid out forever


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Gordon Growth Model be accurate

  • Assuming dividend growth is constant, Equation 3 can be written as

  • Assuming the growth rate is less than the required return on equity, Equation 4 can be written as

(4)

(5)


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Exercise 2 be accurate

Intel Share Price

12% return is required on equity

16 cent was last dividend paid.

10% dividend growth rate expected.


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The Fundamentalist Approach be accurate

Assumption: the required return on equity, ke, is equal to the market interest rate, R.

Rewriting equation (5),

(6)


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Anomalies and Other features of stock price behaviour be accurate

  • Volatility and its Measurement

  • Price-Earnings Ratio

  • January & other calendar effects

  • Bubbles (South Sea, Mississippi, Tulipmania)

  • International Linkages


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What Causes “Noise” in Stock Markets be accurate

Case 1: Market dominated

by Informed Traders

Noisy

Traders

 LOW VOLATILITY

Inf.

Traders

Noisy Traders

Informed

Traders

Case 2: Market dominated by

Uninformed traders

HIGH VOLATILITY


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Stock Market Volume be accurate



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Summary be accurate

  • Stock market behaviour is governed by the efficient markets hypothesis which comes in the weak, semi-strong and strong forms

  • The Fundamentalist approach explains the determination of stock prices according to the flow of dividends generated by a stock

  • Stock price behaviour is also subject to a number of anomalies and there are a number of other interesting aspects about stock prices


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