Topic 6, page 1

Topic 6
The Stock Market

Department of Economics, SUNY ECO 350 • Money and Banking

 Topic 6, page 2

[Background]
A. Common Stock and Stockholders
i. Equity capital, dividends
ii. Residual claimant

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 3

[Background]
A. Common Stock and Stockholders
i. Equity capital, dividends
ii. Residual claimant
B. Basic Principle of Finance
o The value of any investment is found by computing
the present value of all cash flows the investment
will generate over its life.

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 4

[Background]
A. Common Stock and Stockholders
i. Equity capital, dividends
ii. Residual claimant
B. Basic Principle of Finance
o The value of any investment is found by computing
the present value of all cash flows the investment
will generate over its life.
C. Common stock is valued as the value in today’s dollars of
all future cash flows
o The cash flows a stockholder might earn from stock
are---
Department of Economics, SUNY ECO350 • Money and Banking
 Topic 6, page 5

[Background]
A. Common Stock and Stockholders
i. Equity capital, dividends
ii. Residual claimant
B. Basic Principle of Finance
o The value of any investment is found by computing
the present value of all cash flows the investment
will generate over its life.
C. Common stock is valued as the value in today’s dollars of
all future cash flows
o The cash flows a stockholder might earn from stock
are---dividends, the sales price, or both.
Department of Economics, SUNY ECO350 • Money and Banking
 Topic 6, page 6

1. Fundamental Stock Price

A. Fundamental stock price = discounted sum of expected
dividends:
div1e div2e dive3
PSF = + + +…
1+i (1+i)2 (1+i)3

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 7

1. Fundamental Stock Price

A. Fundamental stock price = discounted sum of expected
dividends:
div1e div2e dive3
PSF = + + +…
1+i (1+i)2 (1+i)3

B. Gordon Growth model

i. Constant dividend growth:
e e
div2e = (1+g)dive1; div3 = (1+g)div2 = (1+g)2div1e
div1e
ii. If i > g, PSF =
i–g
iii. If i ≤ g, PSF = ∞.

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 8

1. Fundamental Stock Price (continued)

[Example] D1 = $2, g = 3%

Investor Discount Rate Stock Price

You 15% $16.67
Jennifer 12% $22.22
Bud 10% $28.57

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 9

1. Fundamental Stock Price (continued)

C. How the market sets stock prices
i. The price is set by the buyer willing to pay the
highest price.
• The price is not necessarily the highest price the
asset could fetch. It is incrementally greater than
what any other buyer is willing to pay.
ii. The market price will be set by the buyer who can
take best advantage of the asset.

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 10

1. Fundamental Stock Price (continued)

C. How the market sets stock prices
iii. Superior information about an asset can increase its
value by reducing its risk.
• The buyers who has the best information about
the future cash flows will discount them at a
lower interest rate than will a buyer who is very
uncertain.
D. An Application---Monetary Policy and Stock Prices
i. lower interest rate → lower required rate of return
on equity
ii. lower interest rate → higher g

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 11

2. Rational Expectations
A. Rational expectations: Expectations (predictions) are
statistically optimal forecasts using all available
information.

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 12

2. Rational Expectations
A. Rational expectations: Expectations (predictions) are
statistically optimal forecasts using all available
information.
• Best possible given the available information
• The forecast does not have to be perfectly
accurate to be rational.

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 13

2. Rational Expectations (continued)

[Example] Best possible given the available information

o If a forecaster spends hours every day studying data

to forecast interest rates but his expectations are
not as accurate as predicting that tomorrow’s
interest rates will be identical to today’s interest rate,
are his expectations rational?

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 14

2. Rational Expectations (continued)

[Example] Best possible given the available information

o If a forecaster spends hours every day studying data

to forecast interest rates but his expectations are
not as accurate as predicting that tomorrow’s
interest rates will be identical to today’s interest rate,
are his expectations rational?
o No. Because he could improve the accuracy of his
forecasts, his forecast is not optimal.

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 15

2. Rational Expectations (continued)

[Example] Best possible given the available information

o Whenever it is snowing when Joe Commuter gets up

in the morning, he misjudges how long it will take
him to drive to work. Otherwise, his expectations of
the driving time are perfectly accurate. Considering
that it snows only once every ten years where Joe
lives, Joe’s expectations are almost always perfectly
accurate. Are Joe’s expectations rational?

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 16

2. Rational Expectations (continued)

[Example] Best possible given the available information

o Whenever it is snowing when Joe Commuter gets up

in the morning, he misjudges how long it will take
him to drive to work. Otherwise, his expectations of
the driving time are perfectly accurate. Considering
that it snows only once every then years where Joe
lives, Joe’s expectations are almost always perfectly
accurate. Are Joe’s expectations rational?
o No. He doesn’t take account of a snowfall in his
forecasts.

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 17

2. Rational Expectations (continued)

[Example] The forecast does not have to be perfectly
accurate to be rational.
o “Forecasters’ predictions of inflation are notoriously
inaccurate, so their expectations of inflation cannot
be rational.” Is this statement true, false, or
uncertain?

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 18

2. Rational Expectations (continued)

[Example] The forecast does not have to be perfectly
accurate to be rational.
o “Forecasters’ predictions of inflation are notoriously
inaccurate, so their expectations of inflation cannot
be rational.” Is this statement true, false, or
uncertain?
o False. A forecast is optimal if it is the best possible
even if the forecast errors are large.

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 19

2. Rational Expectations (continued)

B. Implication: The forecast errors of expectations will, on
average, be zero and cannot be predicted ahead of time.

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 20

2. Rational Expectations (continued)

B. Implication: The forecast errors of expectations will, on
average, be zero and cannot be predicted ahead of time.

C. Justification: Suboptimal forecasts are costly.

• How much inventory should Wal-Mart keep?
• In financial markets, people loss money if their
expectations are not rational.

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 21

3. The Efficient Market Hypothesis

A. Efficient Market Hypothesis

i. Rational expectations applied to the pricing of stocks

and other securities
ii. The hypothesis says that: In an efficient market, a
security’s price fully reflects all publicly available
information and all unexpected profit opportunities
will be eliminated.

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 22

3. The Efficient Market Hypothesis

A. Efficient Market Hypothesis

i. Rational expectations applied to the pricing of stocks

and other securities
ii. The hypothesis says that: In an efficient market, a
security’s price fully reflects all publicly available
information and all unexpected profit opportunities
will be eliminated.
iii. Justification: if prices are not rational, there are
unexploited profit opportunities. Ex. R of > R*

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 23

3. The Efficient Market Hypothesis

A. Efficient Market Hypothesis

i. Rational expectations applied to the pricing of stocks

and other securities
ii. The hypothesis says that: In an efficient market, a
security’s price fully reflects all publicly available
information and all unexpected profit opportunities
will be eliminated.
iii. Justification: if prices are not rational, there are
unexploited profit opportunities. Ex. R of > R*
⇒ profits available to investors who buy ⇒ Pt bid up
until R of = R* .

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 24

3. The Efficient Market Hypothesis (continued)

B. Implications of RE/EMH
i. Past values of ret do not predict future values.
ii. Events that were predicted should not affect stock
prices.
iii. Future changes in stock prices should be
unpredictable: Random Walk Hypothesis

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 25

3. The Efficient Market Hypothesis (continued)

[Example] Implications of RE/EMH

o If you read in the Wall Street Journal that the “smart

money” on Wall Street expects stock prices to fall,
should you follow that lead and sell all your stocks?

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 26

3. The Efficient Market Hypothesis (continued)

[Example] Implications of RE/EMH

o If you read in the Wall Street Journal that the “smart

money” on Wall Street expects stock prices to fall,
should you follow that lead and sell all your stocks?
o No, because this is publicly available information and
is already incorporated into stock prices. The optimal
forecast of stock returns will equal the equilibrium
return. Therefore, there is no benefit from selling
your stocks.

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 27

3. The Efficient Market Hypothesis (continued)

[Example] Implications of RE/EMH

o If the public expects a corporation to lose $5 per

share this quarter and it actually loses $4, which is
still the largest loss in the history of the company,
what does the efficient market hypothesis say will
happen to the price of the stock when the $4 loss is
announced?

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 28

3. The Efficient Market Hypothesis (continued)

[Example] Implications of RE/EMH

o If the public expects a corporation to lose $5 per

share this quarter and it actually loses $4, which is
still the largest loss in the history of the company,
what does the efficient market hypothesis say will
happen to the price of the stock when the $4 loss is
announced?
o The stock price will rise. The price of the stock
reflects an even larger expected loss.

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 29

3. The Efficient Market Hypothesis (continued)

B. Empirical Evidence
i. Generally favorable
• Performance of Investment Analysts and Mutual
Funds
• Stock prices reflect publicly available information.
• Stock prices follow random-walk.

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 30

3. The Efficient Market Hypothesis (continued)

B. Empirical Evidence
i. Generally favorable
• Performance of Investment Analysts and Mutual
Funds
• Stock prices reflect publicly available information.
• Stock prices follow random-walk.
ii. Anomalies
• Small-Firm Effect
• January Effect
• Market Overreaction
• Excessive Volatility
• Mean Reversion

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 31

4. Speculative Bubbles
A. Speculative Bubble: the price of an asset differs from its
fundamental (intrinsic) market value.
i. Prices rise today because investors expect them to
rise tomorrow, regardless of fundamentals.
(overconfidence and social contagion)
• Pt is high because investors expect Pt+1 to be even
higher.
• Pt+1 is expected to be high because investors
expect Pt+2 to be even higher.

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 32

4. Speculative Bubbles (continued)

B. Speculative bubbles can be consistent with rational
expectations.
• Stock market crashes (or the bursting of the bubble)
are unpredictable and so there are no unexploited
profit opportunities.

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 33

4. Speculative Bubbles (continued)

B. Speculative bubbles can be consistent with rational
expectations.
• Stock market crashes (or the bursting of the bubble)
are unpredictable and so there are no unexploited
profit opportunities.
C. Strong version of efficient market hypothesis: Forecasts
are rational, and there are no speculative bubbles.

Department of Economics, SUNY ECO350 • Money and Banking

 Topic 6, page 34

Was there a speculative bubble in housing in the early 2000s?

S&P/Case-Shiller Housing Price Index

250
225.54
200

150
123.93
100
62.82
50

0
Jan-87

Jan-89

Jan-91

Jan-93

Jan-95

Jan-97

Jan-99

Jan-01

Jan-03

Jan-05

Jan-07
http://www2.standardandpoors.com/spf/pdf/index/CSHomePrice_History_122622.xls

Department of Economics, SUNY ECO350 • Money and Banking