LEC 5 TOPIC 7 : THE STOCK MARKET

OUTLINE
### Objectives
1. Calculate stock prices using various valuation models.
2. Explain how the market sets stock prices.
3. Clarify the theory of rational expectations.
4. Apply the efficient market hypothesis to stock price changes.
### Common Stocks
- Principal method of equity financing.
- Represents ownership with rights to vote and claim residuals.
- Dividends are periodic payments determined by the board.
### Pricing a Common Stock
- Stock price equals the present value of future cash flows (dividends and sales).
- **One-Period Valuation Model**: Example calculations based on expected returns and
dividends.
Example: After necessary analysis on Vinamilk stock, Nam decided that he would be
satisfied with a 12% return on investment. Vinamilk pays VND5,000 per share annual
dividend. Nam expects to sell 1 Vinamilk stock at VND120,000 in 1 year. What should be the
price of Vinamilk stock today (intrinsic value)? If the market stock price is currently at
VND100,000, should Nam buy the stock?
solve :
→ Since the intrinsic value (VND 111,607.14) is greater than the market price (VND

100,000), Nam should buy the stock as it is undervalued in the market.

- **Generalized Dividend Valuation Model**: Formula for calculating stock price based on
future dividends.
- **Gordon Growth Model**: Assumes constant growth in dividends; used to calculate
intrinsic stock price.
### Stock Price Determination

- Stock prices are influenced by investor expectations and information.

- Prices are set through bidding among market players.
- Example calculations for different investors based on their required rates of return.

● Price Determination by Willingness to Pay:the buyer willing to pay the most for a
stock will set the price → reflects the value they perceive based on their information
and expectations.
● Role of Information: Buyers with superior information about a company’s prospects
can assess the stock's value more accurately. For example, if one investor knows
that a company's earnings will significantly increase, they might be willing to pay
more for the stock than someone who does not have this information.
● Example of Auction Dynamics:
● The document uses an analogy of an auto auction to illustrate how prices are
determined. Two buyers, each with different information about the value of a
car, bid against each other. The buyer who values the car more (due to better
information about its condition) wins the auction at a price that reflects their
perceived value.
● Market Reactions to New Information:
● Stock prices frequently change in response to new information. For instance,
if a company announces better-than-expected earnings, investors will
reassess the future cash flows and may bid higher for the stock, driving up its
price.
● Expectations and Rational Behavior:
● Investors form expectations about future cash flows (dividends and sales
prices) based on all available information. The theory of rational expectations
suggests that these expectations are optimally formed, meaning that they
reflect the best guess based on current knowledge.
 ● Arbitrage and Market Efficiency:
● play a critical role in ensuring that stock prices reflect all available information.
● stock is undervalued, arbitrageurs will buy it, driving up the price until it aligns
with its true value.
● a stock is overvalued, they will sell it, bringing the price down.
● Volatility and Market Psychology: The market can experience volatility due to
changes in investor sentiment or behavior. For example, during times of uncertainty,
prices may fluctuate widely as investors react to news and rumors, sometimes
leading to irrational pricing.

### Money policy & stock price

● Lower Interest Rates:

● When a central bank lowers interest rates, the return on bonds (which are
considered an alternative investment to stocks) also declines. This makes
bonds less attractive to investors.
● Lower Required Rate of Return:
● As the return on bonds decreases, investors may be willing to accept a lower
required rate of return on stocks (denoted as ke) This means they are more
willing to invest in stocks even if the expected returns are lower than before.
● Stimulating Economic Growth:
● Lower interest rates can stimulate economic activity. When borrowing costs
decrease, businesses are more likely to invest and expand, which can lead to
higher earnings and dividends in the future.
● Higher Growth Rate in Dividends:
● As the economy grows, the growth rate of dividends (denoted as g) is likely to
increase. This can further enhance the attractiveness of stocks.
In this example, after the central bank lowers interest rates, the stock price rises significantly
from $50 to $200 due to the combination of a lower required return and an increased
growth rate in dividends.

→ This illustrates how monetary policy can positively influence stock prices.

→ Overall Impact on Stock Prices: With a lower required rate of return and potentially higher
growth rates in dividends, stock prices are likely to increase as investors adjust their
expectations and valuations based on these factors.

### Theory of Rational Expectations

**Key Points**:
* Content : Expectations will be identical to optimal forecasts using all available
information, A prediction may not always be perfectly accurate. (But it has to be
correct on average)
Rof = Re

* Implication :
➕If there is a change in the way a variable moves, the way in which expectations of
this 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 Market Hypothesis (EMH)

- Assumes: prices of securities in financial markets fully reflect all available information
Re is hard to observe. Demand and supply analysis concludes that: the expected return
on a security will have a tendency to head toward the equilibrium return

Rof = R* trong đó ( R*=Re)

( optimal forecast of a security’s return using all available information equals the

security’s equilibrium return)

- Implication : Unexploited profit opportunities are quickly eliminated.
- Stock prices follow a random walk, making future price changes unpredictable.

➢ Efficient Market Hypothesis (EMH)

**Definition**: The Efficient Market Hypothesis posits that financial markets are
"informationally efficient." This means that asset prices reflect all available information
at any given time. Therefore, it is impossible to consistently achieve higher returns
than the average market return on a risk-adjusted basis, because any new
information that could affect prices is already incorporated into the current prices.
ANALYZE THIS THEORY 👍
Example: Stock Market Arbitrage : Consider two stocks, A and B, in an

efficient market.

● Stock A has a price of $100 and offers a dividend yield that translates to
an effective return of Rof =8%.
● Stock B has a price of $90 and offers a higher effective return of
Rof=10%.
● Identifying the Opportunity:
● Investors notice that Stock B offers a higher return than Stock A.
● Rational investors will buy Stock B and sell Stock A to maximize
their returns.
● Market Reaction:
● As demand for Stock B increases, its price will rise, and as more
investors sell Stock A, its price will fall.
● This buying and selling will continue until the returns on both
stocks are aligned with the equilibrium rate R*
● Elimination of Profit Opportunity:
● Eventually, the price of Stock B will increase (lowering its yield)
and the price of Stock A will decrease (raising its yield) until both
stocks offer the same effective return.
 ● This adjustment eliminates the arbitrage opportunity,
demonstrating how efficient markets work to ensure all profit
opportunities are quickly resolved.

**Key Points**:
- There are three forms of EMH: weak, semi-strong, and strong, based on the
type of information considered.
- **Weak Form**: Prices reflect all past trading information.
- **Semi-Strong Form**: Prices reflect all publicly available information.
- **Strong Form**: Prices reflect all information, both public and private.
- Investors cannot consistently outperform the market.

### Relationship Between Rational Expectations and EMH

- **Interconnectedness**: Rational Expectations supports the EMH by suggesting that

if investors form their expectations rationally, then they will react to new information
in a way that keeps the market efficient. If everyone uses all available information to
make decisions, prices will adjust quickly and accurately to new information.
- **Implication for Policy**: If markets are efficient and expectations are rational, then
government policies (like monetary or fiscal policy) may have limited effectiveness, as
people will anticipate the effects of these policies and adjust their behavior
accordingly.

### Example to Clarify

**Scenario**: Consider a company, XYZ Corp, that is expected to announce earnings.

1. **Rational Expectations**:
- Investors analyze all available information (like past earnings reports, market
conditions, etc.) to predict XYZ Corp's upcoming earnings. They anticipate that the
earnings will be higher than last quarter due to increased sales.

2. **Efficient Market Hypothesis**:

- As soon as any news about increased sales becomes public, the stock price of XYZ
Corp adjusts immediately to reflect this new information. If the market is semi-strong
efficient, the price reflects not only past performance but also this new public
information.
**Outcome**:
- If investors had rational expectations, they would have already anticipated the
positive earnings announcement based on available information. Therefore, by the
time of the actual announcement, the stock price may not significantly change, as it
already reflects the expected earnings.

### Conclusion
Rational Expectations provides a foundation for understanding how individuals form
expectations, while EMH explains how those expectations are reflected in market
prices. → they imply that markets are efficient and that consistently outperforming
the market is challenging.