1 / 22

Rational Expectations, Efficient Markets, and the Valuation of Corporate Securities

Rational Expectations, Efficient Markets, and the Valuation of Corporate Securities. Chapter 7. Learning Objectives. Define rational expectations Explain how corporate equities are valued under the assumption of rational expectations

temima
Download Presentation

Rational Expectations, Efficient Markets, and the Valuation of Corporate Securities

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Rational Expectations, Efficient Markets, and the Valuation of Corporate Securities Chapter 7

  2. Learning Objectives • Define rational expectations • Explain how corporate equities are valued under the assumption of rational expectations • Write down and apply the equation for the Gordon growth model • Distinguish between the three forms of market efficiency and relate to fundamental and technical analysis • Explain how bubbles can form

  3. Rational Expectation • expectation based on all available information • an educated guess • example: estimating travel time • not influenced by psychological bias

  4. Intrinsic (or fundamental) value of a financial instrument The rational expectation of the value Present value of all future cash flows

  5. Future cash flows for an equity security Dividends: share of profit of company distributed to the owners Usually paid on a quarterly basis (every 3 months). Let Et represent the expected dividend at time t

  6. What if a company does not pay dividends? Estimate the period in which it will begin to pay them

  7. Recall: Present Value Formula PV present value FV future value iperiodic interest rate in decimal form n number of periods

  8. Rate of discount For equities instead of using the interest rate, use the required rate of return, k k reflects the risk that dividends will not be as high as expected

  9. Value of Corporate Equity Present value each dividend using k as the rate of discount, and add them all together

  10. Gordon Growth Model Assume dividends grow at a constant rate g So, Et = Et-1 (1+g) If the most recent dividend (E0 ) was $100 and dividends are expected to grow at an annualized rate of 8%, then this quarter’s dividend should be $102 And next quarter’s dividend will be $104.04

  11. Gordon Growth Model Present value each dividend using k as the rate of discount, and add them all together

  12. Gordon Growth Model Using the formula for an infinite series the present value formula simplifies down to:

  13. Efficient Markets Hypothesis The prices of equities reflect their intrinsic (or fundamental) values … … that is the present value of future dividends.

  14. Three Forms of Market Efficiency • Weak: past prices no use • Semi-strong: publicly available info no use • Strong: even inside info no use

  15. Implication of Market Efficiency • Best to invest in low cost index funds

  16. Fundamental vs Technical Analysis

  17. Anomalies • Small firm effect • Mean reversion • January effect

  18. Behavioral Finance Studies both rational, and irrational, expectations. http://www.nbr.com/videos/video/1397919189001/dan-ariely-on-framing-and-investment-decisions-may-24-2010#.UG0Enxgx_2s To learn more about behavioral economics, see http://danariely.com/

  19. Bubbles • Prices going above their intrinsic value • Hard to see when they are happening but obvious after they burst

  20. 1636: One tulip cost 10X the salary of a skilled craftsman.

More Related