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

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

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

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**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 • 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**Rational Expectation**• expectation based on all available information • an educated guess • example: estimating travel time • not influenced by psychological bias**Intrinsic (or fundamental) value of a financial instrument**The rational expectation of the value Present value of all future cash flows**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**What if a company does not pay dividends?**Estimate the period in which it will begin to pay them**Recall: Present Value Formula**PV present value FV future value iperiodic interest rate in decimal form n number of periods**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**Value of Corporate Equity**Present value each dividend using k as the rate of discount, and add them all together**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**Gordon Growth Model**Present value each dividend using k as the rate of discount, and add them all together**Gordon Growth Model**Using the formula for an infinite series the present value formula simplifies down to:**Efficient Markets Hypothesis**The prices of equities reflect their intrinsic (or fundamental) values … … that is the present value of future dividends.**Three Forms of Market Efficiency**• Weak: past prices no use • Semi-strong: publicly available info no use • Strong: even inside info no use**Implication of Market Efficiency**• Best to invest in low cost index funds**Anomalies**• Small firm effect • Mean reversion • January effect**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/**Bubbles**• Prices going above their intrinsic value • Hard to see when they are happening but obvious after they burst**1636:**One tulip cost 10X the salary of a skilled craftsman.