The Stock Market,
Information and Financial
Market Efficiency
Required Reading: Mishkin, Chapter 7
Prepared By:
AMNA ASIM
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Stocks and the Stock Market
• Corporation – a legal form of business that provides owners with
protection from losing more than their investment if the business fails
• Limited liability – the legal provision that shields owners of a
corporation from losing more than they have invested in the firm
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Common Stock Versus Preferred Stock
• Both are partial ownership of a corporation
• Preferred stockholders do not have a say in the election of the board of directors like common
stockholders
• Dividends – a payment that a corporation makes to stockholders, typically on a quarterly basis
• Preferred shareholders obtain a fixed dividend that is set when the corporation makes the issuance
while common only obtain the right to a dividend that the corporation has the option to pay out, but
typically rises and falls based on profits
• If a corporation is making dividend payments, then they must be delivered to preferred first
• In the event of bankruptcy, debt holders have rights to company assets based on priority, then
preferred and then common
• Market capitalization is calculated by adding the values of preferred and common together
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How and Where Stocks Are Bought and
Sold
• Millions of sole proprietorships and partnerships while only a few thousand
publicly traded corporations
• NASDAQ is an over-the-counter market in which dealers operate their own
inventories to buy and sell stock through computers
• Online brokers offer lower commissions but do not provide the same advice that
may be provided by a traditional broker
• Investors can take ownership of foreign companies through American Depository
Receipts, which are receipts for shares of stock in foreign countries traded on
domestic exchanges
• Investors may buy issues on foreign exchanges after setting up an account with
foreign brokerage firms
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Measuring the Performance of the Stock
Market
• Stock market indexes used to measure performance of overall stock
market
• A bull market is an increase in stock prices of more than twenty
percent while a bear market is a decrease in stock prices of more than
twenty percent
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Does the Performance of the Stock Market
Matter to the Economy?
• Many economists believe there is a correlation between the performance of the
stock market and the economy since increases in the stock market increase the
wealth of consumers who then spend more, increasing the income of others,
inducing economic growth in a self-reinforcing cycle, and vice versa.
• Additionally, strong stock market performance makes it easier for companies to
finance capital investments via fund seeking through the equity market
• To delineate the effect of stock market performance on household wealth, the
book provides figures
o Rising stock prices between 1995 and 2000 increased household wealth by $9 trillion
o The decline in the stock market between 2000 and 2002 annihilated $7 trillion in wealth
o The financial crisis of 2007-2009 destroyed household wealth by $8.5 trillion
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• Perhaps the most prominent effect of stock market movement is how it
alters the expectations of consumers and firms
o When the stock market crashes, consumers are more uncertain about their
future economic lifestyles, causing them to cut down on spending on goods,
and then causing a recession
o There is a potential element of self-fulfilling expectations here
 Major past stock market declines have been followed up by a contraction in the overall
economy
 Consumers who know this cut down on spending upon seeing a decline in the stock
market in order to protect themselves. However, if enough people do this, then the
possible relationship between stock market crashes and depressions is fulfilled due to their
actions.
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How Stock Prices Are Determined
This book holds that is possible to determine the present value of an
equity through the same manner that one determines the price of a bond
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Investing in Stock for One Year
• The value of a stock is determined by the present value of the cash flows
consisting of dividend payments and capital gains
• Required return on equities – the expected return necessary to compensate
for the risk of investing in stocks, also called the equity cost of capital if
using the viewpoint of the business who sees this return as the rate they
must offer in order to attract investors
• Besides the risk-free interest rate, the composition of the required return on
equities includes the systematic risk due to general price movements in the
overall market as well as unsystematic, idiosyncratic risk which is due to
the firm’s stock price movement rather than overall market
• If one decides a required rate of return for a stock based on the above
variables, he may arrive at the present value of the stock. If the current stock
price is less than the present, value he should buy the stock.
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• Taking this to the extreme, one could apply this to investors as a group,
assuming they all expect the same rate of return, the price of a stock should
be the result of the following equation, where r stands for the required
return on equity, D for the present value of the dividend expected to be paid
at the end of the year, and P^e the expected price of the stock at the end of
the year
• The equation is enormously misleading since the investor must know, in order for
it to be accurate, the dividend the company will pay at the end of the year and the
stock price at the end of the year
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The Rate of Return on a One-Year Investment
in a Stock
• Dividend yield – the expected annual dividend yield divided by the current price of a
stock
• Expected rate of return on a stock is equal to the price of the stock during the year divided
by the price of the stock at the beginning of the year
• Rate of return = (Expected annual dividend/Initial price) + (Expected change in price/
Initial price)
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The Fundamental Value of a Stock

The above equation is the present value of an investment that will be held for two years
• The fundamental value of a stock is equal to the present value of all dividend payments into the indefinite
future with no final price P since the equation represents an infinite stream of dividend payments
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The Gordon Growth Model
• Since the above equation requires that its user forecast the value of an infinite
number of dividends, it is not that helpful
• Myron J. Gordon of MIT developed the below equation to help define the
fundamental value of a stock by using a growth rate to estimate the value of future
dividend payments
• Gordon growth model – a model that uses the current dividend paid, the expected
growth rate of dividends, and the required return on equities to calculate the price
of a stock
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• Important points to acknowledge for the Gordon growth model
1. Assumes that investors obtain first dividend payment at beginning of the
first period rather than at the end
2. Assumes that the growth rate of dividends is constant which quite
unrealistic
3. Required rate of return on the stock should be greater than the dividend
growth rate
4. Expectations of investors relating to the future earnings (and therefore
dividends) are necessary in finding the price of stocks
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Adaptive Expectations versus Rational
Expectations
Expectations hold an extremely important role throughout the economy, driving economic
cycles and much more
• Adaptive expectations – the assumption that people make forecasts of future values of a
variable using only past values of the variable
• Adaptive expectations is employed in the practice of technical analysis, which is when
stock pickers use the past performance of stocks to predict the performance of stock
prices in the future
• Rational expectations – the assumption that people make forecasts of future values of a
variable using all available information; formally, the assumption that expectations equal
optimal forecasts, using all available information
• Rational expectations does not argue that the investors’ forecasts will be correct but that
they will be optimal
• Expected price of a stock at the end of the trading day tomorrow is likely to be different
from the actual price of stock due to release of additional information during that trading
day, creating a forecast error
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The Efficient Markets Hypothesis
Efficient markets hypothesis – the application of rational expectations to
financial markets; the hypothesis that the equilibrium price of a security is
equal to its fundamental value
An Example of the Efficiency Markets Hypothesis
• If a stock price is lower or higher than the optimal forecast of its
fundamental value, then the actions of participants in financial markets will
buy or sell until it reaches the optimal forecast of its fundamental value,
causing all available information to incorporated into financial prices
• Financial arbitrage – the process of buying and selling securities to profit
form prices changes over a brief period of time
• Rational expectations does not require that all traders possess rational
expectations since prices may be driven to their fundamental value by a few
well-informed traders who perform financial arbitrage
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What About “Inside Information”?
• Inside information – relevant information about a security that is not
publicly available
• SEC laws hold that employees of a firm may not buy/sell stock based
on information that is not publicly available, nor may they tell others
the information that is not publicly disclosed
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Are Stock Prices Predictable?
• Implication of efficient market hypothesis is that stock prices are
always “right” since they price in all available information and are
therefore unpredictable since any information that will change the
price is yet to be available
• This also implies that it is not possible to beat the market and that
stock prices follow a random walk
• Random walk – the unpredictable movements of the price of a security
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Efficient Markets and Investment
Strategies
If the efficient market hypothesis is true, then these investment
strategies would be best
• Portfolio Allocation
Since all the news that will affect stock prices in the future is unpredictable, it is
best to hold a diversified portfolio across varying assets and securities in order to
capture returns across markets while avoiding too much exposure to any one
asset class or security
• Trading
Since stock prices are unpredictable, traders are wasting their time by paying
commissions on any assets that they trade. It would be best to buy and hold for a
long period of time.
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Financial Analysts and Hot Tips
• Financial analysts are sometimes divided into two broad segments
1. Technical analysts who only use the past prices to predict the future course of prices
2. Fundamental analysts who attempt to predict future earnings which will affect the
course of prices
• The efficient market hypothesis delineates that technical analysts would not
beat the market since they neglect information that other traders know since
they only use past prices when there is myriad more information available
• EMH also delineates that fundamental analysts will have a difficult time
beating the market since all the information that they know is also priced in
to the markets by the work of other traders
• Additionally, any company that seems destined to report greater earnings in
the future will most likely have this factored into its price already, making it
no better than an investment that may be expected to report negative
earnings
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Actual Efficiency in Financial Markets
Many actual participants in the market do not agree with the consensus
of academia as to markets being perfectly efficient. They point to three
things to corroborate their position that markets in practice do not align
with their theoretical behavior.
• Pricing anomalies exist in the market that allow some investors to earn aboveaverage returns
• Some price changes are predictable, allowing investors to milk these for
above-average returns despite EMH arguing that this is impossible
• Stock prices shift by more than their intrinsic values while EMH attempts to
say that markets are always right as to the true value of a security
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Noise Trading and Bubbles
• People show overconfidence in their ability to create high returns in the
market
• Noise trading – when investors overreact to good or bad news on the
assumption that they understand the significance of the piece of news
• Herd behavior in the markets occur as well as investors trade based on what
other investors are doing rather than on the fundamental value of securities
• Bubble – a situation in which the price of an asset rises well above the
asset’s fundamental value
• The greater fool theory is applicable to bubbles as one is not a fool to buy
something that is overpriced as long as there is someone else, the greater
fool, who he may sell it to
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THE END
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