The Stock Market, the

7
Theory of Rational
Expectations, and the
Efficient Market Hypothesis
Learning Objectives
• Calculate the price of Preview
R
common stock. arely does a day go by that the stock market isn’t a major news item. We have
• Recognize the impact witnessed huge swings in the stock market in recent years. The 1990s were an
of new information on extraordinary decade for stocks: The Dow Jones and S&P 500 indexes increased
stock prices. by more than 400%, while the tech-laden NASDAQ index rose by more than 1,000%.
• Compare and contrast By early 2000, all three indexes had reached record highs. Unfortunately, the good
adaptive expectations times did not last. Starting in early 2000, the stock market began to decline and many
and rational investors lost their shirts. The NASDAQ crashed, falling by more than 50%, while the
expectations. Dow Jones and S&P 500 indexes fell by 30% through January 2003. After subsequently
• Explain why arbitrage rising by over 30%, the stock market crashed again during the global financial crisis,
opportunities imply falling by over 50% from its peak in the fall of 2007. Starting in 2009, the stock market
that the efficient market recovered quickly, more than doubling and reaching new highs by 2014.
hypothesis holds. Because so many people invest in the stock market and the prices of stocks affect
• Identify and explain the ability of people to retire comfortably, the market for stocks is undoubtedly the
the implications of financial market that receives the most attention and scrutiny. In this chapter, we look
the efficient market first at how this important market works.
hypothesis for financial We begin by discussing the fundamental theories that underlie the valuation of
markets. stocks. These theories are critical to understanding the forces that cause the value of
• Summarize the reasons stocks to rise and fall minute by minute and day by day. Once we have learned the
why behavioral finance methods for stock valuation, we need to explore how expectations about the market
suggests that the affect its behavior. We do so by examining the theory of rational expectations. When this
efficient market theory is applied to financial markets, the outcome is the efficient market hypothesis,
hypothesis may not which has some general implications for how markets in other securities besides stocks
hold. operate. The theory of rational expectations is also central to debates about the conduct
of monetary policy, to be discussed in Chapter 25.

Computing the Price of Common Stock

Common stock is the principal medium through which corporations raise equity capital.
Stockholders—those who hold stock in a corporation—own an interest in the corpo-
ration equal to the percentage of outstanding shares they own. This ownership interest
gives them a bundle of rights. The most important are the right to vote and to be a
residual claimant of all funds flowing into the firm (known as cash flows), meaning
that the stockholder receives whatever remains after all other claims against the firm’s
186

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 Chapter 7   The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 187

assets have been satisfied. Stockholders may receive dividends from the net earnings of
the corporation. Dividends are payments made periodically, usually every quarter, to
stockholders. The board of directors of the firm sets the level of the dividend, usually
based on the recommendation of management. In addition, the stockholder has the
right to sell the stock.
One basic principle of finance is that the value of any investment is calculated by
computing the present value of all cash flows the investment will generate over its life.
For example, a commercial building will sell for a price that reflects the net cash flows
(rents minus expenses) it is projected to have over its useful life. Similarly, we value
common stock as the value in today’s dollars of all future cash flows. The cash flows
that a stockholder might earn from stock are dividends, the sales price, or both.
To develop the theory of stock valuation, we begin with the simplest possible sce-
nario: You buy the stock, hold it for one period to get a dividend, then sell the stock.
We call this the one-period valuation model.

The One-Period Valuation Model

Suppose that you have some extra money to invest for one year. After a year, you will
need to sell your investment to pay tuition. After watching CNBC or Nightly Business
Report on TV, you decide that you want to buy Intel Corp. stock. You call your broker
and find that Intel is currently selling for $50 per share and pays $0.16 per year in
dividends. The analyst on CNBC predicts that the stock will be selling for $60 in one
year. Should you buy this stock?
To answer this question, you need to determine whether the current price accu-
rately reflects the analyst’s forecast. To value the stock today, you need to find the pres-
ent discounted value of the expected cash flows (future payments) using the formula in
Equation 1 of Chapter 4. In this equation, the discount factor used to discount the cash
flows is the required return on investments in equity rather than the interest rate. The
cash flows consist of one dividend payment plus a final sales price. When these cash
flows are discounted back to the present, the following equation computes the current
price of the stock:

D1 P1
P0 = + (1)
(1 + ke) (1 + ke)

where P0 = the current price of the stock. The zero subscript refers to
time period zero, or the present.
D1 = the dividend paid at the end of year 1
ke = the required return on investments in equity
P1 = the price at the end of the first period; the predicted sales
price of the stock
To see how Equation 1 works, let’s compute the price of the Intel stock if, after
careful consideration, you decide that you would be satisfied to earn a 12% return
on the investment. If you have decided that ke = 0.12, are told that Intel pays $0.16
per year in dividends 1D1 = 0.162, and forecast the share price of $60 for next year
1P1 = $602, you get the following result from Equation 1:

0.16 $60
P0 = + = $0.14 + $53.57 = $53.71
1 + 0.12 1 + 0.12

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 188 P a r t 2   Financial Markets

On the basis of your analysis, you find that the present value of all cash flows from
the stock is $53.71. Because the stock is currently priced at $50 per share, you would
choose to buy it. However, you should be aware that the stock may be selling for less
than $53.71, because other investors have placed a greater risk on the cash flows or
estimated the cash flows to be less than you did.

The Generalized Dividend Valuation Model

Using the present value concept, we can extend the one-period dividend valuation
model to any number of periods: The value of a stock today is the present value of all
future cash flows. The only cash flows that an investor will receive are dividends and a
final sales price when the stock is ultimately sold in period n. The generalized multipe-
riod formula for stock valuation can be written as
D1 D2 Dn Pn
P0 = 1 + 2 + g + n + (2)
11 + ke 2 11 + ke 2 11 + ke 2 11 + ke 2 n

where Pn = the price of the stock in period n

Di = the dividend paid at the end of year i
If you tried to use Equation 2 to find the value of a share of stock, you would soon
realize that you must first estimate the value the stock will have at some point in the
future before you can estimate its value today. In other words, you must find Pn before
you can find P0. However, if Pn is far in the future, it will not affect P0. For example, the
present value of a share of stock that sells for $50 seventy-five years from now, using
a 12% discount rate, is just one cent 3$50/(1.1275) = $0.014. This reasoning implies
that the current value of a share of stock can be calculated as simply the present value
of the future dividend stream. The generalized dividend model is given in Equation
3. Note that it is the same formula as Equation 2, but without the final sales price:

P0 = a
∞ Dt
t (3)
t = 1 11 + ke 2

Consider the implications of Equation 3 for a moment. The generalized dividend

model states that the price of a stock is determined only by the present value of the
dividends and that nothing else matters. Many stocks do not pay dividends, so how is
it that these stocks have value? Buyers of the stock expect that the firm will pay dividends
someday. Most of the time a firm institutes dividends as soon as it has completed the
rapid growth phase of its life cycle.
The generalized dividend valuation model requires that we compute the present
value of an infinite stream of dividends, a process that could be difficult, to say the least.
Therefore, simplified models have been developed to make the calculations easier. One
such model is the Gordon growth model, which assumes constant dividend growth.

The Gordon Growth Model

Many firms strive to increase their dividends at a constant rate each year. Equation 4 is
derived from Equation 3 to reflect this constant growth in dividends:

D0 * (1 + g)1 D0 * (1 + g)2 D0 * (1 + g) ∞
P0 = + + c + (4)
(1 + ke)1 (1 + ke)2 (1 + ke) ∞

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 Chapter 7   The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 189

where D0 = the most recent dividend paid

g = the expected constant growth rate in dividends
ke = the required return on an investment in equity
Equation 4 can be simplified to obtain Equation 5:1

D0 * 11 + g2 D1
P0 = = (5)
1ke - g2 1ke - g2

This model is useful for finding the value of a stock, given a few assumptions:
1. Dividends are assumed to continue growing at a constant rate forever. Actually, as long
as the dividends are expected to grow at a constant rate for an extended period of
time, the model should yield reasonable results. This is because errors about distant
cash flows become small when discounted to the present.
2. The growth rate is assumed to be less than the required return on equity, ke. Myron Gordon,
in his development of the model, demonstrated that this is a reasonable assumption.
In theory, if the growth rate were faster than the rate demanded by holders of the
firm’s equity, then in the long run the firm would grow impossibly large.

How the Market Sets Stock Prices

Suppose you go to an auto auction. The cars are available for inspection before the
auction begins, and you find a little Mazda Miata that you like. You test-drive it in the
parking lot and notice that it makes a few strange noises, but you decide that you still
like the car. You decide that $5,000 is a fair price that will allow you to pay some repair
bills should the noises turn out to be serious. You see that the auction is ready to begin,
so you go in and wait for the Miata to be auctioned.
Suppose another buyer also spots the Miata. He test-drives the car and recognizes
that the noises are simply the result of worn brake pads that he can fix himself at a
nominal cost. He decides that the car is worth $7,000. He also goes in and waits for the
Miata to come up for auction.

1
To generate Equation 5 from Equation 4, first multiply both sides of Equation 4 by 11 + ke 2>11 + g2, and then
subtract Equation 4 from the result. This yields
P0 * 11 + ke 2 D0 * 11 + g2 ∞
- P0 = D0 -
11 + g2 11 + ke 2 ∞

Assuming that ke is greater than g, the term on the far right will approach zero and so can be dropped. Thus, after
factoring P0 out of the left-hand side,
1 + ke
P0 * c - 1 d = D0
1 + g

Next, simplify by combining terms:

11 + ke 2 - 11 + g2
P0 * = D0
1 + g
D0 * (1 + g) D1
P0 = =
ke - g ke - g

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 190 P a r t 2   Financial Markets

Who will buy the car, and for how much? Suppose only the two of you are inter-
ested in the Miata. You begin the bidding at $4,000. Your competitor ups your bid to
$4,500. You bid your top price of $5,000. He counters with $5,100. The price is now
higher than you are willing to pay, so you stop bidding. The car is sold to the more
informed buyer for $5,100.
This simple example raises a number of important points. First, the price is set
by the buyer who is willing to pay the highest price. This price is not necessarily the
highest price the asset could fetch, but it is incrementally greater than what any other
buyer is willing to pay.
Second, the market price will be set by the buyer who can take best advantage of
the asset. The buyer who purchased the car knew that he could fix the noise easily and
cheaply. As a consequence, he was willing to pay more for the car than you were. The
same concept holds for other assets. For example, a piece of property or a building will
sell to the buyer who can put the asset to the most productive use.
Finally, the example shows the role played by information in asset pricing. Superior
information about an asset can increase its value by reducing its risk. When you con-
sider buying a stock, the future cash flows are subject to many unknowns. The buyer
who has the best information about these cash flows will discount them at a lower
interest rate than will a buyer who is very uncertain.
Now let’s apply these ideas to stock valuation. Suppose you are considering the
purchase of stock expected to pay a $2 dividend next year. Market analysts expect the
firm to grow at 3% indefinitely. You are uncertain about both the constancy of the divi-
dend stream and the accuracy of the estimated growth rate. To compensate yourself for
this uncertainty (risk), you require a return of 15%.
Now suppose Jennifer, another investor, has spoken with industry insiders and
feels more confident about the projected cash flows. Jennifer requires only a 12% return
because her perceived risk is lower than yours. Bud, on the other hand, is dating the
CEO of the company. He knows with more certainty what the future of the firm actually
looks like, and thus requires only a 10% return.
What value will each investor give to the stock? Applying the Gordon growth
model yields the following stock prices:

Investor Discount Rate Stock Price

You 15% $16.67

Jennifer 12% $22.22
Bud 10% $28.57

You are willing to pay $16.67 for the stock. Jennifer will pay up to $22.22, and Bud
will pay $28.57. The investor with the lowest perceived risk is willing to pay the most
for the stock. If there were no other traders but these three, the market price would be
between $22.22 and $28.57. If you already held the stock, you would sell it to Bud.
We thus see that the players in the market, bidding against one another, establish
the market price. When new information is released about a firm, expectations change,
and with them, prices change. New information can cause changes in expectations about
the level of future dividends or the risk of those dividends. Because market participants
are constantly receiving new information and revising their expectations, it is reasonable
that stock prices are constantly changing as well.

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 Chapter 7   The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 191

A p p li c ati o n Monetary Policy and Stock Prices

Stock market analysts tend to hang on every word uttered by the chair of the Federal
Reserve because they know that an important determinant of stock prices is monetary
policy. But how does monetary policy affect stock prices?
The Gordon growth model in Equation 5 explains this relationship. Monetary
policy can affect stock prices in two ways. First, when the Fed lowers interest rates,
the return on bonds (an alternative asset to stocks) declines, and investors are likely
to accept a lower required rate of return on an investment in equity (ke). The resulting
decline in ke lowers the denominator in the Gordon growth model (Equation 5), leads
to a higher value of P0, and raises stock prices. Furthermore, a lowering of interest rates
is likely to stimulate the economy, so the growth rate in dividends, g, is likely to be
somewhat higher. This rise in g also causes the denominator in Equation 5 to decrease,
which also leads to a higher P0 and a rise in stock prices.
As we will see in Chapter 26, the impact of monetary policy on stock prices is one
of the key ways in which monetary policy affects the economy.

A p p li c ati o n The Global Financial Crisis and the Stock Market

The global financial crisis that started in August 2007 led to one of the worst stock
market declines in the past 50 years. Our analysis of stock price valuation, again
using the Gordon growth model, can help us understand how this event affected
stock prices.
The global financial crisis had a major negative impact on the economy, leading
to a downward revision of the growth prospects for U.S. companies, thus lowering the
dividend growth rate (g) in the Gordon model. In terms of Equation 5, the resulting
increase in the denominator would lead to a decline in P0 and hence a decline in stock
prices.
Increased uncertainty about the U.S. economy and the widening credit spreads
caused by the subprime crisis also raised the required return on investment in equity.
In terms of Equation 5, a higher ke leads to an increase in the denominator, a decline in
P0, and a general fall in stock prices.
In the early stages of the global financial crisis, the declines in growth prospects and
credit spreads were moderate, and so, as the Gordon model predicts, the stock market
decline was also moderate. However, when the crisis entered a particularly virulent
stage in October 2008, credit spreads shot through the roof, the economy tanked, and
as the Gordon model predicts, the stock market crashed. From its peak in October
2007 (high of 14,066 for the DJIA) to its lowest point in March 2009 (DJIA low of
6,547), the market lost 53% of its value. ◆

The Theory of Rational Expectations

The analysis of stock price evaluation we outlined in the previous section depends on
people’s expectations—especially expectations of cash flows. Indeed, it is difficult to
think of any sector of the economy in which expectations are not crucial; this is why it

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 192 P a r t 2   Financial Markets

is important to examine how expectations are formed. We do so by outlining the theory

of rational expectations, currently the most widely used theory to describe the formation
of business and consumer expectations.
In the 1950s and 1960s, economists regularly viewed expectations as formed from
past experience only. Expectations of inflation, for example, were typically viewed
as being an average of past inflation rates. This view of expectation formation, called
adaptive expectations, suggests that changes in expectations will occur slowly over
time, as data for a variable evolve.2 So, if inflation had formerly been steady at a 5%
rate, expectations of future inflation would be 5%, too. If inflation rose to a steady rate
of 10%, expectations of future inflation would rise toward 10%, but slowly: In the first
year, expected inflation might rise only to 6%; in the second year, to 7%; and so on.
The adaptive expectations hypothesis has been faulted on the grounds that people
use more information than just past data on a single variable to form their expectations
of that variable. Their expectations of inflation will almost surely be affected by their
predictions of future monetary policy, as well as by current and past monetary policy.
In addition, people often change their expectations quickly in the light of new informa-
tion. To address these objections to the validity of adaptive expectations, John Muth
developed an alternative theory of expectations, called rational expectations, which
can be stated as follows: Expectations will be identical to optimal forecasts (the best
guess of the future) using all available information.3
What exactly does this mean? To explain it more clearly, let’s use the theory of
rational expectations to examine how expectations are formed in a situation that most
of us will encounter at some point in our lifetime: our drive to work. Suppose that if
Joe Commuter travels when it is not rush hour, his trip takes an average of 30 minutes.
Sometimes his trip takes 35 minutes; other times, 25 minutes; but the average, non-
rush-hour driving time is 30 minutes. If, however, Joe leaves for work during the rush
hour, it takes him, on average, an additional 10 minutes to get to work. Given that he
leaves for work during the rush hour, the best guess of his driving time—the optimal
forecast—is 40 minutes.
If the only information available to Joe before he leaves for work related to his
driving time is that he is leaving during the rush hour, what does rational expectations
theory allow you to predict about Joe’s expectations of his driving time? Since the best
guess of his driving time, using all available information, is 40 minutes, Joe’s expecta-
tion should be the same. Clearly, an expectation of 35 minutes would not be rational,
because it is not equal to the optimal forecast, or the best guess of the driving time.
Suppose that the next day, given the same conditions and expectations, it takes Joe
45 minutes to drive to work because he hits an abnormally large number of red lights.
The day after that, Joe hits all the lights right and it takes him only 35 minutes to drive
to work. Do these variations mean that Joe’s 40-minute expectation is irrational? No; an
expectation of 40 minutes’ driving time is still a rational expectation. In both cases, the

2
More specifically, adaptive expectations—say, of inflation—are written as a weighted average of past inflation rates:

πet = 11 - l2 a ljπt - j
∞

j=0

where πet = adaptive expectation of inflation at time t

πt - j = inflation at time t - j
l = a constant between the values of 0 and 1
3
John Muth, “Rational Expectations and the Theory of Price Movements,” Econometrica 29 (1961): 315–335.

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 Chapter 7   The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 193

forecast is off by five minutes, so the expectation has not been perfectly accurate each
time. However, the forecast does not have to be perfectly accurate to be rational—it
need only be the best possible forecast given the available information; that is, it has to
be correct on average, and the 40-minute expectation meets this requirement. As there
is bound to be some randomness in Joe’s driving time regardless of driving conditions,
an optimal forecast will never be completely accurate.
The example makes the following important point about rational expectations:
Even though a rational expectation equals the optimal forecast using all available
information, a prediction based on it may not always be perfectly accurate.
What if an item of information relevant to predicting driving time is unavailable
or ignored? Suppose that on Joe’s usual route to work, an accident occurs and causes a
two-hour traffic jam. If Joe has no way of ascertaining this information, his rush-hour
expectation of 40 minutes’ driving time is still rational, because the accident informa-
tion is not available to him for incorporation into his optimal forecast. However, if there
was a radio or TV traffic report about the accident that Joe did not bother to listen to,
or heard but ignored, his 40-minute expectation is no longer rational. In light of the
availability of this information, Joe’s optimal forecast should have been two hours and
40 minutes.
Accordingly, an expectation may fail to be rational for two reasons:
1. People might be aware of all available information but find it takes too much effort
to make their expectation the best guess possible.
2. People might be unaware of some available relevant information, so their best guess
of the future will not be accurate.
Nonetheless, it is important to recognize that if an additional factor is important but
information about it is not available, an expectation that does not take that factor into
account can still be rational.

Formal Statement of the Theory

We can state the theory of rational expectations somewhat more formally. If X stands
for the variable that is being forecast (in our example, Joe Commuter’s driving time),
Xe for the expectation of this variable ( Joe’s expectation of his driving time), and Xof for
the optimal forecast of X using all available information (the best guess possible of Joe’s
driving time), the theory of rational expectations then simply states
X e = X of (6)

That is, the expectation of X equals the optimal forecast using all available information.

Rationale Behind the Theory

Why do people try to make their expectations match their best possible guess of future
results, using all available information? The simplest explanation is that it is costly for
people not to do so. Joe Commuter has a strong incentive to make his expectation of the
time it takes him to drive to work as accurate as possible. If he underpredicts his driving
time, he will often be late to work and risk being fired. If he overpredicts, he will, on
average, get to work too early and will have given up sleep or leisure time unnecessar-
ily. Accurate expectations are desirable, and therefore people have a strong incentive to
try to make expectations equal to optimal forecasts by using all available information.

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 194 P a r t 2   Financial Markets

The same principle applies to businesses. Suppose an appliance manufacturer—

say, General Electric—knows that interest-rate movements are important to the sales of
appliances. If GE makes poor forecasts of interest rates, it will earn less profit, because
it will produce either too many or too few appliances. The incentives are strong for GE
to acquire all available information to help it forecast interest rates and make the best
possible guess of future interest-rate movements.

Implications of the Theory

Rational expectations theory leads to two commonsense implications regarding the
formation of expectations. These implications are important in the analysis of both the
stock market and the aggregate economy:
1. If there is a change in the way a variable moves, the way in which expecta-
tions of this variable are formed will change as well. This tenet of rational expectations
theory can be most easily understood through a concrete example. Suppose interest
rates move in such a way that they tend to return to a “normal” level over time. If today’s
interest rate is high relative to the normal level, an optimal forecast of the interest rate
in the future is that it will decline to the normal level. Rational expectations theory
would imply that when today’s interest rate is high, the expectation is that it will fall
in the future.
Suppose now that the way in which the interest rate moves changes so that when the
interest rate is high, it stays high. In this case, when today’s interest rate is high, the
optimal forecast of the future interest rate, and hence the rational expectation, is that it
will stay high. Expectations of the future interest rate will no longer indicate that
the interest rate will fall. The change in the way the interest-rate variable moves has
therefore led to a change in the way that expectations of future interest rates are formed.
The rational expectations analysis here is generalizable to expectations of any variable.
Hence, when a change occurs in the way any variable moves, the way in which expecta-
tions of this variable are formed will change, too.
2. The forecast errors of expectations will, on average, be zero and cannot be
predicted ahead of time. The forecast error of an expectation is X – Xe, the difference
between the realization of a variable X and the expectation of the variable. That is, if
Joe Commuter’s driving time on a particular day is 45 minutes and his expectation of
the driving time is 40 minutes, the forecast error is five minutes.
Suppose that in violation of the rational expectations tenet, Joe’s forecast error is
not, on average, equal to zero; instead, it equals five minutes. The forecast error is now
predictable ahead of time because Joe will soon notice that he is, on average, five min-
utes late for work and can improve his forecast by increasing it by five minutes. Rational
expectations theory implies that this is exactly what Joe will do because he will want
his forecast to be the best guess possible. When Joe has revised his forecast upward by
five minutes, on average, the forecast error will equal zero, so it cannot be predicted
ahead of time. Rational expectations theory implies that forecast errors of expectations
cannot be predicted.

The incentives for equating expectations with optimal forecasts are especially
strong in financial markets. In these markets, people with better forecasts of the future
get rich. The application of the theory of rational expectations to financial markets
(where it is called the efficient market hypothesis or the theory of efficient capital
markets) is thus particularly useful.

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 Chapter 7   The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 195

The Efficient Market Hypothesis: Rational

Expectations in Financial Markets
While monetary economists were developing the theory of rational expectations,
financial economists were developing a parallel theory of expectations formation for
financial markets. It led them to the same conclusion as that of the rational expecta-
tions theorists: Expectations in financial markets are equal to optimal forecasts using
all available information.4 Although financial economists, such as Eugene Fama, winner
of the Nobel Prize in economics, gave their theory another name, calling it the efficient
market hypothesis, in fact their theory is just an application of rational expectations to
the pricing of stocks and other securities.
The efficient market hypothesis is based on the assumption that prices of securities
in financial markets fully reflect all available information. You may recall from Chapter 4
that the rate of return from holding a security equals the sum of the capital gain on the
security (the change in the price), plus any cash payments, divided by the initial purchase
price of the security:

Pt + 1 - Pt + C
R = (7)
Pt
where R = rate of return on the security held from time t to time t + 1 (say,
the end of 2015 to the end of 2016)
Pt + 1 = price of the security at time t + 1, the end of the holding period
Pt = price of the security at time t, the beginning of the holding period
C = cash payment (coupon or dividend payments) made in the
period t to t + 1
Let’s look at the expectation of this return at time t, the beginning of the holding
period. Because the current price Pt and the cash payment C are known at the outset,
the only variable in the definition of the return that is uncertain is the price next period,
Pt + 1.5 Denoting expectation of the security’s price at the end of the holding period as
P et + 1, the expected return Re is
P et + 1 - Pt + C
Re =
Pt
The efficient market hypothesis views expectations of future prices as equal to
optimal forecasts using all currently available information. In other words, the market’s
expectations of future securities prices are rational, so that
P et + 1 = P of
t+1

which in turn implies that the expected return on the security will equal the optimal
forecast of the return:
Re = Rof (8)

4
The development of the efficient market hypothesis was not wholly independent of the development of rational
expectations theory in that financial economists were aware of Muth's work.
5
There are cases in which C might not be known at the beginning of the period, but that does not make a substan-
tial difference to the analysis. We would in that case assume that not only price expectations but also the expecta-
tions of C are optimal forecasts using all available information.

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 196 P a r t 2   Financial Markets

Unfortunately, we cannot observe either Re or P et + 1, so the rational expectations equations

by themselves do not tell us much about how the financial market behaves. However, if
we can devise some way to measure the value of Re, these equations will have important
implications for how prices of securities change in financial markets.
The supply and demand analysis of the bond market that we developed in Chapter 5
showed us that the expected return on a security (the interest rate, in the case of
the one-year discount bond we examined) will have a tendency to move toward the
equilibrium return that equates the quantity demanded to the quantity supplied. Supply
and demand analysis enables us to determine the expected return on a security with the
following equilibrium condition:
The expected return on a security Re equals the equilibrium return R*, which
equates the quantity of the security demanded to the quantity supplied; that is,
Re = R* (9)

The academic field of finance explores the factors (risk and liquidity, for example) that
influence the equilibrium returns on securities. For our purposes, it is sufficient to
know that we can determine the equilibrium return and thus determine the expected
return with the equilibrium condition.
We can derive an equation to describe pricing behavior in an efficient market by
using the equilibrium condition to replace Re with R* in the rational expectations equation
(Equation 8). In this way, we obtain
Rof = R* (10)

This equation tells us that current prices in a financial market will be set so that the
optimal forecast of a security’s return using all available information equals the security’s
equilibrium return. Financial economists state it more simply: In an efficient market, a
security’s price fully reflects all available information.

Rationale Behind the Hypothesis

To see why the efficient market hypothesis makes sense, we make use of the concept
of arbitrage, in which market participants (arbitrageurs) eliminate unexploited profit
opportunities, that is, returns on a security that are larger than what is justified by
the characteristics of that security. Arbitrage is of two types: pure arbitrage, in which
the elimination of unexploited profit opportunities involves no risk, and the type of
arbitrage we discuss here, in which the arbitrageur takes on some risk when eliminating
the unexploited profit opportunities. To see how arbitrage leads to the efficient market
hypothesis given a security’s risk characteristics, let’s look at an example. Suppose the
normal return on ExxonMobil common stock is 10% at an annual rate, and its current
price Pt is lower than the optimal forecast of tomorrow’s price P oft + 1, so that the optimal
forecast of the return at an annual rate is 50%, which is greater than the equilibrium
return of 10%. We are now able to predict that, on average, ExxonMobil’s return will
be abnormally high, so there is an unexploited profit opportunity. Knowing that, on
average, you can earn an abnormally high rate of return on ExxonMobil stock (because
Rof 7 R*), you will buy more, which will in turn drive up the stock’s current price Pt
relative to its expected future price P of of
t + 1, thereby lowering R . When the current price
of
has risen sufficiently so that R equals R* and the efficient market condition (Equation
10) is satisfied, the buying of ExxonMobil stock will stop, and the unexploited profit
opportunity will disappear.

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 Chapter 7   The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 197

Similarly, a security for which the optimal forecast of the return is -5% and the
equilibrium return is 10% 1Rof 6 R*2 would be a poor investment because, on aver-
age, the security earns less than the equilibrium return. In such a case, you would sell
the security and drive down its current price relative to the expected future price until
Rof rose to the level of R* and the efficient market condition was again satisfied. Our
discussion can be summarized as follows:
Rof 7 R* S Pt c S Rof T

Rof 6 R* S Pt T S Rof c
until
Rof = R*

Another way to state the efficient market condition is this: In an efficient market, all
unexploited profit opportunities will be eliminated.
An extremely important factor in this reasoning is that not everyone in a finan-
cial market must be well informed about a security or have rational expectations
for its price to be driven to the point at which the efficient market condition holds.
Financial markets are structured so that many participants can play. As long as a few
people (often referred to as the “smart money”) keep their eyes open for unexploited
profit opportunities, they will eliminate the profit opportunities that appear, because
in doing so they make a profit. The efficient market hypothesis makes sense because
it does not require that everyone in a market be cognizant of what is happening to
every security.

Random-Walk Behavior of Stock Prices

The term random walk describes the movements of a variable whose future values
cannot be predicted (are random) because, given today’s value, the value of the variable
is just as likely to fall as it is to rise. An important implication of the efficient market
hypothesis is that stock prices should approximately follow a random walk; that is,
future changes in stock prices should, for all practical purposes, be unpredictable. The
random-walk implication of the efficient market hypothesis is the one most commonly
mentioned in the press because it is the most readily comprehensible to the public. In
fact, when people mention the “random-walk theory of stock prices,” they are in reality
referring to the efficient market hypothesis.
The case for random-walk stock prices can be demonstrated. Suppose people
could predict that the price of Happy Feet Corporation (HFC) stock would rise 1% in
the coming week. The predicted rate of capital gains and rate of return on HFC stock
would then exceed 50% at an annual rate. Since this is very likely to be far higher than
the equilibrium rate of return on HFC stock (Rof 7 R* ), the efficient market hypothesis
indicates that people would immediately buy this stock and bid up its current price.
The action would stop only when the predictable change in the price dropped to near
zero, so that Rof = R*.
Similarly, if people could predict that the price of HFC stock would fall by 1%,
the predicted rate of return would be negative (Rof 7 R* ), and people would imme-
diately sell the stock. The current price would fall until the predictable change in the
price rose back to near zero, where the efficient market condition again would hold.
The efficient market hypothesis suggests that the predictable change in stock prices
will be near zero, leading to the conclusion that stock prices will generally follow a

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 198 P a r t 2   Financial Markets

Global Should Foreign Exchange Rates Follow a Random Walk?

Although the efficient market hypothesis is usually the predictable change in the exchange rate dropped
applied to the stock market, it can also be used to to near zero so that the optimal forecast of the return
show that foreign exchange rates, like stock prices, no longer differed from the equilibrium return.
should generally follow a random walk. To see why Likewise, if investors could predict that the currency
this is the case, consider what would happen if would fall in value by 1% in the coming week, they
investors could predict that a currency would rise would sell it until the predictable change in the
in value by 1% in the coming week. By buying this exchange rate was again near zero. The efficient mar-
currency, they could earn a greater than 50% return ket hypothesis therefore implies that future changes
at an annual rate, which is likely to be far above in exchange rates should, for all practical purposes,
the equilibrium return for holding a currency. As a be unpredictable; in other words, exchange rates
result, investors would immediately buy the currency should follow random walks. Indeed, the random-
and bid up its current price, thereby reducing the walk behavior of exchange rates is exactly what is
expected return. The process would only stop when found in the data.

random walk.6 As the Global Box “Should Foreign Exchange Rates Follow a Random
Walk?” indicates, the efficient market hypothesis suggests that foreign exchange rates
should also follow a random walk.

A p p li c ati o n Practical Guide to Investing in the Stock Market

The efficient market hypothesis has numerous applications to the real world.7 It is
especially valuable because it can be applied directly to an issue that concerns many
of us: how to get rich (or at least not get poor) by investing in the stock market. A
practical guide to investing in the stock market, which we develop here, provides a
better understanding of the use and implications of the efficient market hypothesis.

How Valuable Are Reports Published

by Investment Advisers?
Suppose you have just read in the “Heard on the Street” column of the Wall Street Journal
that investment advisers are predicting a boom in oil stocks because an oil shortage is
developing. Should you proceed to withdraw all of your hard-earned savings from the
bank and invest them in oil stocks?

6
Note that the random-walk behavior of stock prices is only an approximation derived from the efficient market
hypothesis. Random-walk behavior would hold exactly only for a stock for which an unchanged price leads to
its having the equilibrium return. Then, when the predictable change in the stock price is exactly zero, Rof = R*.
7
The empirical evidence on the efficient market hypothesis is discussed in an appendix to this chapter, which can
be found on the Companion Website at [Link]

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 Chapter 7   The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 199

The efficient market hypothesis tells us that when purchasing a security, we can-
not expect to earn an abnormally high return, or a return greater than the equilibrium
return.
Information in newspapers and in the published reports of investment advisers is
readily available to many market participants and is already reflected in market prices.
So acting on this information will not yield abnormally high returns, on average. The
empirical evidence for the most part confirms that recommendations from investment
advisers cannot help us outperform the general market. Indeed, as the FYI box suggests,
human investment advisers in San Francisco do not, on average, even outperform an
orangutan!
Probably no other conclusion is met with more skepticism by students than this
one when they first hear it. We all know, or have heard of, someone who has been
successful in the stock market for a period of many years. We wonder, “How could
someone be so consistently successful if he or she did not really know how to predict
when returns would be abnormally high?” The following story, reported in the press,
illustrates why such anecdotal evidence is not reliable.
A get-rich-quick artist invented a clever scam. Every week, he wrote two letters. In
letter A, he would pick team A to win a particular football game; in letter B, he would
pick the opponent, team B. He would then separate a mailing list into two groups, and
he would send letter A to the people in one group and letter B to the people in the
other. The following week he would do the same thing, but this time he would send
these letters only to the group who had received the first letters containing the correct
prediction. After doing this for ten games, he had a small cluster of people who had
received letters predicting the correct winning team for every game. He then mailed a
final letter to this group, declaring that since he was obviously an expert predictor of the
outcome of football games (he had picked the winning teams ten weeks in a row), and
since his predictions were profitable for the recipients who bet on the games, he would
continue to send his predictions only if he were paid a substantial amount of money.
When one of his clients figured out what he was up to, the con man was prosecuted
and thrown in jail!
What is the lesson of the story? Even if no forecaster is an accurate predictor of the
market, there will always be a group of consistent winners. A person who has done well
regularly in the past cannot guarantee that he or she will do well in the future. Note that
there will also be a group of persistent losers, but you rarely hear about them because
no one brags about a poor forecasting record.

Should You Be Skeptical of Hot Tips?

Suppose your broker phones you with a hot tip to buy stock in the Happy Feet Cor-
poration (HFC) because it has just developed a product that is completely effective in
curing athlete’s foot. The stock price is sure to go up. Should you follow this advice
and buy HFC stock?
The efficient market hypothesis indicates that you should be skeptical of such
news. If the stock market is efficient, it has already priced HFC stock so that its
expected return will equal the equilibrium return. The hot tip is not particularly valu-
able and will not enable you to earn an abnormally high return.
You might wonder, though, if the hot tip is based on new information and would
give you an edge on the rest of the market. If other market participants have gotten this
information before you, the answer again is no. As soon as the information hits the street,
the unexploited profit opportunity it creates will be quickly eliminated. The stock’s

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 200 P a r t 2   Financial Markets

FYI Should You Hire an Ape as Your Investment Adviser?

The San Francisco Chronicle came up with an amusing World/Africa USA in Vallejo, California. Jolyn beat
way of evaluating how successful investment advisers the investment advisers as often as they beat her.
are at picking stocks. They asked eight analysts to Given this result, you might be just as well off hir-
pick five stocks at the beginning of the year and then ing an orangutan as your investment adviser as you
compared the performance of their stock picks to would be hiring a human being!
those chosen by Jolyn, an orangutan living at Marine

price will already reflect the information, and you should expect to realize only the
equilibrium return. But if you are one of the first to gain the new information, it can
do you some good. Only then can you be one of the lucky ones who, on average, will
earn an abnormally high return by helping eliminate the profit opportunity by buying
HFC stock.

Do Stock Prices Always Rise When There Is Good News?

If you follow the stock market, you might have noticed a puzzling phenomenon: When
good news about a corporation, such as a particularly favorable earnings report, is
announced, the price of the corporation’s stock frequently does not rise. The efficient
market hypothesis explains this phenomenon.
Because changes in stock prices are unpredictable, when information is announced
that has already been expected by the market, stock prices will remain unchanged. The
announcement does not contain any new information that would lead to a change in
stock prices. If this were not the case, and the announcement led to a change in stock
prices, it would mean that the change was predictable. Because such a scenario is ruled
out in an efficient market, stock prices will respond to announcements only when the
information being announced is new and unexpected. If the news is expected, no stock
price response will occur. This is exactly what the evidence shows: Stock prices do
reflect publicly available information.
Sometimes an individual stock price declines when good news is announced.
Although this seems somewhat peculiar, it is completely consistent with the workings
of an efficient market. Suppose that although the announced news is good, it is not as
good as expected. HFC’s earnings may have risen by 15%, but if the market expected
earnings to rise by 20%, the new information is actually unfavorable, and the stock
price declines.

Efficient Market Prescription for the Investor

What does the efficient market hypothesis recommend for investing in the stock mar-
ket? It tells us that hot tips and investment advisers’ published recommendations—all
of which make use of publicly available information—cannot help an investor outper-
form the market. Indeed, it indicates that anyone without better information than other
market participants cannot expect to beat the market. So what is an investor to do?

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 Chapter 7   The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 201

The efficient market hypothesis leads to the conclusion that such an investor (and
almost all of us fit into this category) should not try to outguess the market by con-
stantly buying and selling securities. This process does nothing but boost the income of
brokers, who earn commissions on each trade.8 Instead, the investor should pursue a
“buy and hold” strategy—purchase stocks and hold them for long periods of time. This
will lead to the same returns, on average, but the investor’s net profits will be higher
because fewer brokerage commissions will have to be paid.
A sensible strategy for a small investor, whose costs of managing a portfolio may
be high relative to its size, is to buy into a mutual fund rather than to buy individual
stocks. Because the efficient market hypothesis indicates that no mutual fund can con-
sistently outperform the market, an investor should not buy into a fund that has high
management fees or pays sales commissions to brokers, but rather should purchase a
no-load (commission-free) mutual fund that has low management fees.
The evidence indicates that it will not be easy to beat the prescription suggested
here, although some anomalies (discussed in an appendix found on this book’s website)
to the efficient market hypothesis suggest that an extremely clever investor (that rules
out most of us) may be able to outperform a buy-and-hold strategy. ◆

Why the Efficient Market Hypothesis Does Not

Imply That Financial Markets Are Efficient
Many financial economists take the efficient market hypothesis one step further in their
analysis of financial markets. Not only do they believe that expectations in financial
markets are rational—that is, equal to optimal forecasts using all available informa-
tion—but they also add the condition that prices in financial markets reflect the true
fundamental (intrinsic) value of the securities. In other words, all prices are always
correct and reflect market fundamentals (items that have a direct impact on future
income streams of the securities), and so financial markets are efficient.
This stronger view of market efficiency has several important implications in the
academic field of finance. First, it implies that in an efficient capital market, one invest-
ment is as good as any other because the securities’ prices are correct. Second, it implies
that a security’s price reflects all available information about the intrinsic value of the
security. Third, it implies that security prices can be used by managers of both financial
and nonfinancial firms to assess their costs of capital (costs of financing their investments)
accurately and hence that security prices can be used to help these managers make correct
decisions about whether a specific investment is worth making. This stronger version of
market efficiency is a basic tenet of much analysis in the finance field.
The efficient market hypothesis may be misnamed, however. It does not imply the
stronger view of market efficiency, but rather just that prices in markets like the stock
market are unpredictable. Indeed, as the following application suggests, the existence
of market crashes and bubbles, in which the prices of assets rise well above their
fundamental values, casts serious doubt on the stronger view that financial markets
are efficient. However, market crashes and bubbles do not necessarily provide strong
evidence against the basic tenets of the efficient market hypothesis.

8
The investor may also have to pay Uncle Sam capital gains taxes on any profits that are realized when a security
is sold—an additional reason why continual buying and selling does not make sense.

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 202 P a r t 2   Financial Markets

A p p li c ati o n  hat Do Stock Market Crashes Tell Us About

W
the Efficient Market Hypothesis and the
Efficiency of Financial Markets?
On October 19, 1987, dubbed “Black Monday,” the Dow Jones Industrial Average
declined by more than 20%, the largest one-day decline in U.S. history. The collapse
of the high-tech companies’ share prices from their peaks in March 2000 caused the
heavily-tech-laden NASDAQ index to fall from about 5,000 in March 2000 to about
1,500 in 2001 and 2002, a decline of well over 60%. These stock market crashes
caused many economists to question the validity of the efficient market hypothesis.
These economists do not believe that a rational marketplace could have produced
such a massive swing in share prices. To what degree should these stock market
crashes make us doubt the validity of the efficient market hypothesis?
Nothing in efficient markets theory rules out large changes in stock prices. A
large change in stock prices can result from new information that produces a dramatic
decline in optimal forecasts of the future valuation of firms. However, economists are
hard pressed to find fundamental changes in the economy that would have caused the
Black Monday and tech crashes. One lesson from these crashes is that factors other
than market fundamentals probably have an effect on asset prices. Indeed, as we will
explore in Chapters 8 and 12, there are good reasons to believe that impediments to
the proper functioning of financial markets do exist. Hence, these crashes have con-
vinced many economists that the stronger version of market efficiency, which states
that asset prices reflect the true fundamental (intrinsic) value of securities, is incorrect.
These economists attribute a large role in determination of stock and other asset prices
to market psychology and to the institutional structure of the marketplace. However,
nothing in this view contradicts the basic reasoning behind rational expectations or
the efficient market hypothesis—that market participants eliminate unexploited profit
opportunities. Even though stock market prices may not always solely reflect market
fundamentals, as long as market crashes are unpredictable, the basic premises of effi-
cient markets theory hold.
However, other economists believe that market crashes and bubbles suggest that unex-
ploited profit opportunities may exist and that the efficient market hypothesis might be
fundamentally flawed. The controversy over the efficient market hypothesis continues. ◆

Behavioral Finance
Doubts about the efficiency of financial markets, triggered by the stock market crash
of 1987, led economists such as Nobel Prize winner Robert Shiller to develop a new
field of study called behavioral finance. It applies concepts from other social sciences,
such as anthropology, sociology, and particularly psychology, to explain the behavior
of securities prices.9

9
Surveys of this field can be found in Hersh Shefrin, Beyond Greed and Fear: Understanding of Behavioral Finance
and the Psychology of Investing (Boston: Harvard Business School Press, 2000); Andrei Shleifer, Inefficient Markets
(Oxford, UK: Oxford University Press, 2000); and Robert J. Shiller, “From Efficient Market Theory to Behavioral
Finance,” Cowles Foundation Discussion Paper No. 1385 (October 2002).

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 Chapter 7   The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 203

As we have seen, the efficient market hypothesis assumes that unexploited profit
opportunities are eliminated by “smart money” market participants. But can smart
money dominate ordinary investors so that financial markets are efficient? Specifically,
the efficient market hypothesis suggests that smart money participants will sell when a
stock price goes up irrationally, with the result that the stock price falls back down to
a level that is justified by fundamentals. For this to occur, smart money investors must
be able to engage in short sales; that is, they must borrow stock from brokers and then
sell it in the market, with the aim of earning a profit by buying the stock back again
(“covering the short”) after it has fallen in price. Work by psychologists, however, sug-
gests that people are subject to loss aversion: They are more unhappy when they suffer
losses than they are happy when they achieve gains. Short sales can result in losses far
in excess of an investor’s initial investment if the stock price climbs sharply higher than
the price at which the short sale is made (and losses might be unlimited if the stock
price climbs to astronomical heights).
Loss aversion can thus explain an important phenomenon: Very little short selling
actually takes place. Short selling may also be constrained by rules restricting it, because
it seems unsavory for someone to make money from another person’s misfortune. The
existence of so little short selling can explain why stock prices are sometimes overval-
ued. That is, the lack of enough short selling means that smart money does not drive
stock prices back down to their fundamental value.
Psychologists have also found that people tend to be overconfident in their own
judgments. As a result, investors tend to believe that they are smarter than other inves-
tors. Because investors are willing to assume that the market typically doesn’t get it
right, they trade on their beliefs rather than on pure facts. This theory may explain
why securities markets have such a large trading volume—something that the efficient
market hypothesis does not predict.
Overconfidence and social contagion (fads) provide an explanation for stock mar-
ket bubbles. When stock prices go up, investors attribute their profits to their intel-
ligence and talk up the stock market. This word-of-mouth enthusiasm and glowing
media reports then can produce an environment in which even more investors think
stock prices will rise in the future. The result is a positive feedback loop in which prices
continue to rise, producing a speculative bubble, which finally crashes when prices get
too far out of line with fundamentals.10
The field of behavioral finance is a young one, but it holds out hope that we
might be able to explain some features of securities markets’ behavior that are not well
explained by the efficient market hypothesis.

10
See Robert J. Shiller, Irrational Exuberance (New York: Broadway Books, 2001).

Summary
1. Stocks are valued as the present value of future divi- forever. Given our uncertainty regarding future divi-
dends. Unfortunately, we do not know very precisely dends, this assumption is often the best we can do.
what these dividends will be. This uncertainty intro- 2. The interaction among traders in the market is what
duces a great deal of error into the valuation process. actually sets prices on a day-to-day basis. The trader
The Gordon growth model is a simplified method of who values the security the most (either because of
computing stock value that depends on the assumption less uncertainty about cash flows or because of greater
that the dividends are growing at a constant rate estimated cash flows) will be willing to pay the most.

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 204 P a r t 2   Financial Markets

As new information is released, investors will revise periods of time. Empirical evidence generally supports
their estimates of the true value of the security and these implications of the efficient market hypothesis in
will either buy or sell it, depending on how the market the stock market.
price compares with their estimated valuation. Because 5. The existence of market crashes and bubbles has con-
small changes in estimated growth rates or required vinced many economists that the stronger version of
returns result in large changes in price, it is not sur- market efficiency, which states that asset prices reflect
prising that the markets are often volatile. the true fundamental (intrinsic) value of securities, is
3. The efficient market hypothesis states that current not correct. There is, however, less evidence that these
security prices will fully reflect all available informa- crashes prove that the efficient market hypothesis is
tion, because in an efficient market, all unexploited wrong. Even if the stock market were driven by factors
profit opportunities are eliminated. The elimination of other than fundamentals, these crashes do not clearly
unexploited profit opportunities necessary for a finan- demonstrate that many basic tenets of the efficient
cial market to be efficient does not require that all mar- market hypothesis are no longer valid, as long as the
ket participants be well informed. The efficient markets crashes could not have been predicted.
hypothesis implies that stock prices generally follow a 6. The new field of behavioral finance applies concepts
random walk. from other social sciences, such as anthropology, soci-
4. The efficient market hypothesis indicates that hot tips ology, and psychology, to our understanding of the
and investment advisers’ published recommendations behavior of securities prices. Loss aversion, overcon-
cannot help an investor outperform the market. The fidence, and social contagion can explain why trading
best prescription for investors is to pursue a buy-and- volume is so high, why stock prices become overval-
hold strategy—purchase stocks and hold them for long ued, and why speculative bubbles occur.

Key Terms
adaptive expectations, p. 192 generalized dividend model, p. 188 short sales, p. 203
arbitrage, p. 196 Gordon growth model, p. 188 stockholders, p. 186
behavioral finance, p. 202 market fundamentals, p. 201 theory of efficient capital markets,
bubbles, p. 201 optimal forecast, p. 192 p. 194
cash flows, p. 186 random walk, p. 197 unexploited profit opportunity,
dividends, p. 187 rational expectations, p. 192 p. 196
efficient market hypothesis, p. 194 residual claimant, p. 186

Questions
Select questions are available in MyEconLab at can monetary policy be used to prick a market bubble?
[Link] Explain using the Gordon growth model.
1. What basic principle of finance can be applied to the 4. If monetary policy becomes more transparent about the
valuation of any investment asset? future course of interest rates, how will stock prices be
2. What are the two main sources of cash flows for a affected, if at all?
stockholder? How reliably can these cash flows be esti- 5. “Forecasters’ predictions of inflation are notoriously
mated? Compare the problem of estimating stock cash inaccurate, so their expectations of inflation cannot
flows to the problem of estimating bond cash flows. be rational.” Is this statement true, false, or uncertain?
Which security would you predict to be more volatile? Explain your answer.
3. Some economists think that central banks should try to 6. “Anytime it is snowing when Joe Commuter gets up in
prick bubbles in the stock market before they get out the morning, he misjudges how long it will take him to
of hand and cause later damage when they burst. How drive to work. When it is not snowing, his expectations

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 Chapter 7   The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis 205

of the driving time are perfectly accurate. Considering of common stocks will not fully reflect information
that it snows only once every ten years where Joe lives, about them.” Is this statement true, false, or uncertain?
Joe’s expectations are almost always perfectly accurate.” Explain your answer.
Are Joe’s expectations rational? Why or why not? 15. “An efficient market is one in which no one ever prof-
7. If a forecaster spends hours every day studying data to its from having better information than the rest of the
forecast interest rates, but his expectations are not as market participants.” Is this statement true, false, or
accurate as predicting that tomorrow’s interest rate will uncertain? Explain your answer.
be identical to today’s interest rate, are his expectations 16. If higher money growth is associated with higher future
rational? inflation, and if announced money growth turns out
8. “If stock prices did not follow a random walk, there to be extremely high but is still less than the market
would be unexploited profit opportunities in the mar- expected, what do you think will happen to long-term
ket.” Is this statement true, false, or uncertain? Explain bond prices?
your answer. 17. “Foreign exchange rates, like stock prices, should fol-
9. Suppose that increases in the money supply lead to a rise low a random walk.” Is this statement true, false, or
in stock prices. Does this mean that when you see that the uncertain? Explain your answer.
money supply has sharply increased in the past week, you
18. Can we expect the value of the dollar to rise by 2%
should go out and buy stocks? Why or why not?
next week if our expectations are rational?
10. If the public expects a corporation to lose $5 per share
19. “Human fear is the source of stock market crashes, so
this quarter and it actually loses $4, which is still the
these crashes indicate that expectations in the stock
largest loss in the history of the company, what does
market cannot be rational.” Is this statement true, false,
the efficient market hypothesis predict will happen to
or uncertain? Explain your answer.
the price of the stock when the $4 loss is announced?
20. In the late 1990s, as information technology advanced
11. If you read in the Wall Street Journal that the “smart
rapidly and the Internet was widely developed, U.S.
money” on Wall Street expects stock prices to fall,
stock markets soared, peaking in early 2001. Later that
should you follow that lead and sell all your stocks?
year, these markets began to unwind and then crashed,
12. If your broker has been right in her five previous buy with many commentators identifying the previous few
and sell recommendations, should you continue listen- years as a “stock market bubble.” How might it be pos-
ing to her advice? sible for this episode to be a bubble but still adhere to
13. Can a person with rational expectations expect the price the efficient market hypothesis?
of a share of Google to rise by 10% in the next month? 21. Why might the efficient market hypothesis be less
14. “If most participants in the stock market do not follow likely to hold when fundamentals suggest stocks
what is happening to the monetary aggregates, prices should be at a lower level?

Applied Problems
Select applied problems are available in MyEconLab at 24. The current price of a stock is $55.68. If dividends
[Link] are expected to be $0.80 per share for the next five
22. Compute the price of a share of stock that pays a $5 years, and the required return is 6%, then what should
per year dividend and that you expect to be able to the price of the stock be in 5 years when you plan to
sell in one year for $20, assuming you require a 20% sell it? If the dividend and required return remain the
return. same, and the stock price is expected to increase by
23. After careful analysis, you have determined that a $1 five years from now, does the current stock price
firm’s dividends should grow at 2%, on average, in the also increase by $1? Why or why not?
foreseeable future. The firm’s last dividend was $1.50. 25. A company has just announced a 3-for-1 stock split,
Compute the current price of this stock, assuming the effective immediately. Prior to the split, the company
required return is 5%. had a market value of $5 billion with 100 million

M07_MISH4182_11_GE_C07.indd 205 28/05/15 1:50 pm

 206 P a r t 2   Financial Markets

shares outstanding. Assuming the split conveys no new the price per share after the split? If the actual market
information about the company, what are the value of price immediately following the split is $17.00 per
the company, the number of shares outstanding, and share, what does this tell us about market efficiency?

Data Analysis Problems

The Problems update with real-time data in MyEconLab and (B056RC1A027NBEA). Adjust the units setting to
are available for practice or instructor assignment. “Percent Change from Year Ago,” and download the
1. Go to the St. Louis Federal Reserve FRED database, data into a spreadsheet.
and find data on the Dow Jones Industrial Average a. Calculate the average annual growth rate of divi-
(DJIA). Assume the DJIA is a stock that pays no divi- dends from 1960 to the most recent year of data
dends. Apply the one-period valuation model, using the available.
data from one year prior up to the most current date b. Find data on the Dow Jones Industrial Average
available, to determine the required return on equity (DJIA) for the most recent day of data available.
investment. In other words, assume the most recent Suppose that a $100 dividend is paid out at the
stock price of DJIA is known one year prior. What rate end of next year. Use the Gordon growth model
of return would be required in order to “buy” a share of and your answer to part (a) to calculate the
DJIA? Suppose that a $100 dividend is paid out instead. rate of return that would be required for equity
How does this change the required rate of return? investment over the next year, assuming you
2. G
 o to the St. Louis Federal Reserve FRED database, could buy a share of DJIA.
and find data on net corporate dividend payments

Web Exercises
1. Visit [Link] Click on Summary section to view current data on the Dow
Stock Index at the very top of the page. Now choose Jones Industrial Average. Click on the chart to manipu-
U.S. Stock Indices—monthly. Review the indexes for late the different variables. Change the time range and
the DJIA, the S&P 500, and the NASDAQ composite. observe the stock trend over various intervals. Have
Which index appears most volatile? In which index stock prices been going up or down over the past day,
would you rather have invested in 1985 if the invest- week, three months, and year?
ment had been allowed to compound until now? 3. Eugene Fama and Robert Shiller recently won the
2. The Internet is a great source of information on stock Nobel Prize in economics. Go to [Link]
prices and stock price movements. Yahoo Finance is a nobel_prizes/economics/ and locate the press release on
great source for stock market data. Go to [Link] Eugene Fama and Robert Shiller. What was the Nobel
.[Link] and click on the DOW ticker in the Market Prize to them awarded for? When was it awarded?

Web References
[Link] [Link]
Access detailed stock quotes, charts, and historical stock data. Learn more about the efficient market hypothesis.

Web Appendix
Please visit the Companion Website at [Link] Appendix: Evidence on the Efficient Market Hypothesis
.[Link]/Mishkin to read the Web appen-
dix to Chapter 7.

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