Equilibrium
To summarize, in
equilibrium two related conditions
must hold:
1. A stock’s expected rate
of return as seen by the marginal
investor must equal its
required rate of return: kˆI
= kI .
2. The actual market price of the stock must equal
its intrinsic value as esti- mated by the marginal investor: P0 = Pˆ0.
Marginal Investor
A
representative investor whose actions reflect the beliefs of those people who
are currently trading a stock. It is the marginal investor who determines a
stock’s price.
CHANGES IN
EQUILIBRIUM STOCK PRICES
Stock prices are not constant — they undergo violent changes at times. Stock prices
certainly change, sometimes violently
and rapidly, but this simply reflects changing conditions and expectations.
THE
EFFICIENT MARKETS HYPOTHESIS
Efficient Markets Hypothesis(EMH)
The hypothesis that securities are typically in
equilibrium — that they are fairly
priced in the sense that the price reflects all publicly available information
on each security.
The
Efficient Markets Hypothesis
(EMH) holds (1) that stocks are al- ways
in equilibrium and (2) that it is
impossible for an investor who does not have inside information to
consistently “beat the market.”
Therefore,according to the EMH, stocks are always fairly valued (Pˆ 0 = P0),
the re- quired return on a stock is equal to its expected
return (k = kˆ ), and all stocks’
expected returns plot on the SML.
LEVELS OF
MARKET EFFICIENCY
Weak-Form Efficiency
weak- form efficiency implies that
any information that comes from past stock prices is rapidly incorporated into
the current stock price.
Semistrong-Form
Efficiency
states that current
market prices reflect
all publicly available information.
Strong-Form Efficiency
The strong form of the EMH states that current market prices reflect all perti- nent information, whether publicly
available or privately held.
IMPLICATIONS OF
MARKET EFFICIENCY
Market efficiency also
has important implications for
managerial decisions, especially those per- taining to common stock issues,
stock repurchases, and tender offers.
Stocks appear to be fairly val- ued, so
decisions based on
the premise that a
stock is undervalued or
overvalued must be ap-
proached with caution.
ACTUAL STOCK
PRICES AND RETURNS
PREFERRED STOCK
Preferred stock is a hybrid — it is similar
to bonds in
some respects and to
common stock in others. The
hybrid nature of preferred
stock becomes ap- parent when we try to classify it in relation to bonds and common stock.
a preferred stock
entitles its owners to regular, fixed divi- dend payments.
If the payments last forever,
the issue is a perpetuity whose value, Vp, is found as follows:
Vp
=
Allied Food
Products has preferred stock outstanding that pays a dividend of $10
per year. If the required rate of
return on this pre- ferred stock is 10
percent, then its value is $100, found by solving Equation 9-8 as follows:
Vp =
In equilibrium the
expected return, ˆkp, is equal to the
required return, kp. Thus, if we know the current price of a preferred stock and its dividend, we can solve for the
expected rate of return as follows:
kˆ p = .
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