Chapter 6
The Stock Market, Information, and
Financial Market Efficiency
Brief Chapter Summary and Learning Objectives
6.1 Stocks and the Stock Market (pages 158–164)
Understand the basic operations of the stock market.
Publicly traded companies sell stocks on the stock market.
The overall performance of the stock market is measured using stock market indexes, which are
averages of stock prices.
Fluctuations in stock prices affect the ability of firms to raise funds by selling stock and also
affect the spending of households and firms.
6.2 How Stock Prices Are Determined (pages 164–170)
Explain how stock prices are determined.
The fundamental value of a share of stock is the present value of the dividends investors expect
to receive from owning the stock.
For a particular holding period, the rate of return from owning a share of stock equals the
dividend yield plus the rate of capital gain.
The Gordon growth model states that if investors expect a firm’s dividend to increase at a
constant growth rate, g, then the price of a stock is related to the current dividend, Dt, and
growth rate of dividends and the required return on equities. The equation for the Gordon
growth model is:
(1 ) .
( )
t t
E
g
P D r g
+
= ´ –
6.3 Rational Expectations and Efficient Markets (pages 170–177)
Explain the connection between the assumption of rational expectations and the efficient markets
hypothesis.
The application of rational expectations to financial markets, known as the efficient markets
hypothesis, states that when investors and traders use all available information in forming
expectations of future dividend payments, the equilibrium price of a stock equals the market’s
optimal forecast of the stock’s fundamental value.
One implication of the efficient markets hypothesis is that stock prices are not predictable.
6.4 Actual Efficiency in Financial Markets (pages 177–180)
Discuss the actual efficiency of financial markets.
Some economists point to three differences between the theoretical behavior of financial
markets and their actual behavior: pricing anomalies, mean reversion, and excess volatility.
Economists debate whether these apparent deviations from efficient markets can be explained
within the efficient markets framework.
6.5 Behavioral Finance (pages 181–183)
Discuss the basic concepts of behavioral finance.
Behavioral finance is a field of study that applies the ideas of behavioral economics to understand
financial market topics such as workers saving for retirement, the popularity of technical
analysis among some stock market investors, and the reluctance of investors to take capital losses.
Behavioral finance can also help us understand noise trading and herd behavior, which can
contribute to financial market bubbles.
Key Terms
Adaptive expectations The assumption that
people make forecasts of future values of a
variable using only past values of the variable.
Behavioral finance The application of concepts
from behavioral economics to understand how
people make choices in financial markets.
Bubble A situation in which the price of an asset
rises well above the asset’s fundamental value.
Corporation A legal form of business that
provides owners with protection from losing
more than their investment if the business fails.
Dividend A payment that a corporation makes to
stockholders, typically on a quarterly basis.
Dividend yield The expected annual dividend by
the current price of a stock.
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.
Financial arbitrage The process of buying and
selling securities to profit from price changes
over a brief period of time.
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.
Inside information Relevant information about
a security that is not publicly available.
Limited liability A legal provision that shields
owners of a corporation from losing more than
they have invested in the firm.
Over-the-counter market A market in which
financial securities are bought and sold by dealers
linked by computer.
Publicly traded company A corporation that
sells stock in the U.S. stock market; only 5,100 of
the 5 million U.S. corporations are publicly traded
companies.
Random walk The unpredictable movements of
the price of a security.
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.
Required return on equities, rE The expected
return necessary to compensate for the risk of
investing in stocks.
Stock exchange A physical location where stocks
are bought and sold face-to-face on a trading floor.
Stock market index An average of stock prices
that is used to measure the performance of the
stock market.
Chapter Outline
Teaching Tips
One of the key ideas that students should take away from the course is that financial markets are efficient
markets. The basic idea will initially seem counterintuitive to many students, but eventually most come
to see the logic of it. Most students believe that being knowledgeable about how the stock and bond
markets work and closely studying the corporations issuing securities is enough to allow an investor to
make high returns. They will probably need some convincing that the stock-picking advice given on
cable business programs or in newspaper financial columns is largely worthless. The investment strategy
implications of the efficient markets hypothesis are should prove of great interest to many students. A key
point to stress is that asset prices determined in an efficient market provide valuable information to savers
and borrowers. The prices of assets traded in markets that are highly liquid and where information costs
are low—the market for T-bills, for example—reflect all available information about the fundamental
value of the assets. Whether the stock market is an efficient market is subject to debate, of course.
Sections 6.4 and 6.5 address this issue.
When financial markets are not efficient, problems of excessive price fluctuations and inefficiencies
arising from information costs can occur. Because of the inefficiencies of high information costs, financial
markets are unable to perform fully the role of matching savings and borrowers. Financial intermediaries
exist to reduce information costs for savers and borrowers. Stressing this point can provide a lead-in to
the material in Chapter 9, “Transactions Costs, Asymmetric Information, and the Structure of the
Financial System.”
Are You Willing to Invest in the Stock Market?
The chapter opener uses Apple stock to highlight the volatility of the stock market. The table on page 157
tracks the price per share of Apple stock from 1995 to 2012. Someone who purchased shares in 1995
would have earned a substantial profit, but they would have gone through periods of significant losses as
well as significant gains. Although the stock market has always been volatile, the movements in stock
prices during the past 15 years have been particularly large. It’s unclear how this volatility will affect
people’s willingness to invest in stocks in the coming years.
6.1 Stocks and the Stock Market (pages 158–164)
Learning Objective: Understand the basic operations of the stock market.
A. Common Stock versus Preferred Stock
Corporations can issue two forms of stock: common and preferred. Holders of preferred stock receive
fixed dividends set when the stock is first issued, while dividends of common stock may fluctuate with
the profitability of the firm. If the company suspends its dividend temporarily and then decides to reinstate
it, the company must pay the dividends promised to preferred stockholders before paying holders of common
stock. Similarly, if a corporation declares bankruptcy, creditors and bondholders are paid first, followed by
holders of preferred stock. Common stockholders are paid only if there are any funds left after preferred
stockholders are paid.
B. How and Where Stocks Are Bought and Sold
The stock market refers to the many places where stocks are bought and sold, whether physical or virtual.
The electronic trading of stocks has become increasingly important. Investors can buy individual stocks
or mutual funds. Mutual funds provide investors with diversification by holding many stocks.
C. Measuring the Performance of the Stock Market
The most widely watched stock indexes are the Dow Jones Industrial Average, the S&P 500,
and the NASDAQ Composite Index. Although these three stock indexes are averages of the
stock prices of different companies, they move broadly together.
D. Does the Performance of the Stock Market Matter to the Economy?
Economists believe that fluctuations in stock prices can affect the economy by affecting the
spending of households and firms. Large corporations use the stock market as an important
source of funds for expansion. When stock prices rise, so does household wealth, which affects
consumer spending. Perhaps the most important consequence of fluctuations in stock prices
may be their effect on the expectations of consumers and firms.
6.2 How Stock Prices Are Determined (pages 164–170)
Learning Objective: Explain how stock prices are determined.
A. Investing in Stock for One Year
The price of a financial asset reflects the present value of the payments to be received from
owning it. For a stock held for one year, the payments are the dividends received during the
year and the expected stock price at the end of the year. The discount rate used is the required
rate of return on equities, rE, which represents the expected return on alternative investments of
comparable risk.
B. The Rate of Return on a One-Year Investment in a Stock
For a stock held for one year, the rate of return is the dividend yield plus the rate of capital gains.
Teaching Tips
Have students calculate the rate of return for a specific stock–such as Microsoft, Apple, or McDonald’s–
over the previous year by obtaining data including the price one year ago, the current price, and the
dividend paid. Have students research what news about the company during the year might explain the
rate of return they calculated—in particular, what might account for the change in the price of the stock
during the year?
C. The Fundamental Value of Stock
Economists consider the fundamental value of a share of stock to be equal to the present value
of all the dividends expected to be received into the indefinite future. In the case of firms that
do not pay dividends, we can use this same approach to calculate the fundamental value of the
firm under the assumption that investors expect the firm to eventually start paying dividends.
D. The Gordon Growth Model
Using the assumption that dividends are expected to grow at a constant rate, Gordon developed
an equation showing the relationship between the current price of the stock (Pt), the current
dividend paid (Dt), the expected growth rate of dividends (g), and the required return on equities
(rE):
(1 ) .
( )
t t
E
g
P D r g
+
= ´ –
The Gordon model highlights that investors’ expectations of the future profitability of firms and,
therefore, their future dividends, is crucial in determining the prices of stocks. Solved Problem
6.2 on pages 169–170 shows students how to apply the Gordon growth model to calculate stock
prices for General Electric and IBM.
6.3 Rational Expectations and Efficient Markets (pages 170–177)
Learning Objective: Explain the connection between the assumption of rational expectations and
the efficient markets hypothesis.
A. Adaptive Expectations Versus Rational Expectations
With adaptive expectations, investors’ expectations of the price of a firm’s stock depend only
on past prices of the stock. When using rational expectations, people make forecasts using all
available information. In forecasting the price of a firm’s stock, investors would use not just
past prices of the stock, but any other information helpful in forecasting the future profitability
of the firm.
B. The Efficient Markets Hypothesis
The application of rational expectations to financial markets is known as the efficient markets
hypothesis. According to this hypothesis, the equilibrium price of a stock equals the market’s
optimal forecast—the best forecast given the available information—of the stock’s fundamental
value. All investors and traders do not need to have rational expectations; competition among
even a few well-informed traders will be enough to quickly drive the price up to its new
fundamental value. Stock prices constantly change as news that affects fundamental value
becomes available.
C. Are Stock Prices Predictable?
A key implication of the efficient markets hypothesis is that stock prices are not predictable.
The best forecast of the price of a stock tomorrow is its price today because the price today
reflects every piece of relevant information that is currently available. Rather than being
predictable, stock prices follow a random walk, which means that on any given day, they are as
likely to
rise as to fall.
D. Efficient Markets and Investment Strategies
As long as all market participants have the same information, the efficient markets hypothesis
predicts that the trading process will eliminate opportunities for above-average profits. Therefore,
you should not actively trade or follow hot tips, but instead you should hold a diversified portfolio
to minimize risk. Solved Problem 6.3, Should You Pay Attention to Investment Analysts?, on
pages 176–177 provides a useful tool to help students to think through the real-world
implications of the efficient markets hypothesis.
Teaching Tips
Choose a stock that has recently reported earnings that have increased, but less than expected. Ask
students to consider how they think the stock price responded to the news that earnings increased
compared to the previous year. Next, let them know what the forecasted earnings per share were, on
average (for example, see http://finance.yahoo.com to find the average forecast). Continue the discussion.
Students should see how the stock price already incorporated expected future earnings and responded to
new information that was not included in the forecast.
6.4 Actual Efficiency in Financial Markets (pages 177–180)
Learning Objective: Discuss the actual efficiency of financial markets.
A. Pricing Anomalies
Some analysts believe they have found trading strategies that exploit apparent pricing
anomalies to produce above-average profits. The ability to consistently earn above-average
profits contradicts the efficient markets hypothesis. One anomaly, the small firm effect, is not a
contradiction because the prices of the stocks of small firms are more volatile than those of large
firms and the hypothesis predicts that all stock investments should have the same return, after
adjustment for differences in risk, liquidity, and information costs. Returns also need to take
into account trading costs and taxes. Often anomalies have been found in past data, but have
failed to provide the basis for future investments.
B. Mean Reversion
Mean reversion is the tendency for stocks that have recently been earning high returns to
experience low returns in the future and vice versa. Momentum investing is based on the idea
that there can be persistence in stock movements, so that a stock that is increasing in price is
somewhat more likely to rise than to fall. Careful studies indicate that, in practice, trading
strategies based on these strategies have difficulty earning above-average returns in the long
run, particularly when trading costs and taxes are taken into account.
C. Excess Volatility
Robert Shiller of Yale University has estimated over a period of decades the fundamental value
of the stocks included in the S&P 500 and concluded that the actual fluctuations in the prices of
these stocks have been much greater than the fluctuations in their fundamental values. Some
have questioned Shiller’s analysis because there are disagreements over estimates of stocks’
fundamental values and other issues. Shiller’s analysis does raise doubts as to whether the
efficient markets hypothesis applies exactly to the stock market. In principle, an investor could
use Shiller’s results to earn above-average returns by buying stocks when they are below their
fundamental values. In practice, though, attempts by investors to use this trading strategy have
not been able to consistently produce above-average returns.
6.5 Behavioral Finance (pages 181–183)
Learning Objective: Discuss the basic concepts of behavioral finance.
Behavioral finance is related to the field of behavioral economics, which is the study of situations
in which people make choices that do not appear to be economically rational. By rational,
economists mean that investors are taking actions that are appropriate to reach their goals, given the
information available to them. Studies have shown examples inconsistent with rationality, such as
investors being more likely to sell stocks that have experienced price gains instead of losses
(“locking-in gains”).
A. Noise Trading and Bubbles
Research has shown that many investors are overconfident in their investment ability, as indicated
by overestimating their actual returns. One consequence of overconfidence can be noise
trading, which involves investors overreacting to good or bad news. Noise trading can lead to herd
behavior in which relatively uninformed investors imitate the behavior of other investors. Investors
imitating each other can help fuel a speculative bubble, which occurs when the price of an asset
exceeds its fundamental value
B. How Great a Challenge is Behavioral Finance to the Efficient Markets Hypothesis?
Few economists now believe that investors can rely on asset prices to continually reflect
fundamental values, but many economists still believe that it is unlikely that investors can hope to
earn above-average profits in the long run by following trading strategies. Behavioral finance is
an area of ongoing research.