Book cover for The Economics of Money, Banking, and Financial Markets

The Economics of Money, Banking, and Financial Markets

Frederic S. Mishkin

ISBN #9780132770248

10th Edition

610 Questions

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Summary
Learning Objectives
Key Concepts
Example Problems
Explanations
Common Mistakes

Summary

This chapter segment explains how common stocks are valued by computing the present value of expected dividends and future sale prices using the one-period and Gordon growth models. It emphasizes the impact of investor risk perceptions, required returns, and dividend growth assumptions on stock valuation. Additionally, the integration of rational expectations and the efficient market hypothesis underscores that stock prices often reflect all available information, although behavioral and real-world factors may lead to market volatility.

Learning Objectives

1

Understand methods for valuing common stocks including the one-period and Gordon growth models.

2

Explain how investor risk perceptions and required returns influence market prices.

3

Describe the theory of rational expectations and the efficient market hypothesis and their role in stock valuation.

4

Analyze the impact of real-world uncertainties and behavioral factors on market volatility.

Key Concepts

CONCEPT

DEFINITION

Present Value

The current worth of a future sum of money or stream of cash flows given a specific rate of return.

Dividend

A portion of a company’s earnings distributed to shareholders.

One-Period Model

A valuation method that computes the price of a stock using the expected dividend in a single future period divided by the required rate of return.

Gordon Growth Model

A model used to value a stock by assuming that dividends grow at a constant rate indefinitely, with price calculated as the next period's dividend divided by the difference between the required rate of return and the growth rate (P = D1/(r – g)).

Rational Expectations

The theory that investors make decisions based on all available information and rational forecasts of future events.

Efficient Market Hypothesis (EMH)

The hypothesis that market prices fully reflect all available information, meaning that no consistent opportunity for unexploited profit exists.

Example Problems

Example 1

What basic principle of finance can be applied to the valuation of any investment asset?

Example 2

What are the two main sources of cash flows for a stockholder? How reliably can these cash flows be estimated? Compare the problem of estimating stock cash flows to estimating bond cash flows. Which security would you predict to be more volatile?

Example 3

Some economists think that central banks should try to prick bubbles in the stock market before they get out of hand and cause later damage when they burst. How can monetary policy be used to prick a bubble? Explain how it can do this using the Gordon growth model.

Example 4

If monetary policy becomes more transparent about the future course of interest rates, how would that affect stock prices, if at all?

Example 5

"Forecasters' predictions of inflation are notoriously inaccurate, so their expectations of inflation cannot be rational." Is this statement true, false, or uncertain? Explain your answer
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Step-by-Step Explanations

QUESTION

How can you compute the price of a common stock using the one-period model?

STEP-BY-STEP ANSWER:

Step 1: Estimate the dividend expected in the next period.
Step 2: Determine the investor's required rate of return.
Step 3: Divide the expected dividend by the required rate of return to compute the stock price.
Final Answer: The stock price is equal to the expected dividend divided by the required return.

One-Period Model

QUESTION

How does the Gordon growth model value a stock?

STEP-BY-STEP ANSWER:

Step 1: Identify the current dividend and estimate next period's dividend (often by applying a constant growth rate).
Step 2: Determine the constant growth rate of dividends.
Step 3: Establish the investor's required rate of return.
Step 4: Use the formula P = D1/(r – g), where D1 is the next period’s dividend, r is the required return, and g is the growth rate.
Final Answer: The stock price is calculated by dividing the next period's dividend by the difference between the required return and the dividend growth rate.

Gordon Growth Model

QUESTION

What is the Efficient Market Hypothesis and how does it impact stock valuation?

STEP-BY-STEP ANSWER:

Step 1: Acknowledge that the EMH assumes market prices reflect all available information.
Step 2: Understand that arbitrage opportunities are quickly exploited, eliminating the possibility of unexploited profits.
Step 3: Conclude that, because prices are fair and information is fully incorporated, consistently outperforming the market is very difficult.
Final Answer: Under the efficient market hypothesis, stock prices are considered to be fair and unpredictable, as they fully incorporate all current information.

Efficient Market Hypothesis

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Common Mistakes

  • Confusing the one-period model with more complex, multi-period valuation methods.
  • Assuming a constant growth rate in all situations without considering market variations.
  • Overlooking the influence of investor risk perceptions when determining required returns.
  • Believing that the efficient market hypothesis guarantees that there are never short-term price fluctuations.