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7: Rational Expectations, Efficient Markets, and the Valuation of Corporate Equities

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    By the end of this chapter, students should be able to:

    • Explain when expectations are rational and when they are irrational.
    • Explain how corporate equities (stocks, shares of a corporation) are valued.
    • Explain what is meant by the term market efficiency.
    • Describe the ways in which financial markets are efficient.
    • Describe the ways in which financial markets are inefficient.

    • 7.1: The Theory of Rational Expectations
      Market volatility, the constantly changing prices of financial instruments, tricks some people into thinking that financial markets, especially stock markets, are flim-flams or gigantic roulette wheels. Stock prices, they suspect, are at best random and at worst rigged. In fact, financial markets are typically more efficient, and hence fairer, than other markets. The direction of price movements (up or down) is indeed random, but price levels are usually based on the rational expectations.
    • 7.2: Valuing Corporate Equities
      A corporate equity, or stock, is sometimes called a share because it is just that, a share in the ownership of a joint-stock corporation. Ownership entitles investors to a say in how the corporation is run. Today that usually means one vote per share in corporate elections for the board of directors, a group of people who direct, oversee, and monitor the corporation’s professional managers.
    • 7.3: Financial Market Efficiency
    • 7.4: Evidence of Market Efficiency
    • 7.5: Suggested Reading