Discussion:
Shiller's analysis of efficient markets (applied to a single stock).
You are studying the past pattern of dividend payments of a specific firm. You know this firm has paid dividends regularly starting in 1990 and on average its dividends have typically grown about 1% per year, although in some years unexpected events led to higher dividend growth and in some years to lower dividend growth. You also know that the firm has an expected return to equity of 5% based on its correlation with market returns.
A. Based on the efficient market theory as elaborated by Shiller, what is the best estimate of the firm's expected stock price in time period t, * Pt , as a function of its next dividend payment in time t+1? Briefly explain what justifies this model of the expected stock price. (Hint: Give a simple reason why investors buy stocks.)
B. Would you expect * Pt to increase over time? Why or why not?
C. According to Shiller, what evidence should you look for about the actual stock price Pt that would help you determine whether markets are efficient? Explain your answer.
D. Now assume your company's stock is about to experience a bubble. Define a bubble, and make up a story to explain why this bubble might occur and what types of human psychology contribute to its formation. Consider this a "creative writing exercise", so you can make up a company and fabricate details. However, you must use and explain at least two terms in your story from behavioral finance discussed in the readings and lectures.