CH 7: The Stock Market...

Question 1

Stockholders

Answer 1

Holder of stock in a corporation

Question 2

Residual Claimant

Answer 2

A stockholder’s right to receive whatever remains after all other claims against a firm’s assets have been satisfied.

Question 3

Cash Flows

Answer 3

Cash payments to the holder of a security

Question 4

Dividends

Answer 4

Periodic payments made by equities to shareholders

Question 5

One-Period Valuation Model

Answer 5

A model which calculates the discounted present value of dividends and selling price over a one-year holding period.

Question 6

Generalized Dividend Valuation Model

Answer 6

A model in which the price of the stock is determined only by the present value of the dividends.

Question 7

Gordon Growth Model

Answer 7

A simplified model used to compute the value of stock by assuming constant dividend growth.

Question 8

What are the key assumptions of the Gordon Growth Model?

Answer 8

1. Dividends are assumed to continue growing at a constant rate forever.
2. The growth rate is assumed to be less than the required return on equity, ke.

Question 9

What is the impact of Monetary Policy and Stock Prices?

Answer 9

1. When Fed lowers interest rates, the return of bonds declines and investors are likely to accept a lower required rate of return on investment in equity (ke) resulting in a rise of stock prices.
2. When Fed lowers interest rates stimulates the economy, so the growth rate in dividends, (g), rises resulting in a rise in stock prices.

Question 10

Theory of Rational Expectation

Answer 10

Economic theory states that individuals make decisions based on the best available information in the market and learn from past trends.

Question 11

What is an example of Rational Expectations Theory?

Answer 11

A situation in which a consumer delays buying a certain good because, based on his/her observations and experiences, he/she believes that the price will be less expensive in a month. If enough consumers believe that, demand eases and the good is likely to be less expensive next month. Thus, the consumer waits a month before buying the good.

Question 12

Adaptive Expectations

Answer 12

Expectations for the value of a variable that are based on an average of past values of the variable.

Question 13

Optimal Forecast

Answer 13

The best guess of future conditions, made using all available information.

Question 14

Failure of Rational Expectation (2 Reasons)

Answer 14

1. People might be aware of all available information but find it takes too much effort to make their expectations the best guess possible.
2. People might be unaware of some available relevant information, so their best guess of the future will not be accurate.

Question 15

Rational Expectation Theory Equation

Answer 15

The expectation of X equals the optimal forecast using all available information.

Question 16

Two Implications of Rational Expectation Theory

Answer 16

1. If there is a change in the way a variable moves, the way in which expectations of this variable are formed will change as well.
2. The forecast errors of expectations will, on average, be zero and cannot be predicted ahead of time.

Question 17

Efficient Market Hypothesis

Answer 17

• The efficient market hypothesis (EMH) or theory states that share prices reflect all information.
• The EMH hypothesizes that stocks trade at their fair market value on exchanges.
• Proponents of EMH posit that investors benefit from investing in a low-cost, passive portfolio.
• Opponents of EMH believe that it is possible to beat the market and that stocks can deviate from their fair market values.

Question 18

Efficient Market Hypothesis Equation

Question 19

Arbitrage

Answer 19

Elimination of a riskless profit opportunity in a market.

Question 20

Market Fundamentals

Answer 20

Items that have a direct impact on the future income streams of a security.

Question 21

Random Walk

Answer 21

Movements of a variable whose future values cannot be predicted (are random) because, given today’s value, the value of the variable is just as likely to fall as it is to rise.

Question 22

Short Sales

Answer 22

Borrowing stock from brokers and then selling the stock in the market, with the hope that a profit will be earned by buying the stock back again (“covering the short”) after it has fallen in price.

Question 23

Behavioral Finance

Answer 23

A subfield of finance that applies concepts from other social sciences, such as anthropology, sociology, and particularly psychology, to explain the behavior of securities prices.

Question 24

Unexploited Profit Opportunity

Answer 24

A situation in which an investor can earn a higher-than-normal return.

Question 25

Bubble

Answer 25

A situation in which the price of an asset differs from its fundamental market value.

Question 26

Cash Flows

Answer 26

Cash payments to the holder of a security