Chapter 7: Stock Market Flashcards
What is the relationship between high-interest rates and stocks?
instant gratification, future worth less
What is the relationship between low-interest rates and stocks?
delayed gratification, future worth more
What does higher interest rates lead to?
decrease value, change in distribution
How do higher interest rates change investment decision timelines?
- investments that payoff earlier are more valuable than investments that pay off later
- reinvest profits or dividend payouts: what are the timings of cash flow
- don’t repay callable bonds
- don’t prepay fixed rate mortgages (payments have already fallen in value)
how does money affect the stock market?
personal wealth (when wealth is down, consumption is down), business investment decisions
One-period valuation model
buy stock, hold for 1 period, collect dividend, sell stock
One-period valuation equation
P_0 = Div_1/(1+K) + P_1/(1+K)
generalized dividend valuation model
value is present value of all future cash flows
generalized dividend valuation equation
P_0 = D_1/(1+K)^1 + … + D_n/(1+K)^n + P_n/(1+K)^n
What must you know to predict future dividends?
level of Dt+1 and risk of Dt+1
Gordon growth
assume dividends grow at a constant growth rate g which is less than K
Gordon growth equation
P_0 = D_0(1+g)^1/(1+K)^1 + … = D_0(1+g)/(K - g)
how does monetary policy affect stock prices
- when i is down, return on bonds is down, relative return on stocks is up, k is down, and P_0 is up
- when i is down, borrowing is up, investment is up, GDP is up, g is up, and P_0 is up
How does rising inflation affect the Gordon growth model?
as g goes up, P_0 goes up
stockholders
those who hold stock in a corporation
residual claimant
the stockholder receives whatever remains after all other claims against the firm’s assets have been satisfied
dividends
payments made periodically, usually every quarter, to stockholders
adaptive expectations
suggests that changes in expectations will occur slowly over time, as data for variable evolve
rational expectations
expectations will be identical to optimal forecasts (the best guess of the future) using all available information
are rational expectations always accurate
even though a rational expectation equals the optimal forecast using all available information, a prediction based on it may not always be perfectly accurate
What are the two implications of the rational expectations theory?
- 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
- the forecast errors of expectations will, on average, be zero and cannot be predicted ahead of time
arbitrage
occurs when a security is purchased in one market and simultaneously sold in another market, for a higher price
unexploited profit opportunities
returns on a security that are larger than what is justified by the
characteristics of that security
In an efficient market, what happens to unexploited profit opportunities?
unexploited profits opportunities will be eliminated
random walk
describes the 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
Are future changes in stock price predictable?
In an efficient market, no
market fundamentals
items that have a direct impact on future
income streams of the securities
short sales
they must borrow stock from brokers and then
sell it in the market, with the aim of earning a profit by buying the stock back again after it has fallen in price
efficient market hypothesis
expectations in financial markets are equal to optimal forecasts using all available information
do stock prices always rise when there is good news?
no, if the information is expected by the market, the price won’t change
under what conditions
do stock prices change?
stock prices will respond to announcements only when the information being announced is new and unexpected
behavioral finance
applies concepts from social sciences to explain the behavior of securities prices
optimal forecast
the best guess of the future using all available information
how does monetary expansion affect stocks?
stock prices increase because of a decrease in the required rate of return and an increase in the dividend growth rate
