Stock Market

Question 1

What are the rights of a Stockholder?

Answer 1

• Right to vote
• Residual claimant of cash-flow
• Receives dividends

Question 2

What models are used to compute the price of a stock?

Answer 2

1) One-period valuation model
2) Generalized dividend valuation m.
3) Gordon growth model

Question 3

Why do stocks have value?

Answer 3

• Pay dividends
• Rise in value generating capital gains

Question 4

What is the required return?

Answer 4

The minimum amount of return the stockholder would be satisfied to earn (percentage).

Question 5

What is a residual claimant?

Answer 5

Stockholders receive whatever remains after all other liabilities have been repaid by the corp.

Question 6

Dividends

Answer 6

Payments made periodically (usually quarterly) + the board of directors sets the dividend price.

Question 7

What does the generalized dividend valuation model show?

Answer 7

The current value of a share of stock can be calculated as the present value of the future dividend stream.

Question 8

How does the gordon growth model differ from the generalized dividend valuation model?

Answer 8

The generalized dividend vm. expects the dividends to be infinite, the gordon growth model sets a limit.

Question 9

What are the assumptions of the gordon growth model?

Answer 9

1) Dividends grow at a constant rate
2) Growth rate < required return

Question 10

Who sets the stock market prices?

Answer 10

• The highest bidder
• Who can take the best advantage

Question 11

How does information affect the price of a stock?

Answer 11

Superior information about an asset can increase its value by reducing its
risk (less uncertainty about future cash-flows).

Question 12

Why will a buyer purchase a stock at discount cash flows at lower interest rate?

Answer 12

Because they have superior information which gives them less uncertainty and risk.

Question 13

Why are stock prices volatile?

Answer 13

Because information is constantly changing.

Question 14

What is the effect of expansionary monetary policy on stock prices?

Answer 14

Lower interest rates → lower Re → denominator decreases → stock value is raised.

Question 15

What is the effect of contractionary monetary policy on stock prices?

Answer 15

Higher interest rates → higher Re → denominator increases → stock value is lower.

Question 16

How can expansionary monetary policy affect g in the gordon growth model?

Answer 16

Lower interest rates → economy is stimulated → g increases → denominator decreases → stock value increases.

Question 17

Adaptive expectations

Answer 17

Changes in expectations that occur slowly over time as the data for a variable evolves.

Question 18

Rational expectations

Answer 18

Expectations will be identical to optimal forecasts (the best guess of the future) using all available information.

Question 19

Why can expectations fail to be rational?

Answer 19

• Too much effort to find info
• Unaware of relevant info

Question 20

What are the assumptions of rational expectation theory?

Answer 20

1) If there is a change in which the variable moves, expectations will change accordingly.
2) The forecast errors of expectations will on average be zero and cannot be predicted ahead of time.

Question 21

Efficient market hypothesis

Answer 21

Expectations in the financial market are equal to optimal forecasts using all available information.

Question 22

What does the efficient market hypothesis tells us about stock prices?

Answer 22

If Rof = Re, and Re = R, then Rof = R

Question 23

What is arbitrage?

Answer 23

When market participants eliminate unexploited profit opportunities from the market.

Question 24

Are stock prices predictable?

Answer 24

No: they follow a random walk behavior.

Question 25

What is a “buy-and-hold” strategy?

Answer 25

Purchase stocks and hold them for long periods of time.

Question 26

Why is a buy-and-hold strategy advantageous?

Answer 26

The investor’s net profits will be higher because fewer brokerage commissions will have to be paid.

Question 27

What are the arguments in favor of market efficiency?

Answer 27

• Performing well in the past does not mean it will perform well in the future.
• Stock prices = public information
• Random-walk
• Analysts cannot predict price changes

Question 28

What are the arguments against market efficiency?

Answer 28

• Small-firm effect
• January effect
• Stock market crashes and bubbles
• Excessive volatility
• New info does not immediately affect

Question 29

What is the small firm effect?

Answer 29

Smaller firms typically are able to grow much faster than larger companies.

Question 30

What is the January effect?

Answer 30

Stock prices rise in the first month of the year following a year-end sell-off for tax purposes.

Question 31

What is behavioral finance?

Answer 31

Explains the behavior of security prices using the concept of loss aversion.

Question 32

What are market crashes and bubbles?

Answer 32

Situations where prices of assets rise above their inherent value.

Question 33

How does behavioral finance explain patterns of short-sales?

Answer 33

Agents that invest in short-sales can result with losses far in excess of an investor’s initial investment if the stock price climbs higher than the price of its sale. Thus, loss aversion explains why little short-selling actually takes place.

Question 34

How does behavioral finance explain stock market bubbles/crashes?

Answer 34

When stock prices increase, investors attribute their profits to intelligence and talk-up the market causing higher investment such that prices increase until the market crashes.