Stocks Flashcards
1
Q
How can the stock market affect the economy?
A
- Fluctuation in stock prices can affect the economy by affecting the spending of households and firms
- The stock market is an important source of funds for corporations. Stocks also make up a significant portion of household wealth
- Households spend more when their wealth increases and less when their wealth decreases
- Stock market fluctuations can heighten uncertainty and lead households and firms to postpone their spending
2
Q
What is the equity premium?
A
- The equity premium is the additional amount investors must receive in order to invest in equities rather than T bills: Ks - Kt
- The equity premium for an individual stock has two components
- Systematic risk
- Price fluctuaitions in the stock market that affect all stocks
- Unsystematic risk
- Movements in the price of a particular stock
- Systematic risk
3
Q
How are the prices of stocks determined?
A
- The price of a financial asset is equal to the present value of the payments to be received from owning it
- P = PV of payments
- The required return on equities (equity cost of capital) (ke) is the expected return necessary to compensate for the risk of investing in stocks (i.e. is the risk-free rate + equity premium)
- From the viewpoint of firms, this is the rate of return they need to pay to attract investors, so it is called ‘the equity cost of capital’
4
Q
What is price in the one period valuation model?
A
- For investors as a group, the price of a stock today, P0, equals the sum of the present value of the dividend expected to the paid at the end of the year, D1, and the expected price of the stock at the end of the year, P1, discounted by the market’s required return on equities, ke:
- P0 = (D1/(1+ke)) + (P1/(1+ke))
5
Q
Should the government tax dividends and capital gains?
A
- Dividends are subject to double taxation because dividends are taxed at both the firm and the individual level
- Double taxation of dividends reduces investors incentives to buy stocks and gives firms an incentive to retain profits, which may be inefficient
- Taxing capital gains created a lock-in-effect because investors may be reluctant to sell stocks that have substantial capital gains: inefficient
- Equity vs Efficiency: 2003 - 35% to 15%
6
Q
What is the generalised dividend valuation model?
A
- The price of the stock held for n years should be equal to sum of
- The present value of the dividend payment the investor expects to receive during the n years
- The present value of the expected price of the stock at the end of n years
- If n is large enough, Pn does not affect P0
- So, the fundamental value of a share of stock equals the present value of all the dividends expected to be received into the indefinite future
- P0 = ∑ ( Dt/(1+ke)t
- The price of the stock is determined only by the present value of the future dividend stream
7
Q
What is the gordon growth model?
A
- Uses the current dividend paid (D0), the expected growth rate (g) of dividends, and the required return on equities (ke) to calculate the price of a stock:
- P0 = ((D0 (1+g))/(ke - g)) = (D1/(ke - g))
- Key Features
- Growth rate of dividends is constant
- Required rate of return must be treated than the dividend growth rate
- Investors’ expectations of the future profitability of firms (thus future dividend) are crucial in determining the prices of stock
8
Q
How does the market set stock prices?
A
- The price is set by the buyer willing to pay the highest price
- The buyer who can take best advantage of the asset
- Superior information about an asset can increase its value by reducing perceived risk
- Information is important for individuals to value each asset
- When new information is released about a firm, expectations and prices change
- Market participants constantly receive information and revise their expectations, so stock prices change frequently
9
Q
How is MP affected in the Gordon Growth model?
A
- Channel 1
- Lower i: lower return on bonds: lower ke: higher P0
- Channel 2
- Lower i: higher economic activity: higher g: higher P0s
10
Q
What is the theory of RE?
A
- Expectations will be identical to optimal forecasts using all available information: Xe = Xof
- If there is a change in the way a variable moves, the way in which expectations of the variable are formed will change as well
- The forecast errors of expectations will, on average be zero and cannot be predicted
11
Q
What is the efficient market hypothesis and its rationale?
A
- In an efficient market, a security’s price fully reflects all available information: Rt+1of = Rt+1actual
- Financial Arbitrage
- Rof > R* : ↑(D)Pt → ↓Rof
- Rof < R* : ↓(D)Pt → ↑Rof
- Until Rof = R*
- In an efficient market all unexplored profit opportunities will be eliminated
12
Q
What do efficient markets imply about portfolio allocation?
A
- The efficient market hypothesis implies that we should hold a diversified portfolio of stocks and other assets, instead of only one stock
- News that my unfavourably affect the price of one stock can be offset by news that will favourably affect the price of another stock
13
Q
What do efficient markets imply about trading?
A
It is better to buy and hold a diversified portfolio over a long period of time than to churn a portfolio by moving funds repeatedly between stocks
14
Q
What do efficient markets imply about Financial analysis and hot tips?
A
The hypothesis indicates that the stocks that financial analysts recommend as hot tips are unlikely to outperform the markets
15
Q
Are markets actually efficient?
A
- Economists have provided support for the conclusion of the efficient markets hypothesis that changes in stock prices are not predictable
- But the actual behaviour of financial markets raises doubts about the validity of the efficient markets hypothesis
- Pricing anomalies allow investors to earn consistently above-average returns
- Some price changes are predictable using available information
- Changes in stock prices sometimes appear to be larger than changes in the fundamental value of the stocks
