Deck 7: The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis

Question 1

In the generalized dividend model,if the expected sales price is in the distant future ________.

A) it does not affect the current stock price
B) it is more important than dividends in determining the current stock price
C) it is equally important with dividends in determining the current stock price
D) it is less important than dividends but still affects the current stock price

Answer 1

A

Question 2

Common stock is the principal way that corporations raise ________.

A) short-term debt
B) foreign exchange
C) long-term debt
D) equity capital

Answer 2

D

Question 3

In the one-period valuation model,an increase in the required return on investments in equity ________.

A) increases the expected sales price of a stock
B) increases the current price of a stock
C) reduces the expected sales price of a stock
D) reduces the current price of a stock

Answer 3

D

Question 4

The analysts predict that the price of corporation's XYZ stock one year from now will be $120.XYZ announced that is not going to pay dividends next year.You decide that you would be satisfied to earn a 20 percent on the investment on this stock,thus,this stock is worth ________ for you now.

A) $100
B) $120
C) $130
D) $90

Question 5

General Electric announces that it is going to cut its dividends by $0.02 per share in the future.This,everything else remaining the same,will cause its current stock price to ________.

A) increase
B) decrease
C) remain the same
D) fluctuate

Question 6

Stockholders' rights include ________.

A) the right to manage
B) the right to change personnel policy
C) the right to veto management's decisions
D) residual claim on all of a company's assets

Question 7

Stockholders are residual claimants,meaning that they ________.

A) have the first priority claim on all of a company's assets
B) are liable for all of a company's debts
C) will never share in a company's profits
D) receive the remaining cash flow after all other claims are paid

Question 8

The value of any investment is found by computing the ________.

A) present value of all coupon payments
B) present value of all future liabilities
C) future value of all dividends
D) value in today's dollars of all future cash flows

Question 9

In the one-period valuation model with no dividend payments the current price of the stock is given by ________.

Question 10

Dividends are paid from ________.

A) liabilities
B) debts
C) net earnings
D) interest

Question 11

Using the one-period valuation model,assuming a year-end dividend of $1.00,an expected sales price of $100,and a required rate of return of 5 percent,the current price of the stock would be ________.

A) $110.00
B) $101.00
C) $100.00
D) $96.19

Question 12

Periodic payments of net earnings to shareholders are known as ________.

A) capital gains
B) dividends
C) profits
D) interest

Question 13

Using the one-period valuation model,assuming a year-end dividend of $0.11,an expected sales price of $110,and a required rate of return of 10 percent,the current price of the stock would be ________.

A) $110.11
B) $121.12
C) $100.10
D) $100.11

Question 14

The value of any investment is found by computing the ________.

A) present value of all future sales
B) present value of all future liabilities
C) future value of all future expenses
D) present value of all future cash flows

Question 15

In the one-period valuation model,the value of a share of stock today depends upon ________.

A) the present value of both dividends and the expected sales price
B) only the present value of the future dividends
C) the actual value of the dividends and expected sales price received in one year
D) the future value of dividends and the actual sales price

Question 16

The analysts predict that the price of corporation's XYZ stock one year from now will be $22.XYZ announced that is not going to pay dividends next year.You decide that you would be satisfied to earn a 10 percent on the investment on this stock,thus,this stock is worth ________ for you now.

A) $20
B) $22
C) $24
D) $18

Question 17

Stockholders' rights include ________.

A) the right to vote
B) the right to manage
C) primary claims on all cash flows
D) ownership of bonds

Question 18

A stockholder's ownership of a company's stock gives her the right to ________.

A) vote and be the primary claimant of all cash flows
B) vote and be the residual claimant of all cash flows
C) manage and assume responsibility for all liabilities
D) vote and assume responsibility for all liabilities

Question 19

In the one-period valuation model,the current stock price increases if ________.

A) the expected sales price increases
B) the expected sales price falls
C) the required return increases
D) dividends are cut

Question 20

In the generalized dividend model,a future sales price far in the future does not affect the current stock price because ________.

A) the present value cannot be computed
B) the present value is almost zero
C) the sales price does not affect the current price
D) the stock may never be sold

Question 21

Using the Gordon growth formula,if D1 is $1.00,ke is 10 percent or 0.10,and g is 5 percent or 0.05,then the current stock price is ________.

A) $10
B) $20
C) $30
D) $40

Question 22

Using the Gordon growth formula,if D1 is $2.00,ke is 12 percent or 0.12,and g is 10 percent or 0.10,then the current stock price is ________.

A) $20
B) $50
C) $100
D) $150

Question 23

What is the current price of a telecommunication company's stock if earnings per share are projected to be $1.50 per share and the industry's average PE ratio is $30?

A) $45
B) $20
C) $31.50
D) $28.50

Question 24

You believe that a corporation's dividends will grow 5 percent on average into the foreseeable future.If the company's last dividend payment was $5 what should be the current price of the stock assuming a 12 percent required return?

Question 25

Using the Gordon growth model,a stock's price will increase if ________.

A) the dividend growth rate increases
B) the growth rate of dividends falls
C) the required rate of return on equity rises
D) the expected sales price rises

Question 26

A change in perceived risk of a stock changes ________.

A) the expected dividend growth rate
B) the expected sales price
C) the required rate of return
D) the current dividend

Question 27

In asset markets,an asset's price is ________.

A) set equal to the highest price a seller will accept
B) set equal to the highest price a buyer is willing to pay
C) set equal to the lowest price a seller is willing to accept
D) set by the buyer willing to pay the highest price

Question 28

One of the assumptions of the Gordon Growth Model is that dividends will continue growing at ________ rate.

A) an increasing
B) a fast
C) a constant
D) an escalating

Question 29

In the generalized dividend model,the current stock price is the sum of ________.

A) the actual value of the future dividend stream
B) the present value of the future dividend stream
C) the future value of the future dividend stream
D) the present value of the future sales price

Question 30

In the Gordon growth model,a decrease in the required rate of return on equity ________.

A) increases the current stock price
B) increases the future stock price
C) reduces the future stock price
D) reduces the current stock price

Question 31

In the Gordon Growth Model,the growth rate is assumed to be ________ the required return on equity.

A) greater than
B) equal to
C) less than
D) proportional to

Question 32

The price earnings ratio (PE)is a measure of how much the market is willing to pay for $1 of ________ from a firm.

A) earnings
B) dividends
C) assets
D) stock

Question 33

What rights does ownership interest give stockholders?

Question 34

A monetary expansion ________ stock prices due to a decrease in the ________ and an increase in the ________,everything else held constant.

A) reduces; future sales price; expected rate of return
B) reduces; current dividend; expected rate of return
C) increases; required rate of return; future sales price
D) increases; required rate of return; dividend growth rate

Question 35

What is the current price of a telecommunication company's stock if earnings per share are projected to be $2.00 per share and the industry's average PE ratio is $20?

A) $40
B) $10
C) $22
D) $18

Question 36

A stock's price will fall if there is ________.

A) a decrease in perceived risk
B) an increase in the required rate of return
C) an increase in the future sales price
D) current dividends are high

Question 37

Information plays an important role in asset pricing because it allows the buyer to more accurately judge ________.

A) liquidity
B) risk
C) capital
D) policy

Question 38

Explain the Gordon growth model of stock pricing.Explain how changes in each component affect the current stock price.On what assumptions is the model based?

Question 39

New information that might lead to a decrease in an asset's price might be ________.

A) an expected decrease in the level of future dividends
B) a decrease in the required rate of return
C) an expected increase in the dividend growth rate
D) an expected increase in the future sales price

Question 40

Describe the Price Earnings Valuation method for stocks.

Question 41

Rational expectations forecast errors will on average be ________ and therefore ________ be predicted ahead of time.

A) positive; can
B) positive; cannot
C) negative; can
D) zero; cannot

Question 42

The subprime financial crisis lead to a decline in stock prices because ________.

A) of a lowered expected dividend growth rate
B) of a lowered required return on investment in equity
C) higher expected future stock prices
D) higher current dividends

Question 43

In October 2008,the stock market crashed,falling by ________ from its peak value a year earlier.

A) over 40 percent
B) over 30 percent
C) over 50 percent
D) over 25 percent

Question 44

The view that expectations change relatively slowly over time in response to new information is known in economics as ________.

A) rational expectations
B) irrational expectations
C) slow-response expectations
D) adaptive expectations

Question 45

An expectation may fail to be rational if ________.

A) relevant information was not available at the time the forecast is made
B) relevant information is available but ignored at the time the forecast is made
C) information changes after the forecast is made
D) information was available to insiders only

Question 46

If a forecast is made using all available information,then economists say that the expectation formation is ________.

A) rational
B) irrational
C) adaptive
D) reasonable

Question 47

In rational expectations theory,the term "optimal forecast" is essentially synonymous with ________.

A) correct forecast
B) the correct guess
C) the actual outcome
D) the best guess

Question 48

Increased uncertainty resulting from the subprime crisis ________ the required return on investment in equity.

A) raised
B) lowered
C) had no impact on
D) decreased

Question 49

If during the past decade the average rate of monetary growth has been 5 percent and the average inflation rate has been 5 percent,everything else held constant,when the Bank of Canada announces that the new rate of monetary growth will be 10 percent,the adaptive expectation forecast of the inflation rate is ________.

A) 5 percent
B) between 5 and 10 percent
C) 10 percent
D) more than 10 percent

Question 50

Economists have focused more attention on the formation of expectations in recent years.This increase in interest can probably best be explained by the recognition that ________.

A) expectations influence the behavior of participants in the economy and thus have a major impact on economic activity
B) expectations influence only a few individuals, have little impact on the overall economy, but can have important effects on a few markets
C) expectations influence many individuals, have little impact on the overall economy, but can have distributional effects
D) models that ignore expectations have little predictive power, even in the short run

Question 51

If additional information is not used when forming an optimal forecast because it is not available at that time,then expectations are ________.

A) obviously formed irrationally
B) still considered to be formed rationally
C) formed adaptively
D) formed equivalently

Question 52

If market participants notice that a variable behaves differently now than in the past,then,according to rational expectations theory,we can expect market participants to ________.

A) change the way they form expectations about future values of the variable
B) begin to make systematic mistakes
C) no longer pay close attention to movements in this variable
D) give up trying to forecast this variable

Question 53

If expectations are formed adaptively,then people ________.

A) use more information than just past data on a single variable to form their expectations of that variable
B) often change their expectations quickly when faced with new information
C) use only the information from past data on a single variable to form their expectations of that variable
D) never change their expectations once they have been made

Question 54

The major criticism of the view that expectations are formed adaptively is that ________.

A) this view ignores the fact that people use more information than just past data to form their expectations
B) it is easier to model adaptive expectations than it is to model rational expectations
C) adaptive expectations models have no predictive power
D) people are irrational and therefore never learn from past mistakes

Question 55

If a forecast made using all available information is not perfectly accurate,then it is ________.

A) still a rational expectation
B) not a rational expectation
C) an adaptive expectation
D) a second-best expectation

Question 56

According to rational expectations theory,forecast errors of expectations ________.

A) are more likely to be negative than positive
B) are more likely to be positive than negative
C) tend to be persistently high or low
D) are unpredictable

Question 57

Dishonest corporate accounting procedures would cause stock prices to ________.

A) remain unchanged
B) decrease due to lower expected dividend growth and lower required return
C) decrease due to lower expected dividend growth and higher required return
D) increase due to higher expected dividend growth and lower required return

Question 58

People have a strong incentive to form rational expectations because ________.

A) they are guaranteed of success in the stock market
B) it is costly not to do so
C) it is costly to do so
D) everyone wants to be rational

Question 59

If expectations of the future inflation rate are formed solely on the basis of a weighted average of past inflation rates,then economics would say that expectation formation is ________.

A) irrational
B) rational
C) adaptive
D) reasonable

Question 60

An increase in uncertainty for the economy will ________.

A) increase stock prices due to a higher required return
B) not affect stock prices
C) increase stock prices due to a lower required return
D) depress stock prices due to a higher required return

Question 61

The efficient markets hypothesis suggests that if an unexploited profit opportunity arises in an efficient market,________.

A) it will tend to go unnoticed for some time
B) it will be quickly eliminated
C) financial analysts are your best source of this information
D) prices will reflect the unexploited profit opportunity

Question 62

The efficient markets hypothesis indicates that investors ________.

A) can use the advice of technical analysts to outperform the market
B) do better on average if they adopt a "buy and hold" strategy
C) let too many unexploited profit opportunities go by if they adopt a "buy and hold" strategy
D) do better if they purchase loaded mutual funds

Question 63

You read a story in the newspaper announcing the proposed merger of Dell Computer and Gateway.The merger is expected to greatly increase Gateway's profitability.If you decide to invest in Gateway stock,you can expect to earn ________.

A) above average returns since you will share in the higher profits
B) above average returns since your stock price will definitely appreciate as higher profits are earned
C) below average returns since computer makers have low profit rates
D) a normal return since stock prices adjust to reflect expected changes in profitability almost immediately

Question 64

According to the efficient markets hypothesis,the current price of a financial security ________.

A) is the discounted net present value of future interest payments
B) is determined by the highest successful bidder
C) fully reflects all available relevant information
D) is a result of none of the above

Question 65

Monetary economists and financial economists developed ________ theories on expectations formations.

A) parallel
B) opposing
C) dissimilar
D) unusual

Question 66

You have observed that the forecasts of an investment advisor consistently outperform the other reported forecasts.The efficient markets hypothesis says that future forecasts by this advisor ________.

A) may or may not be better than the other forecasts Past performance is no guarantee of the future
B) will always be the best of the group
C) will definitely be worse in the future What goes up must come down
D) will be worse in the near future, but improve over time

Question 67

According to rational expectations,________.

A) expectations of inflation are viewed as being an average of past inflation rates
B) expectations of inflation are viewed as being an average of expected future inflation rates
C) expectations formation indicates that changes in expectations occur slowly over time as past data change
D) expectations will not differ from optimal forecasts that use all available information

Question 68

________ occurs when market participants observe returns on a security that are larger than what is justified by the characteristics of that security and take action to quickly eliminate the unexploited profit opportunity.

A) Arbitrage
B) Mediation
C) Asset capitalization
D) Market intercession

Question 69

The advantage of a "buy-and-hold strategy" is that ________.

A) net profits will tend to be higher because there will be fewer brokerage commissions
B) losses will eventually be eliminated
C) the longer a stock is held, the higher will be its price
D) profits are guaranteed

Question 70

The efficient markets hypothesis suggests that investors ________.

A) should purchase no-load mutual funds which have low management fees
B) can use the advice of technical analysts to outperform the market
C) let too many unexploited profit opportunities go by if they adopt a "buy and hold" strategy
D) act on all "hot tips" they hear

Question 71

According to the efficient markets hypothesis,purchasing the reports of financial analysts ________.

A) is likely to increase one's returns by an average of 10 percent
B) is likely to increase one's returns by about 3 to 5 percent
C) is not likely to be an effective strategy for increasing financial returns
D) is likely to increase one's returns by an average of about 2 to 3 percent

Question 72

If the optimal forecast of the return on a security exceeds the equilibrium return,then ________.

A) the market is inefficient
B) no unexploited profit opportunities exist
C) the market is in equilibrium
D) the market is myopic

Question 73

Suppose Barbara looks out in the morning and sees a clear sky so decides that a picnic for lunch is a good idea.Last night the weather forecast included a 100 percent chance of rain by midday but Barbara did not watch the local news program.Is Barbara's prediction of good weather at lunch time rational? Why or why not?

Question 74

The elimination of unexploited profit opportunities requires that ________ market participants be well informed.

A) all
B) a few
C) zero
D) many

Question 75

Financial markets quickly eliminate unexploited profit opportunities through changes in ________.

A) dividend payments
B) tax laws
C) asset prices
D) monetary policy

Question 76

Assume that your economics professor announces to your class that after thirty years of giving exams only on scheduled dates,this semester she will give only surprise quizzes.What is the rational expectation response to this new policy? Why does your self-interest require that you change your behavior? What would the consequences be for students who changed their expectations about exams adaptively?

Question 77

The theory of rational expectations,when applied to financial markets,is known as ________.

A) monetarism
B) the efficient markets hypothesis
C) the theory of strict liability
D) the theory of impossibility

Question 78

Another way to state the efficient markets condition is: in an efficient market,________.

A) unexploited profit opportunities will be quickly eliminated
B) unexploited profit opportunities will never exist
C) unexploited profit opportunities never existed
D) every financial market participant must be well informed about securities

Question 79

Sometimes one observes that the price of a company's stock falls after the announcement of favorable earnings.This phenomenon is ________.

A) clearly inconsistent with the efficient markets hypothesis
B) consistent with the efficient markets hypothesis if the earnings were not as high as anticipated
C) consistent with the efficient markets hypothesis if the earnings were not as low as anticipated
D) consistent with the efficient markets hypothesis if the favorable earnings were expected

Question 80

If in an efficient market all prices are correct and reflect market fundamentals,which of the following is a false statement?

A) A stock that has done poorly in the past is more likely to do well in the future
B) One investment is as good as any other because the securities' prices are correct
C) A security's price reflects all available information about the intrinsic value of the security
D) Security prices can be used by managers to assess their cost of capital accurately