fin 408 exam 2
What is the opportunity cost of holding $1,000 in cash if the relevant interest rate is 10 percent?
$100
The current price of a stock is $60.33. If dividends are expected to be $0.80 per share for the next six years, and the required return is 6%, then what should the price of the stock be in 6 years when you plan to sell it?
$80
Which of the following is not considered to be a candidate for observed excessive volatility in stock prices?
Extreme fluctuations in the fundamental value of a given stock.
hw6.q4 Risk premiums on corporate bonds are usually anticyclical; that is, they decrease during business cycle expansions and increase during recessions. Why is this so?
Risk premiums on corporate bonds are usually anticyclical; that is, they decrease during business cycle expansions and increase during recessions. Why is this so?
f stock prices did not follow a random walk, which of the following statements would be true?
There would be unexploited profit opportunities in the market and expectations would not be rational
hw6.q24 (FRED) a. Calculate the spread (difference) between the Baa and Aaa corporate bond yield for the most recent month available. The credit spread for September 2020 was _______basis points b. This difference represents the
a.105 b. risk premium
A/an increase in expected inflation causes
bond demand shift to the left bond supply shift to the right and interest rates rise
If the supply of bonds shifts to the right, the price of bonds _____________, and the interest rate ____________.
decreases, increases.
If the demand for bonds shifts to the left, the price of bonds_____________ and interest rates ____________
decreases, rise
hw6.q10b A decrease in the tax rate causes a __________ in the interest rate on tax exempt bonds, such as municipal bonds.
increase If marginal tax bracket decreases, demand shifts to the left.
The asset market approach emphasizes _______________ of assets to determine asset prices.
stocks
Currently a share of stock is paying a dividend (cash payout C) of $4.00 to be paid in exactly one year and has a known selling price in one year (P) of $25.00. The expected return (R) of similar assets is 8.0%, and the current market price is $24.00. What is the total rate of return (R*) on this asset?
20.83
Compute the price of a share of stock that pays a $0.50 per year dividend and that you expect to be able to sell in one year for $40, assuming you require a 20% return.
33.75
Given that the price a stock is bought for is $90. Based on the one-period valuation model of stock prices, if the stock is sold a year later at the price $125 after receiving a dividend of $2, then the required rate of return on equity investments is
41.1
Compute the price of a share of stock that pays a $0.50 per year dividend and that you expect to be able to sell in one year for $50, assuming you require a 20% return.
42.08
Identify the cash flows available to an investor in stock.
Dividends and capital gains.
If your broker has been right in her five previous buy and sell recommendations, you should continue to listen to her advice. Is this statement true or false?
False, although your broker has done well in the past, efficient market theory suggests that she has probably been lucky
hw6.q13 "According to the expectations theory of the term structure, it is better to invest in one-year bonds, reinvested over two years, than to invest in a two-year bond, if interest rates on one-year bonds are expected to be the same in both years." Is this statement true, false, or uncertain?
False: These investments are almost of the same profitability.
Suppose that you decide to play a game. You buy stock by throwing a dice a few times, using that method to select which stock to buy. After ten months you calculate the return on your investment and the return earned by someone who followed "expert" advice during the same period. If both returns are similar, would this constitute evidence in favor of or against the efficient market hypothesis?
In favor of because the "expert" could not provide a better prediction of the movements in stock prices than the method of throwing a die.
hw6.q8 Prior to 2008, mortgage lenders required a house inspection to assess its value, and often used the same one or two inspection companies in the same geographical market. Following the collapse of the housing market in 2008, mortgage lenders required a house inspection, but this was arranged through a third party. How does this illustrate a conflict of interest similar to the role that credit-rating agencies played in the global financial crisis?
Inspection companies may have provided overly optimistic assessments of home values to ensure continued work in the future.
hw6.q5 What will happen to interest rates on a corporation's bonds if the federal government guarantees today that it will pay creditors if the corporation goes bankrupt in the future?
Interest rates on corporate bonds will decrease.
How might a sudden increase in people's expectations of future real estate prices affect interest rates?
Interest rates would increase because real estate would have a relatively higher rate of return compared to bonds, which would cause the demand for bonds to decrease.
A model developed by John Maynard Keynes that predicts the equilibrium interest rate on the basis of the supply of and demand for money. PrintDone
Liquidity Preference Framework
Suppose that you work as a forecaster of future monthly inflation rates and that your last six forecasts have been off by minus 1%. Is it likely that your expectations are optimal?
No. Your expectations are not optimal because they don't include all available information up to date.
Which of the following is an argument in favor of the efficient market hypothesis?
Over the long term, stock prices follow a random walk and do resemble their underlying fundamental value.
"An efficient market is one in which no one ever profits from having better information than the rest." Why is this statement false?
People with better information make the market more efficient by exploiting profit-making opportunities.
What basic principle of finance can be applied to the valuation of any investment asset?
Present value
The term random walk describes the movements of a variable whose future changes cannot be predicted (are random) because, given today's value, the variable is just as likely to fall as to rise. An important implication of the efficient market hypothesis is that stock prices should approximately follow a random walk; that is, future changes in stock prices should, for all practical purposes, be unpredictable. The random-walk implication of the efficient market hypothesis is the one most commonly mentioned in the press, because it is the most readily comprehensible to the public. In fact, when people mention the "random-walk theory of stock prices," they are in reality referring to the efficient market hypothesis.
Random-Walk Behavior of Stock Prices
If the next chair of the Federal Reserve Board has a reputation for advocating an even slower rate of money growth than the current chair, what will happen to interest rates?
Slower money growth will lead to a liquidity effect, which will raise interest rates; however, the lower income, price level, and inflation will tend to lower interest rates.
If monetary policy becomes more transparent about the future course of interest rates, how would that affect stock prices, if at all?
Stock prices will increase, as the risk and required return on the investment will be reduced.
hw6.q6 During 2008, the difference in yield (the yield spread) between 3-month AA-rated financial commercial paper and 3-month AA-rated nonfinancial commercial paper steadily increased from its usual level of close to zero, spiking to over a full percentage point at its peak in October 2008. Which of the following explains this sudden increase?
The increase in the yield spread was a result of the decrease in demand for financial commercial paper due to the uncertainty and soundness of financial companies and banks.
Segmented markets
The interest rate for each bond with a different maturity is determined by the supply of and demand for that bond, with no effects from expected returns on other bonds with other maturities.
Expectations theory
The interest rate on a long-term bond will equal an average of the short-term interest rates that people expect to occur over the life of the long-term bond.
Preferred habitat
The interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium (also referred to as a term premium) that responds to supply and demand conditions for that bond.
hw6.q2 Yields for the following 10-year corporate bonds are listed in the table below along with their Moody's bond rating. If the yield on a 10-year T-note is 4.00%, what is the risk premium on bond 4.
The risk premium is . 60.60%. (Round your response to two decimal places.) What is a likely range of yields for a 10-year corporate bond with a Ba rating? The minimum yield is 7.457.45% and the maximum yield is 7.757.75%. (Round your responses to two decimal places.)
hw6.q9 In 2010 and 2011, the government of Greece risked defaulting on its debt due to a severe budget crisis. Using bond market graphs, determine how default would affect the risk premium between U.S. Treasury debt and Greek debt with comparable maturity.In the case of default, what would happen to the risk premium between U.S. Treasury debt and comparable maturity Greek debt?
The risk premium would increase, which corresponds to segment B on the graphs above.
hw6.q3 In the fall of 2008, AIG, the largest insurance company in the world at the time, was at risk of defaulting due to the severity of the global financial crisis. As a result, the U.S. government stepped in to support AIG with large capital injections and an ownership stake. How would this affect, if at all, the yield and risk premium on AIG corporate debt?
The yield and risk premium will fall since demand for AIG corporate debt will increase.
hw6.20 Following a policy meeting on March 19, 2009, the Federal Reserve made an announcement that it would purchase up to $300 billion of longer-term Treasury securities over the following six months. What effect might this policy have on the yield curve?
The yield curve would shift down, but mostly on medium- and long-term maturities.
M1 money growth in the U.S. was about 16% in 2008, 7% in 2009, and 9% in 2010. Over the same time period, the yield on 3-month Treasury bills fell from almost 3% to close to 0%. Given these high rates of money growth, why did interest rates fall, rather than increase?
The income, price-level, and expected-inflation effects were small relative to the liquidity effect.
Assume that the efficient market hypothesis holds. Marcos has been recently hired by a brokerage firm and claims that he now has access to the best market information. However, he is the "new guy," and no one at the firm tells him much about the business. Would you expect Marcos's clients to be better or worse off than the rest of the firm's clients?
Though Marco's clients would not be at any disadvantage, the hierarchy of the flow of information might be of an advantage to the rest of the firm's clients.
Can a person with rational expectations, given new information about the search technology industry, expect the price of a share of Google to rise by 10% in the next month?
Yes, if this information is such that expectations of growth prospects or desired yields justify such a change.
hw6.q26 Do the magnitudes of these interest rates conform to what economic theory would predict? (Check all that apply.)
Yes.Since Baa-rated corporate bonds have the highest default risk, they also have the highest interest rate. Your answer is correct. Yes. Corporate bonds always have higher interest rates than U.S. Treasury bonds because they always have some risk of default, whereas U.S. Treasury bonds have little to no risk of default.
Suppose that increases in the money supply lead to a rise in stock prices. Should you go out and buy stocks?
You should not buy stocks because the rise in the money supply is publicly available information that will be already incorporated into stock prices
Suppose that you are asked to forecast future stock prices of ABC Corporation, so you proceed to collect all available information. The day you announce your forecast, competitors of ABC Corporation announce a brand new plan to merge and reshape the structure of the industry.
Your forecast is considered optimal, but for a short period of time./Your forecast is still considered to be optimal, since it was made with all available information at the time.
Suppose that in every last week of November stock prices go up by an average of 3%. Would this constitute evidence in favor of or against the efficient market hypothesis? a. An important implication of the efficient market hypothesis is that future changes in stock prices should, for all practical purposes, be unpredictable. This would therefore constitute evidence against the efficient market hypothesis. b. People are not taking into account that stock prices go up every last week of November, because if they did, that price increase would represent a profit opportunity. This would therefore constitute evidence for the efficient market hypothesis.
a
hw6.q11 a. Suppose that your marginal tax rate is 30%.Your after-tax return from holding (to maturity) a one-year corporate bond with a yield to maturity of 5% is b.Suppose your marginal income tax rate is 30%.If a corporate bond pays 15%,then the interest rate that an otherwise identical municipal bond have to pay in order for you to be indifferent between holding the corporate bond and the municipal bond is c. in which of the following situations would you choose to hold the corporate bond over the municipal bond, assuming that corporate and municipal bonds have the same maturity, liquidity, and default risk? a. The corporate bond pays 10%, the municipal bond pays 7%, and your marginal income tax rate is 25%. Your answer is correct. B. The corporate bond pays 10%, the municipal bond pays 9%, and your marginal income tax rate is 20%. C. The corporate bond pays 10%, the municipal bond pays 8%, and your marginal income tax rate is 25%. D. The corporate bond pays 10%, the municipal bond pays 7%, and your marginal income tax rate is 35%.
a. 3.53.5% b. 11% c.The corporate bond pays 10%, the municipal bond pays 7%, and your marginal income tax rate is 25%.
hw6.q30 a. According to the liquidity premium theory of the term structure of interest rates, if the one-year bond rate is expected to be 5%,7%,and 8% over each of the next three years, and if the liquidity premium on a three-year bond is 3%, then the interest rate on a three-year bond is ____ b. According to the liquidity premium and preferred habitat theories of the term structure of interest rates, a flat yield curve indicates that
a. 9% b. future short-term interest rates are expected to fall.
hw6.q17 Suppose you observe a change in the relationship between short-term and long-term bonds. Specifically, you note that although interest rates on both short-term and long-term bond are rising together, as expected, the rate on long-term bonds is not rising by as much as has been observed in the past. a. Assuming the liquidity premium theory of term structure, you conclude that the liquidity premium is b. As a result, the yield curve becomes
a. decreasing b. flatter
hw6.q12 a.Refer to the figure on your right. Suppose that the health of the economy deteriorates so that the probability of corporations defaulting on their bonds increases. b. Which of the following would cause the risk premium on corporate bonds to rise c. If the risk premium on corporate bonds increases, then
a. demand would shift to the left b. there are fewer participants in the market causing a reduction in the daily volume of transactions. c.the spread between the interest rate on corporate bonds and the interest rate on default-free bonds has become greater.
hw6.q15 if a yield curve looks like the one shown in the figure to the right, what is the market predicting about the movement of future short-term interest rates? a. The market is predicting that future short-term interest rates will _______ b. What might the yield curve indicate about the market's predictions for the inflation rate in the future? The market's predictions indicate that inflation will be ________in the future.
a. increase. b.higher
a. The spread between the interest rate on a one-year U.S. Treasury bond and a 20-year U.S. Treasury bond is known as the ______ b. According to the expectations theory of the term structure of interest rates, if the one-year bond rate is 3%, and the two-year bond rate is 4%, next year's one-year rate is expected to be ________
a. term premium b. 5%
hw6.q28 a.A plot of the yields on bonds with different terms to maturity but the same risk, liquidity, and tax considerations is known as _____ b.Suppose people expect the interest rate on one-year bonds for each of the next four years to be 5%,4%,7%, and 6%. If the expectations theory of the term structure of interest rates is correct, then the implied interest rate on bonds with a maturity of four years is _______
a. the yeild curve b. 5%
hw6.q25 (FRED) a. How do the two yield curves compare? b. What does the changing slope potentially say about changes in economic conditions? c. Was there any significant change in the yield curve as a result of the policy statement? How might this be explained?
a.In general, the more recent yield curve is shifted up across most maturities by about 75 basis points. b. increases in future short-term interest rates won't be as significant as anticipated a year earlier with a somewhat steeper long end of the yield curve. c. There is very little change between the two yield curves, indicating that for the most part, markets were not surprised by monetary policy actions, and that no unexpected monetary policy changes were implemented.
hw6.q16 If a yield curve looks like the one shown in the diagram to the right, what is the market predicting about the movement of future short-term interest rates? a. The market is predicting that short-term interest rates will b. What might the yield curve indicate about the market's predictions for the inflation rate in the future? The market's predictions indicate that inflation will
a.increase in the near term, then decrease in the long term b. increase in the near term, then decrease in the long term
hw6.q29 a.Which of the following statements is true? b.According to the segmented markets theory of the term structure of interest rates, if bondholders prefer short-term bonds to long-term bonds, the yield curve will be
a.interest rates on bonds of different maturity tend to move together over time. b. upward slopping
Interest rates have been at 7% for the past four years. The economy goes into a recession causing the Fed chairperson to announce an expansionary monetary policy with an interest rate target of 3.0%. You forecast interest rates for next year to be 7%. This is an example of applying the theory of
adaptive expectations
If John, Jennifer, Arthur, and Lisa are the only prospective buyers of a stock, and they have the discount rates 10%, 16%, 8% and 13%, respectively, then the buyer who will be able to obtain the stock is
arthur
hw6.q21 You are given the following series of one-year interest rates: 5%,7%,12%,12% a. Assuming that the expectations theory is the correct theory of the term structure, calculate the interest rates in the term structure for maturities of one to four years, and plot the resulting yield curve. b.How would your yield curve change if people preferred shorter-term bonds over longer-term bonds?
b. the yield curve would become steeper
John values ABC stock at $10 per share. Susan values it at $15 per share, and Bill values it at $20 per share. In a free-market auction, the individual who ends up buying the item is
bill
A/an decrease in expected inflation causes
bond demand shift to the right bond supply shift to the left and interest rates fall.
a business cycle contraction causes
both bond demand and supply to shift to the left
A business cycle expansion causes
both bond demand and supply to shift to the right
If investors develop a greater aversion to risk or view DuWop stock as having greater risk, k, the share price will
decrease
Suppose there is a downward revision of inflation expectations. Show the effect on the bond market. The effect of this shock will likely cause bond yields to
decrease
When expected inflation rises, causing interest rates to rise, we have seen a demonstration of the
fisher effect
hw6.q19 If expectations of future short-term interest rates suddenly fall, what would happen to the slope of the yield curve? The yield curve would become _______
flatter
Suppose a change in the way a variable moves such that it is much larger than before. If adaptive expectations accurately represent how people form expectations, then the difference between the variable and its expected value is
greater then 0
Explain the effect that a large federal deficit will have on interest rates. The effect of this shock will likely cause interest rates to
increase
IBM announces a merger with Dell Computer. The deal is so complex that only financial analysts and other financially sophisticated people can correctly assess that it will make both firms much more efficient and profitable. If the efficient market hypothesis is true, then the price of IBM stock will
increase
If DuWop announces an increase in the annual dividend, Div, the price of a share of DuWop will
increase
If investors expect an increase in the growth, g, of earnings and dividends over the next 5 years, the price of a share of DuWop will
increase
Show what will happen to interest rates if prices in the bond market become more volatile. The effect of this shock will likely cause bond yields to
increase
hw6.q7 If the income tax exemption on municipal bonds were abolished, the interest rates on these bonds would
increase
If the supply of bonds shifts to the left, the price of bonds ____________, and the interest rate ___________.
increases, decreases
Based on empirical evidence, because interest rates ______________ when the economy is expanding, interest rates are said to be _________________.
increases, procyclical
hw6.q10 Municipal bonds tend to pay lower interest rates than U.S. Treasury bonds because
interest payments received from holding municipal bonds are exempt from federal income tax.
If the public expects a corporation to lose $5 per share this quarter and it actually loses $4, which is still the largest loss in the history of the company, what does the efficient market hypothesisLOADING... say will happen to the price of the stock when the $4 loss is announced?
it will be revised upward
Suppose a change in the way a variable moves such that it is much smaller than before. If adaptive expectations accurately represent how people form expectations, then the difference between the variable and its expected value is
less then 0
If you read in the Wall Street Journal that the "smart money" on Wall Street expects stock prices to fall, you should:
not sell all of your stocks because this is publicly available information and is already reflected in stock prices.
Which of the following is true regarding the pricing of assets?
other things being the same, the price is set by the buyers with the most amount of information regarding the stock.
question 7
question 7
hw6.q18 If the yield curve suddenly becomes steeper, how would you revise your predictions of interest rates in the future? You would __________ your predictions of future interest rates.
raise
The efficient market hypothesis is an application of the theory of
rational expectations
Which of the following statements about rational expectations is true?
rational expectations are identical to optimal forecasts
When the federal government sells a Treasury bond in the primary market—via Treasury auction, it is:
seeking to finance government spending as an alternative to raising taxes.
hw6.q14 Assume the expectations theory of the term structure holds. If bond investors decide that 30-year bonds are no longer as desirable an investment, the yield curve would:
steepen at the end of the yield curve and flatten somewhere along the rest of the curve.
If the price of bonds is above the equilibrium price, there occurs an excess
supply of bonds, the price of the bonds will fall, and the interest rates will rise
what happens when the government increases its budget deficit.
supply shifts to the right and interest rate rises
Monetary policy affects stock prices through the following except
the changes in price level
Using the liquidity preference framework, when the economy expands:
the demand for money will increase, shifting the money demand curve to the right
When the wealth of individuals decreases
the price of bonds decreases while the interest rates increase
when the wealth of individuals increases,
the price of bonds increase while the interest rates decrease.
Suppose that the Fed engages in an contractionary monetary policy, which raises interest rates. Which of the following statements best describes the impact of this event on the stock market?
there will be an increase in required rate of return on equities, a decrease in the growth rate on dividends, and stock prices will fall.
what is the relationship between bond prices and interest rates
they are inversely related
If higher money growth is associated with higher future inflation, and if announced money growth turns out to be extremely high but is still less than the market expected, what do you think would happen to long-term bond prices?
they will increase
Which of the following is not true regarding the pricing of assets?
those with the most wealth pay the highest prices for assets
Foreign exchange rates, like stock prices, should follow a random walk because changes in the exchange rate are unpredictable.
true
If the dividend and required return remain the same, and the stock price is expected to increase by $1 six years from now, does the current stock price also increase by $1?
No, the current stock price will not increase by $1 because the future stock price is discounted by the required return.
