Econ 310 Chapters 1-7
gordon growth model shows that
investors' expectations of the future profitability of firms play a crucial role in determining stock prices.
Spot transactions
involve immediate settlement.
for both stocks and bonds, the secondary market is _____ than the primary market
larger
corporation
legal form of business that provides owners with protection from losing more than their investment if the business fails
limited liability
legal provision that shield owners of a corporation from losing more than they have invested in the firm.
If you sell a futures contract for U.S. Treasury bills and on the delivery date the interest rate of T-bills is higher than you expected, you will have
lost money on the short position
If you buy a futures contract for U.S. Treasury bills and on the delivery date the interest rate on T-bills is lower than you expected, you will have
lost money on your long position
The initial deposit required by a buyer or seller of a futures contract is known as
margin requirement
over the counter market
market in which financial securities are bought and sold by dealers linked by computer ex. NASDAQ
The role of the Commodity Futures Trading Commission is to
monitor potential price manipulation in futures trading.
If insurance is available on an activity:
more of that activity will occur
dividend
payment that a corporation makes to stockholders, typically on quarterly basis
mean reversion
tendency for stocks that have recently been earning high returns to experience low returns to earn high returns in teh future
Futures trading has traditionally been dominated by
the Chicago Board of Trade and the Chicago Mercantile Exchange.
Futures trading practices in the United States are regulated by
the Commodities Futures Trading Commission.
Financial futures contracts are regulated by
the Commodity Futures Trading Commission.
behavioral finance
the application of concepts from behavioral economics to understand how people make choices in financial markets
If the price of a futures contract increases, then
the exchange will collect the amount of the increase from the seller of the contract and transfer it to the account of the buyer of the contract
financial arbitrage
the process of buying and selling securities to profit from price changes over a brief period of time
Marking to market refers to
the settlement of gains and losses on futures contracts each day
random walk
the unpredictable movements in the price of a security -on any given day, prices will rise and fall
Forward contracts are often illiquid because
they generally contain terms specific to the particular buyer and seller.
market capitalization
total market value of firm's common and preferred stock
Which of the following is NOT a benefit of derivatives
guaranteed minimum profit
Which of the following is NOT a benefit of derivatives?
guaranteed minimum profit
shareholder
has legal claim on the firm's profits and on its equity
The buyer of a futures contract
has the obligation to receive the underlying financial instrument at the specified future date.
Forward transactions
have information problems.
Which of the following is NOT a result of the ability of investors to hedge?
increased risk aversion
Standardization of derivative contracts
increases their liquidity.
trading
investors should not move funds repeatedly from one stock to another (churn a portfolio) b/c they have to pay a commission to a broker on each sale/purchase -buy and hold a diversified portfolio over a long period of time
noise trading
-consequence of over confidence -involves investors overreacting to good or bad news
gordon growth model
-dividend-discount model -uses the current dividend paid, the expected growth rate of dividends, and the required return on equities to calculate the price of a stock.
common stockholders
-elect members of the board of directors -receive dividend that fluctuates as profitability of the corporation varies over time
changes in cost of equity funding for firms
-financing spending through stock sales is equity funding -higher stock prices make it easier for firms to fund spending on real physical investments by issuing new stock -lower stock prices make it more difficult for firms to finance this type of spending
preferred stockholders
-not eligible to vote in electing board of directors -receive fixed that is set when the corporation issues the stock
portfolio allocation
-should hold diversified portfolio of assets so news that may unfavorably affect price of one stock can be offset by news that will favorably affect the price of another stock
changes in household wealth and stocks
-stocks make up significant portion of household wealth -when stock prices rise, so does household wealth; when stock prices fall, so does household wealth -households spend more when their wealth increases and less when their health decreases
effect of changes in stock prices on spending occurs through 3 channels:
1) changes in the cost of equity funding for firms 2) changes in household wealth 3) changes in expectations of households and firms
points to notice about gordon growth model
1) model assumes that the growth rate of dividends is constant - may be an unrealistic assumption b/c investors might believe that dividends will grow in an uneven pattern 2) to use the model, required rate of return on the stock must be greater than the dividend growth rate 3) investors' expectations of the future profitability of firms and, therefore, their future dividends, are crucial in determining the price of stocks
In derivative markets, trade takes place in
C) assets that derive their value from underlying assets.
Forward transactions
allow savers and borrowers to conduct a transaction now and settle in the future.
How does hedging affect the flow of funds in the financial system
It increases it because it reduces risk thus encouraging more people to make financial investments.
How does hedging affect the flow of funds in the financial system?
It increases it because it reduces risk thus encouraging more people to make financial investments.
rational expectations
The assumption that people make forecasts of future values of a variable using all available information; formally, the assumption that expectations equal optimal forecasts, using all available information
Which of the following statements about the presence of speculators in futures markets is correct?
They aid hedgers by increasing the liquidity in futures markets.
Forward transactions would be useful to
a business wanting to know the cost of its funds on future loans
Forward transactions would be useful to
a business wanting to know the cost of its funds on future loans.
Speculators in derivatives markets
accept risk transferred to them by hedgers.
Suppose you are a manager for a company that produces grape jelly. Which of the following is the best way for you to reduce your risk?
acquire a derivative that increases in value if grape prices increase
Forward transactions originated in the market for
agricultural and other commodities
Forward transactions originated in the market for
agricultural and other commodities.
efficient markets hypothesis
application of rational expectations to financial markets; the hypothesis that the equilibrium price of a security is equal to its fundamental value -says stock prices are not predictable -stock of a more profitable firm will not be a better investment than the stock of a less profitable firm
The elimination of riskless profit opportunities is known as
arbitrage.
Forward contracts
are subject to default risk
Derivative instruments are
assets which derive their value from underlying assets.
The seller of a futures contract
assumes the short position
adaptive expectations
assumption that people forecast future values of a variable using only past values of the variable -economists assumed that investors' expectations of the price of a firm's stock depended only on past prices of the stock
actively managed funds
attempt to earn high returns by frequently buying and selling individual stocks
stock market index
average of stock prices that investors use to measure the overall performance of the stock market
momentum investing
based on the idea that there can be persistence in stock movements, so that a stock that is increasing in price is somewhat more likely to rise than to fall, and a stock that is decreasing in price is somewhat more likely
Speculators are primarily interested in
betting on anticipated changes in prices.
Using forward transactions allows
both buyers and sellers to reduce risks associated with price fluctuations.
A speculator who believes strongly that interest rates will rise would be likely to
buy futures contracts on Treasury bills.
2 main categories of stock
common and preferred
publicly traded company
corporation that sells stock in the US stock market; only 5100 of the 5 million US corporations are publicly traded companies -remaining are private firms - they dont issue stock that is bought and sold on the stock market
Marking to market involves
crediting or debiting the margin account based on the net change in the value of the futures contract.
bonds represent ____ rather than ____
debt, equity
equity
difference between the value of the firm's assets and the value of its liabilities.
Profits from speculation arise because of
disagreements among traders about future prices of a commodity or financial instrument.
fundamental value of stocks
equal to the present value of all the dividends investors expect to receive into the indefinite future
dividend yield
expected annual dividend divided by the current price of a stock
required return on equities
expected return necessary to compensate for the risk of investing in stocks -rte of return firms need to pay to attract investors - called equity cost of capital -sum of risk-free interest rate and a risk premium b/c investments in stocks are riskier than investments in treasury bills
The most important derivative instruments are
futures, options, and swaps.
Forward transactions
provide risk sharing
stock prices are a leading indicator of
recessions
All of the following are roles of a exchange EXCEPT
reducing the default risk involving forward contracts.
Hedgers are primarily interested in
reducing their exposure to the risk of price fluctuations
Hedgers are primarily interested in
reducing their exposure to the risk of price fluctuations.
The futures price
reflects traders' expectations of the spot price on the day of delivery
herd behavior
relatively uninformed investors imitate the behavior of other investors rather than attempt to trade on the basis of fundamental values
inside information
relevant information about a security that is not publicly available
fundamental analysts
rely on forecasting future profits of firms in order to forecast future stock prices -more consistent with rational expectations approach b/c uses all available info
technical analysts
rely on patterns of past stock prices to predict future stock prices
The existence of counterparty risk
results in information costs for buyers and sellers when analyzing the potential creditworthiness of potential trading partners.
A speculator who believes strongly that interest rates will fall would be likely to
sell futures contracts on Treasury bills.
A lender who is worried that its cost of funds might rise during the term of a loan it has made can hedge against this rise by
selling feature contracts and treasury bills
changes in the expectations of households and firms - stocks
significant declines in stock prices are followed by economic recessions --> consumers aware of this pattern may become more uncertain about their future incomes and jobs when theres a fall in stock prices --> uncertainty so postpone spending on houses and consumer durables- -significant decline in stock prices may lead firms to err on the side of safety and postpone spending until the uncertainty about the economy has diminished
The terms of futures contracts traded in the United States are
standardized as to amount or value and as to location or time of delivery.