408 exam 2
Evidence from studies in behavioral finance suggests that
investment fads cause stock prices to be overvalued most of the time
According to economists:
market crashes and bubbles suggest that unexploited profit opportunities may exist and that the efficient market hypothesis might be fundamentally flawed.
When investors buy short-term bonds, what is the effect on the st bond market? Graph a line on the supply demand curve that shows this effect As a result, the difference between short-term and long-term bond yields will
new demand line shifts right increase
'Anytime it is snowing when Joe Commuter gets up in the morning, he misjudges how long it will take him to drive to work. When it is not snowing, his expectations of the driving time are perfectly accurate. Considering that it snows only once every ten years where Joe lives, Joe's expectations are almost always perfectly accurate.' This statement is _______ because Joe's expectations could still be improved by accounting for a snowfall in his forecasts.
not rational Although Joe's expectations are typically quite accurate, they could still be improved by accounting for a snowfall in his forecasts. Since his expectations could be improved, they are not optimal and hence are not rational expectations.
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.
The efficient markets theory does not hold if crashes are
predictable
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
IBM announces profits of $250 million. Stock analysts predicted profits of $250 million. If the efficient market hypothesis is true, the price of IBM stock will 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
remain the same If announcements of profits are roughly equal to expectations, then stock prices remain the same. However, if they are significantly different, then stock prices adjust to accommodate the announcement of this unanticipated information. Increase It is not necessary that everyone in a financial market be well informed for unexploited profit opportunities to be eliminated. Smart money can move the market.
Assume the segmented markets 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:
result in a jump in the 30-year rate, with the remainder of the yield curve unchanged
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.
When an individual or institution buys a corporate bond in the primary market:
she is making a loan to the corporation issuing the bond.
___________ are the selling of borrowed shares of stock that must be replaced at a later date, thus betting that the stock price will go down.
short sales
Risk premium is the
spread between the interest rate on bonds with default risk and the interest rate on default-free bonds.
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.
How would your yield curve change if people preferred shorter-term bonds over longer-term bonds? The yield curve would become
steeper
The asset market approach emphasizes _______ of assets to determine asset prices.
stocks
Explain the effect that a large federal deficit will have on interest rates. The effect of this shock will likely cause interest rates to
supply line moves down the demand line increase
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
term premium
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 __________
term premium
The current price of a stock is $108.83. If dividends are expected to be $1.00 per share for the next five years, and the required return is 6%, then what should the price of the stock be in 5 years when you plan to sell it? The price 5 years from now will be $__ If the dividend and required return remain the same, and the stock price is expected to increase by $1 five years from now, does the current stock price also increase by $1?
$140 No, the current stock price will not increase by $1 because the future stock price is discounted by the required return.
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. The price of the share is $__
$33.75 40.5/1.2
Suppose that the average growth rate of the economy has been 2%. Given a forecast of 5% growth this year, if rational expectations hold, then the expected forecast error is
0% Under rational expectations, expectations will be identical to optimal forecasts (the best guess of the future) using all available information. The expected forecast error, under rational expectations, is zero.
Using the numbers 1, 2, 3, and 4, rank the following four assets from most liquid (1) to least liquid (4). A 10,000-square-foot office building $2,000 in cash A $10,000 Treasury bill 100 shares of Google stock
1. $2,000 in cash 2. A $10,000 Treasury bill 3. 100 shares of Google stock 4. A 10,000-square-foot office building
Given that the price a stock is bought for is $110. Based on the one-period valuation model of stock prices, if the stock is sold a year later at the price $120 after receiving a dividend of $2, then the required rate of return on equity investments is ___% Now, suppose that the price of the stock above was bought instead for $115. Then, required rate of return on equity investments then
10.9% (120+2-110)/110 decreased (120+2-115)/115
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. This difference represents the Calculate the spread again for the same time one year prior. One year prior in September 2019, the credit spread was ____ basis points. The risk premium has ______ over the last year of available data. Since the year 2000, the highest credit spread occurred in December 2008, at 338 basis points, and the lowest occurred in January 2000 at 55 basis points. How do these compare to the most currently available spread?
105 risk premium 88 One year prior in September 2019, the Baa yield was 3.91% and the Aaa yield was 3.03%, representing a risk premium of 0.88 percentage points, or 88 basis points. increased The current credit spread is much closer to the low reported in January 2000.
Suppose that an Exxon Mobil bond has a return of 22% half the time and 8% the other half. The expected return on this bond is ___%?
15%
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? The total rate of return is Based on this information, you would expect the price of this stock to
20.8 Use the following formula: R* = (Pt+1 −Pt + C) /Pt = (25-24+4)/24 increase
The demand curve and supply curve for one-year discount bonds with a face value of $1,040 are represented by the following equations: Bd: Price = −0.6Quantity + 1,120 Bs: Price = Quantity + 710 The expected equilibrium quantity of bonds is ___ The expected equilibrium price of bonds is ____ The expected interest rate in this market is ___
256 -set equal solve for Q 966 -Plug Q into equation 7.63% - (FV-expected equilibrium price)/Expected equilibrium price all x 100
What is the opportunity cost of holding $750 in cash if the relevant interest rate is 6 percent? The opportunity cost is $___ If interest rates rise, this opportunity cost will ____, and individuals will hold _______ cash balances.
45 increase, smaller
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
5% According to the expectations theory of the term structure of interest rates, thetwo-year bond rate is the average of the one-year bond rates of the two years covered by the same time period.
Suppose that your marginal tax rate is 35%. Your after-tax return from holding (to maturity) a one-year corporate bond with a yield to maturity of 10% is ___% Suppose your marginal income tax rate is 35%. If a corporate bond pays 10%, 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 ___%
6.5% (7%) The equation for the return on the one-year corporate bond is given by r=(1−t)×i where r = return t = marginal tax rate i = corporate bond interest rate 7% The minicipal bond should is = (10) − ((35)×((10)/100))
According to the liquidity premium theory of the term structure of interest rates, if the one-year bond rate is expected to be 4%, 5%, and 7% 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 According to the liquidity premium and preferred habitat theories of the term structure of interest rates, a flat yield curve indicates that
8 = ((4 + 5 + 7)/3) + 3 future short-term interest rates are expected to fall. Based on the liquidity premium and preferred habitat theories, a flat yield curve indicates that future short-term interest rates are expected to fall since the term premium is positive and is countering the decline in the interest rates.
A company has just announced a 3-for-1 stock split, effective immediately. Prior to the split, the company had a market value of $9 billion with 150 million shares outstanding. Assuming that the split conveys no new information about the company, what is the value of the company, the number of shares outstanding, and price per share after the split? The market value of the company is $____ billion. The number of shares after the split is __ million. The new price per share is $__ per share. If the actual market price immediately following the split is $22.00 per share, what does this tell us about market efficiency?
9 450 (150*3) 20 (9 bil/450 mil) Market efficiency is uncertain. The price could indicate both market efficiency or failure depending on whether or not the stock split actually conveyed information about the company.
Assume that a business cycle contraction occurs. show how the demand and/or supply curve of bonds shifts as a result.
A business cycle contraction causes a decrease in expected profit opportunities and a decrease in wealth. Therefore, the bond supply shifts to the left as well as the demand curve. As a result, the change in bond prices and interest rates are ambiguous.
Suppose that the top marginal tax bracket decreases. What happens to demand?
A decrease in the marginal tax rate reduces the demand for municipal bonds. The opposite is true for the reverse condition.
Suppose that the Fed engages in an expansionary monetary policy, which reduces interest rates. Which of the following statements best describes the impact of this event on the stock market? A. There will be a decrease in the required rate of return on equities, an increase in the growth rate on dividends, and stock prices will rise. B. There will be an increase in the required rate of return on equities, a decrease in the growth rate on dividends, and stock prices will rise. C. There will be an increase in the required rate of return on equities, a decrease in the growth rate on dividends, and stock prices will fall. D. There will be a decrease in the required rate of return on equities, a decrease in the growth rate on dividends, and stock prices will fall.
A. There will be a decrease in the required rate of return on equities, an increase in the growth rate on dividends, and stock prices will rise. The type of change in monetary policy affects the stock prices differently. An expansionary monetary policy decreases the required rate of return on equities, increases the growth rate on dividends, and eventually raises stock prices. The opposite is true of contractionary monetary policy.
If stock prices did not follow a random walk, which of the following statements would be true? A. There would be unexploited profit opportunities in the market and expectations would not be rational B. Very small changes in stock prices could not be predicted, and the optimal forecast of returns would not be equal to the equilibrium return C. Unexploited profit opportunities would never exist D. If large changes in a stock price could be predicted, then the optimal forecast of the stock return would be equal to the equilibrium return for that stock
A. There would be unexploited profit opportunities in the market and expectations would not be rational
Asset A pays a return of $3,000 30% of the time and $1000 70% of the time. Asset B pays a return of $2,400 60% of the time and $800 40% of the time. The expected return for Asset A is ___ The expected return for Asset B is _____
A: 1600 B: 1760
Interest rates have been at 4% 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 4%. This is an example of applying the theory of
Adaptive expectations Adaptive expectations base expectations only on past experiences.
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?
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. If there is a phenomenon that takes place regularly and it is not incorporated intopeople's expectations, then these expectations are not optimal (since they are not including all available information). We can conclude that 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 (i.e. someone could buy stock the first week of November and sell it in the last week) and would therefore be quickly exploited. This would therefore constitute evidence against the efficient market hypothesis.
A decrease in the tax rate causes _________ in the interest rate on tax exempt bonds, such as municipal bonds. An increase in the tax rate causes a ______ in the int rate on tax exempt bonds, such as municipal bonds. In a graph if the top marginal tax bracket increases, what happens to the supply/demand graph and price?
An increase A decrease in the tax rate causes an increase in the interest rate on tax-exempt bonds (municipals), which can be considered an increase in the risk premium on municipals. The opposite is true for the reverse condition. a decrease demand would shift up for muni's bc T-Bill tax adjusted interest would decrease. increase in demand causes an increase in price
If John, Jennifer, Arthur, and Lisa are the only prospective buyers of a stock, and they have the discount rates 10%, 15%, 7% and 13%, respectively, then the buyer who will be able to obtain the stock is
Arthur The investor with the lowest perceived risk (and therefore, the lowest discount rate) is willing to pay the most for the stock.
Using the liquidity preference framework, show why interest rates are procyclical (rising when the economy is expanding and falling during recessions). Suppose GDP is rising. Show the effect of rising GDP on the market for money.
As national income increases, the demand for money, not the supply of money, increases.
Risk premiums on corporate bonds are usually anticyclical; that is, they decrease during business cycle expansions and increase during recessions. Why is this so?
As the economy enters an expansion, there is greater likelihood that borrowers will be able to service their debt. Risk premiums will fall in an economic expansion as business revenue and profitsimprove, making it easier for borrowers to make scheduled interest payments on their debt and increasing the likelihood that the business will repay the principle of that debt.
Using the figure of the money market shown to the right, show why a rise in the price level (but not in expected inflation) will cause interest rates to rise when the nominal money supply is fixed.
As the price level rises, households will require larger cash balances to facilitate transactions.
The following two assets and payout data are given below: Asset A: Pays a return of $2,000 20% of the time and $500 80% of the time. Asset B: Pays a return of $1,000 50% of the time and $600 50% of the time. If both assets can be acquired for the same price, as a risk-averse investor, you would prefer
Asset B
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 yourforecast, competitors of ABC Corporation announce a brand new plan to merge and reshape the structure of the industry. Would your forecast still be considered optimal? (Select all that apply.) A. The forecast is not optimal since it fails to take into account the impact of the merger and reshaping of the structure of the industry. B. Your forecast is still considered to be optimal, since it was made with all available information at the time. C. Your forecast is not optimal because it does not adhere to the theory of rational expectations. D. Your forecast is considered optimal, but for a short period of time.
B & C Your forecast is still considered to be optimal, since it was made with all available information at the time. The fact that new information that would most probably impact the stock price of ABC Corporation arrived today, is simply out of theforecaster´s control. In this case, your forecast was optimal, but short-lived.
There are many faults associated with adaptive expectations except that A. people adjust to new information. B. past data do not help predict future values of variables. C. individuals utilize more information that just past data. D. predictions of future values affect expectations.
B. past data do not help predict future values of variables. Adaptive expectations have been faulted on the grounds that people use more information that just past data, such as predicitons about future values as well as new information coming in about the future.
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- in a free-market auction, the individual who values the good the most gets the good in the end. This is true with stocks.
A/an increase in expected inflation causes
Bond demand to shift left, bond supply to shift right, and interest rates to rise.
Situation Three: "I'm so confused," your father tells you. "I want to maximize the money available to me after retirement, but I just have no clue what to do with my small savings. I'm thinking about buying shares in a mutual fund. You've taken some economics and finance classes—what do you suggest I do?" What's your advice for your father?
Buy shares in a no-load mutual fund and make sure that management fees are low.
Which of the following statements about rational expectations is not true? A. Rational expectations are identical to optimal forecasts. B. Rational expectations may not be accurate. C. Rational expectations theory suggests that forecasts errors of expectations are sizable and can be predicted. D. Rational expectations are different from adaptive expectations.
C. Rational expectations theory suggests that forecasts errors of expectations are sizable and can be predicted. Even though a rational expectation equals the optimal forecast using all availableinformation, a prediction based on it may not always be perfectly accurate.
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 9%, and your marginal income tax rate is 20%. B. The corporate bond pays 10%, the municipal bond pays 8%, and your marginal income tax rate is 25%. C. The corporate bond pays 10%, the municipal bond pays 7%, and your marginal income tax rate is 35%. D. The corporate bond pays 10%, the municipal bond pays 7%, and your marginal income tax rate is 25%.
C. The corporate bond pays 10%, the municipal bond pays 7%, and your marginal income tax rate is 25%. The marginal tax rate applies on the returns of corporate bonds. Any investor would then want to purchase bonds that have higher overall interest.
Which of the following will cause interest rates to rise? A. Firms become pessimistic about the future profitability of new plant and equipment. B. The stock market has become more volatile. C. The government increases its budget deficit. D. People reduce their expectations of inflation.
C. The government increases its budget deficit.
Which of the following statements is true? A. Yield curves almost always slope downward. B. When short−term interest rates are low, yield curves tend to be inverted. C. When short-term interest rates are high, yield curves tend to be upward sloping. D. Interest rates on bonds of different maturities tend to move together over time. 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
D. Interest rates on bonds of different maturities tend to move together over time. There are several facts about interest rates. First is that interest rates of bonds tend to move together over time. The second is that yield curves almost always slope upward while the third is that when short-term interest rates are high, yield curves tend to be downward sloping. Upward sloping The segmented markets theory indicates that if bondholders prefer short-term bonds to long-term bonds, they will have to be compensated more to purchaselong-term bonds. Therefore, the yield curve is upward sloping.
Which of the following is true regarding the pricing of assets? A. The price is set by the buyer willing to pay the lowest price. B. Those with the most wealth pay the highest price for assets. C. The price is set by the buyer who can least take advantage of the asset. D. Other things being the same, the price is set by buyers with the most amount of information regarding the stock.
D. Other things being the same, the price is set by buyers with the most amount of information regarding the stock. Several facts can be said about asset pricing. First, the price is set by the buyer willing to pay the highest price. Second, other things being the same, the price is set by buyers with the most amount of information regarding the stock. Lastly, the price is set by the buyer who can best take advantage of the asset.
Monetary policy affects stock prices through the following except A. the changes in the return on bonds. B. the changes in the growth rate of the dividends. C. the changes in the required rate of return. D. the changes in the price level.
D. the changes in the price level. Monetary policy affects the required return to investments and the growth rate in dividends.
Identify the cash flows available to an investor in stock. A. Corporate profits. B. Dividends and capital gains. C. Retained earnings. D. Net income after taxes.
Dividends and capital gains
Stock market bubbles
Does not prove that the efficient market hypothesis is incorrect
Which of the following is not considered to be a candidate for observed excessive volatility in stock prices? A. Computer-driven or program trading. B. Irrational behavior and bandwagon effects. C. Overreaction to the news and new financial information. D. Extreme fluctuations in the fundamental value of a given stock.
Extreme fluctuations in the fundamental value of a given stock.
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. Unless you believe that your broker has better information than the rest of the market, efficient market theory indicates that you cannot expect the broker to beat the market in the future.
Which of the following would cause the risk premium on corporate bonds to fall?
Forecasters predict that the economy will grow more quickly for the next few years. An improved economy as well as an increase in the liquidity of corporate bonds cause the risk premium associated with corporate bonds to fall. The opposite is true for the reverse condition.
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. If both returns are similar, this would constitute evidence in favor of the efficient market hypothesis, that states that so called "expert" advice is not a better predictor of movements in stock prices than a random method. No one can predict a stock price movement if the market is efficient. The only thing that can create a price movement is new information, that by definition no one has.
Use the graph and the supply and demand for bonds to show what will happen to interest rates if the economy's GDP expands. (Remember that bond prices are inversely related to interest rates.) Based on empirical evidence, because interest rates _______ when the economy is expanding, interest rates are said to be ___________ Using the liquidity preference framework, when the economy expands:
In the loanable funds framework, when the economy booms, the demand for bondsincreases: the public's income and wealth rise while the supply of bonds alsoincreases, since firms have more attractive investment opportunities. Both the supply and demand curves shift to the right, but as is indicated in the text, the demand curve probably shifts less than the supply curve, so the equilibrium interest rate rises. increase, procyclical the demand for money will increase, shifting the money demand curve to the right
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 marketexpected, what do you think would happen to long-term bond prices? Long-term bond prices will
Increase Because inflation is less than expected, expectations of future short-term interest rates would be lowered and long-term interest rates would fall. The decline inlong-term interest rates implies that long-term bond prices would rise.
Along the supply curve for bonds, a decrease in the price of bonds
Increases the interest rate and decreases the quantity of bonds supplied Increases in the price of bonds decreases interest rates while increasing the supply of bonds that firms are willing to offer. On the other hand, decreases in the price of bonds increases the interest rate and decreases the quantity of bonds supplied.
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.
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.
Yield curves for July 06, 2017 and July 06, 2016 across all the maturities How do the two yield curves compare? What does the changing slope potentially say about changes in economic conditions? The most recent FOMC meeting policy statement occurred on June 14, 2017. The yield curve below shows yields for the end of trading day on that day, and the day prior. Was there any significant change in the yield curve as a result of the policy statement? How might this be explained?
In general, the more recent yield curve is shifted up across most maturities by about 75 basis points. 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. 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. -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 announced or implemented. However, the long end of the yield curve declined very slightly after the policymeeting, perhaps indicating a slightly dovish stance of monetary policy as viewed by market participants based upon information from the policy statement.
A share of stock in Pria-Utang Corporation pays an annual dividend of $5. The current market price is $40. From the list of individuals below, identify who is likely to be a buyer or a seller of this stock. (Each person currently owns 100 shares.) Janey: required return = 10%, expected growth in dividends = 6% Jimmy: required return = 12%, expected growth in dividends = 2% Johnny: required return = 20%, expected growth in dividends = 5%
Janey (value of the share)=(5*1.06)/(10%-6%)=132.50 , BUY because price is LOWER than value Jimmy (value of the share)=(5*1.02)/(12%-2%)=51.00 , BUY because price is LOWER than value Jonny (value of the share)=(5*1.05)/(20%-5%)=35.00, SELL because price is HIGHER than value
If junk bonds are "junk," then why would investors buy them?
Junk bonds can provide high yields.
Why might the efficient market hypothesis be less likely to hold when fundamentals suggest stocks should be at a lower level?
Most investors are subject to loss aversion, so not enough short selling takes place in the market.
Situation Two: "I'm going to put all my savings into EnvironMart," a classmate tells you. "I subscribe to a 'hot tips' investment newsletter that says they're about to put a product on the market that nearly everyone needs. The price of their stock is sure to skyrocket!" Do you agree with your classmate? Why or why not?
No, because information from an investment newsletter is already public and is therefore already reflected in stock prices.
Situation One: Many of your fellow investors are shocked when great news for TechCorp—strong sales and large profits for the quarter—are met with a decrease in the price of TechCorp stock. Does this indicate a failure of the efficient market hypothesis? Why or why not?
No, the most likely explanation is that investors had expected TechCorp sales and profits to be even higher than those reported.
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. For your expectations to be optimal, they have to include all available information up to date, including the fact that you have been off by minus 1% the last 6 times. This means that you have to incorporate your mistake or forecast errors in your predictions. Failure to do so indicates that your expectations are not optimal. Of course you can miss the observed inflation rate every time, but you cannot miss consistently (i.e. always predict less than the actual inflation rate).
Which of the following is an argument in favor of the efficient market hypothesis? A. Observed behavior in reaction to the "January effect." B. Over the long term, stock prices follow a random walk and do resemble their underlying fundamental value. C. Mean reversion of stock prices. D. Excessive volatility in stock prices as observed in 1987 and 2000-2001.
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 current price of DuWop (a publicly traded company) is $25. The following rules describe the random-walk... behavior of price movements in the future: 1. Gains and losses are equally likely (i.e., pr(gain) = pr(loss) = 0.50). 2. Gains are equal to $2. 3. Losses are equal to $1. Calculate the likely (expected) value of the price of this stock for the next three periods. You observe in time period 3 that the price, Pt+3, of DuWop is equal to $31. Does this imply that this particular stock does not follow a random walk?
Pt = 25 Pt+1 = 25.5 Pt+2 = 26 Pt+3 = 26.5 = Prob[gain](Pt + gain) + Prob[loss](Pt - loss) no
The efficient market hypothesis is an application of the theory of
Rational Expectations The application of the theory of rational expectations to financial markets is known as the efficient market hypothesis or the theory of efficient capital markets.
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. The slower rate of money growth will lead to a liquidity effect, which raises interestrates, while the lower price level, income, and inflation rates in the future will tend to lower interest rates. There are three possible scenarios for what will happen: (a) if the liquidity effect is larger than the other effects, then interest rates will rise; (b) if the liquidity effect is smaller than the other effects and expected inflation adjustsslowly, then interest rates will rise at first but will eventually fall below their initiallevel; and (c) if the liquidity effect is smaller than the expected inflation effect and there is rapid adjustment of expected inflation, then interest rates will immediately fall.
In the late 1990s, as information technology rapidly advanced and the Internet widely developed, U.S. stock markets soared, peaking in early 2001. Later that year, these markets began to unwind, and then crash, with many commentators identifying the previous few years as a "stock market bubble." Why was this episode considered a bubble? How might it be possible for this episode to still adhere to the efficient market hypothesis?
Stock market prices were overvalued and rose well above their fundamental values. Investors were acting on the best information available at that time in valuing their stocks.
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.
Bond market graph: Suppose the effect on the bond market if there is a downward revision of inflation expectations The effect of this shock will likely cause bond yields to
Supply line shifts left Demand line shifts right New equilibrium bond price above decrease
What would happen to the demand for Rembrandt paintings if the stock market undergoes a boom?
The demand for Rembrandt paintings would increase because of the increase in people's wealth
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 ofshort-term interest rates expected to occur over the life of thelong-term bond plus a liquidity premium (also referred to as a term premium) that responds to supply and demand conditions for that bond.
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 because Greek Bonds: demand curve shifts down the supply curve U.S. Treasuries: demand curve shifts up the supply curve Greater difference in equilibrium points
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.
Following a policy meeting on March 19, 2009, the Federal Reserve made an announcement that it would purchase up to $300 billion oflonger-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. If the Federal Reserve purchases a significant amount of longer-term Treasurydebt, this will reduce the effective supply of Treasuries of those particularmaturities, resulting in a higher price and lower yield. This should have the effect of lowering the "long end" of the curve, decreasing medium- and longer-term yields. In other words, the yield curve will shift down, but mostly on medium- andlong-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. The liquidity effect from the greater money growth takes effect immediately. The income and price-level effects take time to work, because it takes time for the increasing money supply to raise the price level and income, which in turn raise interest rates. The expected-inflation effect, which also raises interest rates, can be slow or fast, depending on whether people adjust their expectations of inflation slowly or quickly when the money growth rate is increased. The new level of interest rates depends on which of the effects dominate over the period. With unusually high rates of money growth, this should lead to higher expectedinflation, a jump in the overall price level, and stronger economic growth. These factors should all result in interest rates rising over time, notwithstanding the liquidity effect. However, in the period from 2008 to 2010, unemployment remainedhigh, economic growth was weak, and if anything, policy makers were worried about deflation (a decrease in the price level) rather than any inflationary effects from the money growth. In other words, the income, price-level, and expected-inflation effects of the unusually high money growth conditions were very 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. If the efficient market hypothesis holds, then Marcos' clients would technically not be at any disadvantage with respect to the other clients of the same firm. However, information usually flows according to a set hierarchy, with some individuals getting access to information before others. Even though the SEC makes a huge effort to avoid this phenomenon, it is quite difficult to completely eliminate it. Also, stockbrokers' experiences and expertise play a role in their favor.
Suppose that the health of the economy deteriorates so that the probability of corporations defaulting on their bonds increases. What happens to the supply demand graph?
When corporations impose a lower probability of default on the bonds they offer, the demand for their bonds increases. The opposite is true when the pribability of default increases.
Suppose the expected rate of inflation decreases. When expected inflation rises, causing interest rates to rise, we have seen a demonstration of the
When the expected rate of inflation is higher, the price of bonds fall. The opposite is true when the expected rate of inflation decreases. Fisher Effect- The Fisher effect is given by an observation stating that when the expected inflation rises, interest rates will rise.
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 nextmonth?
Yes, if this information is such that expectations of growth prospects or desired yields justify such a change.
Will there be an effect on interest rates if brokerage commissions on stocks fall?
Yes, interest rates would rise because stocks become more liquid than before, which would reduce the demand for bonds
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
A plot of the yields on bonds with different terms to maturity but the same risk, liquidity, and tax considerations is known as Suppose people expect the interest rate on one-year bonds for each of the next four years to be 4%, 6%, 6%, and 8%. 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 yield curve 6% ((4+6+6+8)/4) x100
Would you be more or less willing to buy a share of Microsoft stock in the following situations: a) Your wealth falls. b) You expect the stock to appreciate in value. c) The bond market becomes more liquid. d) You expect gold to appreciate in value. e) Prices in the bond market become more volatile.
a) Less willing b) More willing c) Less willing d) Less willing e) More willing
Would you be more or less willing to buy long-term AT&T bonds under the following circumstances: a) Trading in these bonds increases, making them easier to sell. b) You expect a bear market in stocks (stock prices are expected todecline). c) Brokerage commissions on stocks fall. d) You expect interest rates to rise. e) Brokerage commissions on bonds fall.
a) More willing b) More willing c) Less willing d) Less willing e) More willing
Explain why you would be more or less willing to buy a share of Microsoft stock in the following situations: a) You would be ______ to buy a share of Microsoft stock if your wealth falls because _______________ b) You would be _______ to buy a share of Microsoft stock if you expect the stock to appreciate in value because ___________ c) You would be ______ to buy a share of Microsoft stock if the bond market becomes more liquid because _________ d) You would be _____ to buy a share of Microsoft stock if you expect gold to appreciate in value because _________ e) You would be ______ to buy a share of Microsoft stock if prices in the bond market become more volatile because _________
a) less willing; you have less money to spend on all of your potential assets. b) more willing; you believe the amount of the return on your investment will be positive c) less willing; you can now sell bonds easier than stocks d) less willing; the return on gold relative to stocks has improved e) more willing; stocks have become relatively safer than bonds
Would you be more or less willing to buy a house under the following circumstances: a) You just inherited $100,000. b) Real estate commissions fall from 6% of the sales price to 5% of the sales price. c) You expect Microsoft stock to double in value next year. d) Prices in the stock market become more volatile. e) You expect housing prices to fall.
a) more willing b) more willing c) less willing d) more willing e) less willing
Explain why you would be more or less willing to buy a house under the following circumstances: a) You would be _____ willing to buy a house if you just inherited $100,000 because ___________ b) You would be ______ willing to buy a house if it meant selling your substantial holdings of Microsoft stock, which you expect will double in value next year because ________ c) You would be ______ willing to buy a house if prices in the stock market become ___________ d) You would be ______ willing to buy a house if you expect housing prices to fall because ___________
a) more; you now have more wealth to spend on all assets b) less; the stock will earn you a very large return c) more; more volatile because stocks have become relatively more risky d) less; the return on your house will actually be negative
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 hypothesis say will happen to the price of the stock when the $4 loss is announced? The stock price will
be revised upward
A business cycle expansion causes
both bond demand and bond supply to shift right.
When the government runs a deficit that is larger than expected, the supply of bonds _________, driving the price of bonds down and the interest rates ____.
increase, up
When Google stock has a higher expected return, relative to alternative assets, due to good business choices, the demand for the alternative assets (substitutes)
declines
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; The government guarantee will reduce the default risk on corporate bonds, making them more desirable to hold relative to Treasury securities. The increased demand for corporate bonds and decreased demand for Treasury securities will lower interest rates on corporate bonds and raise them on Treasury bonds.
If the demand for bonds shifts to the left, the price of bonds
decreases, and interest rates rise
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. Assuming the liquidity premium theory of term structure, you conclude that the liquidity premium is As a result, the yield curve becomes
decreasing flatter
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
demand decreases increase
If the price of bonds is below the equilibrium price, there occurs an excess
demand for bonds, the price of bonds will rise, and the interest rate will fall If the price of bonds is set too low, the quantity demanded is greater than the quantity supplied (excess demand) and people would want to buy more bonds than others are willing to sell, so the price of bonds will be driven up to equilibrium. The opposite is true when there is an excess supply.
Which of the following has most seriously cast doubt on the stronger version of the efficient market hypothesis, in which asset prices reflect the true value of the asset?
events such as "Black Monday" in which asset prices change dramatically without being accompanied by an identifiable fundamental economic change
If the supply of bonds shifts to the left, the price of bonds ________, and the interest rate _________.
increases, decreases
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. The yield from Municipal bonds are not subject to federal taxation. Therefore, their effective returns are higher than that of Treasury bonds.
The president of the United States announces in a press conference that he will fight the higher inflation rate with a new anti-inflation program. Predict what will happen to interest rates if the public believes him. As a result of the president's announcement, people's expectations of inflation will _____, which causes the demand for bonds to shift to the _____. However, the lower expected inflation rate causes the cost of borrowing to ____, so the supply of bonds will _______, which causes the supply curve for bonds to shift to the _____. The impact of this change in bond demand and supply will cause equilibrium interest rates to ________.
fall right rise decrease left decrease If the public believes the president's program will be successful, interest rates will fall. The president's announcement will lower expected inflation. The demand for bonds will increase. For a given nominal interest rate, the lower expected inflation means that the real interest rate has risen, raising the cost of borrowing so that the supply of bonds falls. These impacts cause the equilibrium interest rate to fall.
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 The slope of the yield curve would fall because the drop in expected futureshort-term rates means that the average of expected future short-term rates falls so that long-term rates fall.
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 than 0 If an event makes the average value of a random variable permanently larger, adaptive expectations will fail to fully adjust and will under-predict the variable, making forecast errors non-zero and predictable.
what happens to countries who have a fast, high growth rate of money?
high growth rate: not a one time increase in supply; increase in money supply by substantial amount every year. If economy is growing, incomes are growing and expect demand for money to increase as well. If fed does not respond by also adjusting the supply, the interest rates will be higher. Ex: Turkey
If the income tax exemption on municipal bonds were abolished, the interest rates on these bonds would
increase
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? The market is predicting that future short-term interest rates will 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.
increase higher
Define how the market price of a share of DuWop stock is likely to react to each of the following changes: If DuWop announces an increase in the annual dividend, Div, the price of a share of DuWop will _______. If investors develop a greater aversion to risk or view DuWop stock as having greater risk, k, the share price will _______. 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 decrease increase
If a yield curve looks like the one shown in the diagram to the right (graph has increasing yields until 15 yrs to maturity, then keeps decreasing the rest of the maturity levels) , what is the market predicting about the movement of future short-term interest rates? The market is predicting that short-term interest rates will 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
increase in the near term, then decrease in the long term increase in the near term, then decrease in the long term
When the wealth of individuals decreases,
the price of bonds decreases while the interest rates increase When individuals become wealthier, they demand more bonds, driving the price of bonds higher while lowering the interest rates. The opposite occurs when the wealth of individuals decreases.
If the risk premium on corporate bonds increases, then
the spread between the interest rate on corporate bonds and the interest rate on default-free bonds has become greater.
Foreign exchange rates, like stock prices, should follow a random walk because changes in the exchange rate are unpredictable.
true If a change were predictable, large unexploited profit opportunities would exist in the foreign exchange market. If the foreign exchange market is efficient, these unexploited profit opportunities cannot exist and so the foreign exchange rate will approximately follow a random walk.
"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, oruncertain?
False: These investments are almost of the same profitability. The expectations theory of the term structure implies that, with a $1 investment in one-period bonds over two years, the expected return is given as it+iet+1, which equals 2ie assuming that one-period bond rates are expected to be the same across both periods. With a $1 investment in a two-period bond, the expected return is 2i2t. Thus, only if the (expected) one-period bond rate for both periods is greater than the expected two-period bond rate will one-period bonds be a better investment.
