Chapter 12

Which of the following yields on a stock can be negative?

Capital gains yield and total return

If the variability of the returns on large-company stocks were to decrease over the long-term, you would expect which one of the following as related to large-company stocks to occur as a result?

Decrease in the 68 percent probability range of returns

Assume all stock prices fairly reflect all of the available information on those stocks. Which one of the following terms best defines the stock market under these conditions?

Efficient capital market

Generally speaking, which of the following best correspond to a wide frequency distribution?

High standard deviation, large risk premium

Which one of the following statements is correct based on the historical record for the period 1926-2016?

Long-term government bonds had a lower return but a higher standard deviation on average than did long-term corporate bonds. AND Long-term corporate bonds outperformed long-term government bonds.

Which one of the following is a correct ranking of securities based on the volatility of their annual returns over the period of 1926-2016? Rank from highest to lowest.

Long-term government bonds, long-term corporate bonds, intermediate-term government bonds

Which one of the following correctly describes the dividend yield?

Next year's annual dividend divided by today's stock price

Assume that last year T-bills returned 2.8 percent while your investment in large-company stocks earned an average of 7.6 percent. Which one of the following terms refers to the difference between these two rates of return?

Risk premium

Average Annual Returns vs. Risk Premiums Per Category:

Small stocks: 16.6% Large stocks: 12.0% Long-term Corporate Bonds: 6.3% Long-term Government Bonds: 6.0% U.S. Treasury Bills: 3.4% Inflation: 3.0% Small stocks: 13.2 Large stocks: 8.6% Long-term Corporate Bonds: 2.9% Long-term Government Bonds: 2.6% U.S. Treasury Bills: 0.0%

Which one of the following earned the highest risk premium over the period 1926-2016?

Small-company stocks

The historical record for the period 1926-2016 supports which one of the following statements?

Small-company stocks have lost as much as 50 percent and gained as much as 100 percent in a single year.

Stacy purchased a stock last year and sold it today for $4 a share more than her purchase price. She received a total of $1.15 per share in dividends. Which one of the following statements is correct in relation to this investment?

The capital gains yield is positive.

Which one of the following is the most likely reason why a stock price might not react at all on the day that new information related to the stock's issuer is released? Assume the market is semistrong form efficient.

The information was expected.

The rate of return on which type of security is normally used as the risk-free rate of return?

Treasury bills

Which one of the following categories of securities had the lowest average risk premium for the period 1926-2016?

U.S. Treasury bills

Which one of the following had the least volatile annual returns over the period of 1926-2016?

U.S. Treasury bills

Which one of the following statements is a correct reflection of the U.S. financial markets for the period 1926-2016?

U.S. Treasury bills had an annual return in excess of 10 percent in three or more years.

Standard deviation is a measure of which one of the following?

Volatility

Which form of market efficiency would most likely offer the greatest profit potential to an outstanding professional stock analyst?

Weak

Which one of the following is most indicative of a totally efficient stock market?

Zero net present values for all stock investments

The return earned in an average year over a multiyear period is called the ________ average return.

arithmetic

Many of the sample (or historical) return distributions have a distinct _____ shaped curve.

bell -They are mound-shaped and symmetric -Most observations lay around the sample mean -Fewer observations lay symmetrically on the tails

For the period 2009-2016, U.S. Treasury bills had an annual rate of return that was:

between 0 and .25 percent.

The average compound return earned per year over a multiyear period is called the ________ average return.

geometric

The riskier an asset, the ______ the return is.

higher

To convince investors to accept greater volatility, you must:

increase the risk premium

Evidence seems to support the view that studying public information to identify mispriced stocks is:

ineffective.

The Normal distribution assumes a/an _________ number of observations

infinite -Empirical distributions of returns are only based on hundreds, maybe thousands of observations -Therefore, the Normal distribution is simply an approximation, and returns are only roughly Normal ... ****review slide 25

Equilibrium

is when enough mispricing occurs for a few investors to profit from research and trading.

There is a reward for bearing risk, but only over the _______.

long-run

Individual investors who continually monitor the financial markets seeking mispriced securities:

make the markets increasingly more efficient.

_____ is reflected in security prices almost instantaneously.

news

It is convenient in Finance to assume that the distribution of returns is ______.

normal described by two parameters: Mean Standard Deviation **it allows us to estimate the likelihood/probability of different occurrences for the returns

Estimates of the rate of return on a security based on the historical arithmetic average will probably tend to ________ the expected return for the long-term and estimates using the historical geometric average will probably tend to ________ the expected return for the short-term.

overestimate; underestimate

The primary purpose of Blume's formula is to:

project future rates of return.

For the period 1926-2016, U.S. Treasury bills always:

provided a positive annual rate of return.

The excess return is computed as the:

return on a risky security minus the risk-free rate.

The "reward" for bearing risk of an asset and receiving returns on it, is called ______.

risk premium

You are aware that your neighbor trades stocks based on confidential information he overhears at his workplace. This information is not available to the general public. This neighbor continually brags to you about the profits he earns on these trades. Given this, you would tend to argue that the financial markets are at best ________ form efficient.

semistrong

Small-company stocks, as the term is used in the textbook, are best defined as the:

smallest 20 percent of the companies listed on the NYSE.

Inside information has the least value when financial markets are:

strong form efficient.

Efficient financial markets fluctuate continuously because:

the markets are continually reacting to new information.

Financial markets allow companies, governments, and individuals to increase their utility by allowing:

to defer consumption and earn a return to compensate them for doing so -Borrowers have better access to the capital that is available so that they can invest in productive assets

How are long-run returns measure?

via the geometric mean

Debate on Efficient Market Hypothesis (EMH):

-30 years ago EMH was outright dismissed by practitioners and many academics -Today, it is widely accepted, studied at Business Schools, understood by government and policy-makers when dealing with security markets -Empirical evidence indicates that markets are generally weak form efficient -Empirical evidence indicates that markets are NOT strong form efficient and that insiders could earn abnormal returns -Semi-strong efficiency: greatest controversy ... some equilibrium abnormal profit & anomalies

Competition makes a market efficient:

1. Investors learn as much as possible about companies 2. They then look for securities whose price is not fair (mispricing) based on their analysis 3. Investors trade on these securities: 4. Trading shrinks expected profits and drives prices toward "fair" values: markets gradually become efficient

The enormous amount of data on stocks, bonds, & currencies can help us understand:

1. The historical returns on various types of investments 2. The historical risks on those investments 3. How human being react to and price risk

Year-to-year dollar return: What could you have earned if you had invested $1 into:

1. U.S. Treasury bills: a portfolio of T-bills with 3-month maturity = $20 2. Long-term U.S. Treasury bonds: a portfolio of T-bonds with 20-year maturity = $133 3. Long-term corporate bonds: a portfolio of high-quality bonds with 20-year maturity = ? 4. Large company stocks: the S&P 500 Index, a portfolio of 500 largest U.S. companies for market cap = $6,029 5. Small company stocks: portfolio of the smallest 20% of the companies listed on the NYSE = $33,214

What is the probability that small-company stocks will produce an annual return that is more than one standard deviation below the average?

16 percent

For the period 1926-2016, the average risk premium on large-company stocks was about:

8.6 percent.

Based on the period 1926-2016, the actual real return on large-company stocks has been around:

9 percent

How are short-run returns measure?

Arithmetic Mean

What was the average rate of inflation over the period of 1926-2016?

Between 2.8 and 3.2 percent

Assume you invest in a portfolio of long-term corporate bonds. Based on the period 1926-2016, what average annual rate of return should you expect to earn?

Between 6 and 7 percent

Which of the following statements are true based on the historical record for 1926-2016?

Bonds are generally a safer, or less risky, investment than are stocks.

The Normal Rule (or empirical rule)

In statistics, the 68-95-99.7 rule, also known as the empirical rule, is a shorthand used to remember the percentage of values that lie within a band around the mean in a normal distribution with a width of two, four and six standard deviations, respectively; more accurately, 68.27%, 95.45% and 99.73% of the values lie within one, two and three standard deviations of the mean, respectively. IMPORTANT: If you buy stocks of large companies, you should expect to be outside of this range (-7.2%; +33.2%) one year out of every three on average

Which one of the following statements is correct based on the period 1926-2016?

Long-term government bonds had more volatile annual returns than did the long-term corporate bonds.

Which one of the following statements related to market efficiency tends to be supported by current evidence?

Markets tend to respond quickly to new information.

Which one of the following is defined by its mean and its standard deviation?

Normal distribution

Why do stock and bond prices fluctuate?

Risks such as rising interest rates and economic stimulus policies have an effect on both stocks and bonds, but each reacts in an opposite way. When stocks are on the rise, investors generally move out of bonds and flock to the booming stock market. When the stock market corrects, as it inevitably does, or when severe economic problems ensue, investors seek the safety of bonds. As with any free-market economy, bond prices are affected by supply and demand.

Which one of the following categories of securities had the highest average annual return for the period 1926-2016?

Small-company stocks

Which one of the following categories of securities had the most volatile annual returns over the period 1926-2016?

Small-company stocks

strong form efficiency

Strong form efficiency is the most stringent version of the efficient market hypothesis (EMH) investment theory, stating that all information in a market, whether public or private, is accounted for in a stock's price. Practitioners of strong form efficiency believe that even insider information cannot give an investor an advantage. This degree of market efficiency implies that profits exceeding normal returns cannot be realized regardless of the amount of research or information investors have access to. Example: A highly confidential meeting of the company is on. The CEO of ANY Aero-plane Corporation (whose share was selling for $200 seconds back) announces that the company has just bagged a very lucrative contract from DoD An executive excuses himself to go to the toilet, picks up his cell and calls his broker, and asks him to buy 50,000 shares of ANY @$200 "Are you kidding", says the broker, "The price just shot up to $230, as you guys have bagged a great DoD contract!"

What type of security had the worst returns from 1925 - 2016?

T-bills **However, T-Bills are less risky than other investment options and have more predictable behavior.

Which one of the following best defines the variance of an investment's annual returns over a number of years?

The average squared difference between the actual returns and the arithmetic average return

semi-strong form efficiency

The semi-strong efficiency EMH form hypothesis contends that a security's price movements are a reflection of publicly-available material information. It suggests that fundamental and technical analysis are useless in predicting a stock's future price movement. Only material non-public Iinformation (MNPI) is considered useful for trading. Example: Suppose stock ABC is trading at $10, one day before it is scheduled to report earnings. A news report is published the evening before its earnings call that claims ABC's business has suffered in the last quarter due to adverse government regulation. When trading opens the next day, ABC's stock falls to $8, reflecting movement due to available public information. But the stock jumps to $11 after the call because the company reported positive results on the back of an effective cost-cutting strategy. The MNPI, in this case, is news of the cost-cutting strategy which, if available to investors, would have allowed them to profit handsomely.

weak form efficiency

The weak form efficiency theory, the most lenient of the bunch, argues that stock prices reflect all current information but also concedes that anomalies may be found by researching companies' financial statements thoroughly. Suppose David, a swing trader, sees Alphabet Inc. (GOOGL) continuously decline on Mondays and increase in value on Fridays. He may assume he can profit if he buys the stock at the beginning of the week and sells at the end of the week. If, however, Alphabet's price declines on Monday but does not increase on Friday, the market is considered weak form efficient.

Why are markets generally efficient?

Thousands of trained analysts work on Wall Street Many of them work for big financial firms like Merrill, Morgan, Prudential, which have: -A lot of money, capital available to exploit any mispricing when and if it occurs -Similar, usually almost unlimited access to data -Time to wait until the mispricing occurs

Efficient Market Hypothesis (EMH) does NOT mean that, you cannot gain or lose in the stock-market. In fact, it means that typically you would, though, on the average, you would _______.

break even **EMH does not imply that prices would be steady; rather it suggests that they should fluctuate, as they constantly reflect newly available information.

Bayside Marina just announced it is decreasing its annual dividend from $1.48 per share to $1.45 per share effective immediately. If the dividend yield remains at its pre-announcement level, then you know the stock price:

decreased proportionately with the dividend decrease.

Constant research on companies keep the market _____

efficient

Debt Securities

represents money that is borrowed and must be repaid, with terms that stipulates the size of the loan, interest rate, and maturity or renewal date. Debt securities, which include government and corporate bonds, certificates of deposit (CDs) and collateralized securities (such as CDOs​ and CMOs​), generally entitle their holder to the regular payment of interest and repayment of principal (regardless of the issuer's performance), along with any other stipulated contractual rights (which do not include voting rights). They are typically issued for a fixed term, at the end of which they can be redeemed by the issuer. Debt securities can be secured (backed by collateral) or unsecured, and, if unsecured, may be contractually prioritized over other unsecured, subordinated debt in the case of a bankruptcy.

Equity Securities

represents ownership interest held by shareholders in an entity (a company, partnership or trust), realized in the form of shares of capital stock, which includes shares of both common and preferred stock. Holders of equity securities are typically not entitled to regular payments—although equity securities often do pay out dividends—but they are able to profit from capital gains when they sell the securities (assuming they've increased in value, naturally). Equity securities do entitle the holder to some control of the company on a pro rata basis, via voting rights. In the case of bankruptcy, they share only in residual interest after all obligations have been paid out to creditors. They are sometimes offered as payment-in-kind.

Financial markets also provide us with information about the ________ that are required for various levels of risk

returns

The U.S. Securities and Exchange Commission periodically charges individuals with insider trading and claims those individuals have made unfair profits. Given this, you would be most apt to argue that the markets are less than ________ form efficient.

strong

Variability of an asset's historical returns:

-The greater the volatility (of past returns) the greater the uncertainty (of future returns) -The greater the uncertainty (of future returns) the greater the risk premium investors demand

Which one of the following time periods is associated with low rates of inflation?

2014-2015

The average annual return on small-company stocks was about ________ percent greater than the average annual return on large-company stocks over the period 1926-2016.

5

Which one of the following statements is correct concerning market efficiency?

A firm will generally receive a fair price when it issues new shares of stock if the market is efficient.

Which one of the following statements best defines the efficient market hypothesis?

All securities in an efficient market are zero net present value investments.

Which one of the following statements related to capital gains is correct?

An increase in an unrealized capital gain will increase the capital gains yield.

How are medium-run returns measure?

Arithmetic Mean Geometric Mean