ECN 3210 Chapter 7

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

A) rational. B) irrational. C) adaptive. D) reasonable. Answer: A

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

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

An expectation may fail to be rational if

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

To say that stock prices follow a "random walk" is to argue that stock prices

A) rise, then fall, then rise again. B) rise, then fall in a predictable fashion. C) tend to follow trends. D) cannot be predicted based on past trends. Answer: D

In asset markets, an asset's price is

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

Loss aversion can explain why very little ________ actually takes place in the securities market.

A) short selling B) bargaining C) bartering D) negotiating Answer: A

If a market participant believes that a stock price is irrationally high, they may try to borrow stock from brokers to sell in the market and then make a profit by buying the stock back again after the stock falls in price. This practice is called

A) short selling. B) double dealing. C) undermining. D) long marketing. Answer: A

The efficient markets hypothesis suggests that investors

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

Mean reversion refers to the fact that

A) small firms have higher than average returns. B) stocks that have had low returns in the past are more likely to do well in the future. C) stock returns are high during the month of January. D) stock prices fluctuate more than is justified by fundamentals. Answer: B

If a forecast made using all available information is NOT perfectly accurate, then it is

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

Excessive volatility refers to the fact that

A) stock returns display mean reversion. B) stock prices can be slow to react to new information. C) stock price tend to rise in the month of January. D) stock prices fluctuate more than is justified by dividend fluctuations. Answer: D

Investors tend to trade on their beliefs rather than on pure facts. This statement might explain why securities markets have ________ that the efficient market hypothesis does not predict.

A) such a large trading volume B) short sales C) a random walk D) arbitrage Answer: A

When a corporation announces a major decline in earnings, the stock price may initially decline significantly and then rise back to normal levels over the next few weeks. This impact is called

A) the January effect. B) mean reversion. C) market overreaction. D) the small-firm effect. Answer: C

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

A) the actual value of the future dividend stream. B) the present value of the future dividend stream. C) the present value of the future dividend stream plus the actual future sales price. D) the present value of the future sales price. Answer: B

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

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

Using the Gordon growth model, a stock's current price decreases when

A) the dividend growth rate increases. B) the required return on equity decreases. C) the expected dividend payment increases. D) the growth rate of dividends decreases. Answer: D

A change in perceived risk of a stock changes

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

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

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

Evidence in support of the efficient markets hypothesis includes

A) the failure of technical analysis to outperform the market. B) the small-firm effect. C) the January effect. D) excessive volatility. Answer: A

A stock's price will fall if there is

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

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

A) $10. B) $20. C) $30. D) $40. Answer: B

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

A) $110.00. B) $101.00. C) $100.00. D) $96.19. Answer: D

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

A) $110.11. B) $121.12. C) $100.10. D) $100.11 Answer: C

Using the Gordon growth model, if D1 is $.50, ke is 7%, and g is 5%, then the present value of the stock is

A) $2.50. B) $25. C) $50. D) $46.73. Answer: B

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

A) $20. B) $50. C) $100. D) $150. Answer: C

If during the past decade the average rate of monetary growth has been 5% and the average inflation rate has been 5%, everything else held constant, when the Federal Reserve announces that the new rate of monetary growth will be 10%, the adaptive expectation forecast of the inflation rate is

A) 5%. B) between 5 and 10%. C) 10%. D) more than 10%. Answer: A

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

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

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

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

________ is the field of study that applies concepts from social sciences such as psychology and sociology to help understand the behavior of securities prices.

A) Behavioral finance B) Strategical finance C) Methodical finance D) Procedural finance Answer: A

________ means people are more unhappy when they suffer losses than they are happy when they achieve gains.

A) Loss fundamentals B) Loss aversion C) Loss leader D) Loss cycle Answer: B

Does the efficient markets hypothesis imply that the average investor will not earn anything by purchasing stock?

A) No, the efficient market hypothesis implies that the average investor should not expect to receive abnormally high returns on a consistent basis. B) Yes, the efficient markets hypothesis implies that the best that the average investor can do is break even. C) No, the efficient market hypothesis implies that the investor will consistently earn abnormally high returns by purchasing stock. D) Yes, the efficient markets hypothesis implies that stock purchases are extremely risky and that the average investor has no hope of recovering any loss. Answer: A

________ and ________ may provide an explanation for stock market bubbles.

A) Overconfidence; social contagion B) Underconfidence; social contagion C) Overconfidence; social isolationism D) Underconfidence; social isolationism Answer: A

Which of the following accurately summarize the empirical evidence about technical analysis?

A) Technical analysts fare no better than other financial analysis—on average they do not outperform the market. B) Technical analysts tend to outperform other financial analysis, but on average they nevertheless under-perform the market. C) Technical analysts fare no better than other financial analysis, and like other financial analysts they outperform the market. D) Technical analysts fare no better than other financial analysis, and like other financial analysts they under-perform the market. Answer: A

The efficient markets hypothesis predicts that stock prices follow a "random walk." The implication of this hypothesis for investing in stocks is

A) a "churning strategy" of buying and selling often to catch market swings. B) turning over your stock portfolio each month, selecting stocks by throwing darts at the stock page. C) a "buy and hold strategy" of holding stocks to avoid brokerage commissions. D) following the advice of technical analysts. Answer: C

Rules used to predict movements in stock prices based on past patterns are, according to the efficient markets hypothesis

A) a waste of time. B) profitably employed by all financial analysts. C) the most efficient rules to employ. D) consistent with the random walk hypothesis. Answer: A

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

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

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

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

New information that might lead to a decrease in a stock's price might be

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

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

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

According to rational expectations theory, forecast errors of expectations

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

Studies of mutual fund performance indicate that mutual funds that outperformed the market in one time period usually

A) beat the market in the next time period. B) beat the market in the next two subsequent time periods. C) beat the market in the next three subsequent time periods. D) do not beat the market in the next time period. Answer: D

For small investors, the best way to pursue a "buy and hold" strategy is to

A) buy and sell individual stocks frequently. B) buy no-load mutual funds with high management fees. C) buy no-load mutual funds with low management fees. D) buy load mutual funds. Answer: C

The efficient markets hypothesis indicates that investors

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

Periodic payments of net earnings to shareholders are known as

A) capital gains. B) dividends. C) profits. D) interest. Answer: B

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

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

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

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

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

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

Financial markets quickly eliminate unexploited profit opportunities through changes in

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

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

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

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

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

According to rational expectations

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

Stock market crashes lead us to believe that

A) factors other than market fundamentals have an effect on asset prices. B) unexploited profit opportunities never exist. C) crashes are always predictable when market participants behave rationally. D) bubbles are a natural outcome of an efficient market. Answer: A

Evidence against market efficiency includes

A) failure of technical analysis to outperform the market. B) the random walk behavior of stock prices. C) the inability of mutual fund managers to consistently beat the market. D) the January effect. Answer: D

Which of the following types of information most likely allows the exploitation of a profit opportunity?

A) financial analysts' published recommendationsB) technical analysis C) hot tips from a stockbroker D) insider information Answer: D

The efficient markets hypothesis implies that prices in the stock market

A) follow a definite pattern. B) are more likely to go up than down. C) always undervalue the true assets of a corporation. D) are unpredictable. Answer: D

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

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

Stockholders are residual claimants, meaning that they

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

If a mutual fund outperforms the market in one period, evidence suggests that this fund is

A) highly likely to consistently outperform the market in subsequent periods due to its superior investment strategy. B) likely to under-perform the market in subsequent periods to average its overall returns. C) not likely to consistently outperform the market in subsequent periods. D) not likely to outperform the market in any subsequent period. Answer: C

When Happy Feet Corporation announces that their fourth quarter earnings are up 10%, their stock price falls. This is consistent with the efficient markets hypothesis

A) if earnings were not as high as expected. B) if earnings were not as low as expected. C) if a merger is anticipated. D) the company just invented a new bunion product. Answer: A

In a one-period valuation model, a decrease in the required return on investments in equity causes a(n) ________ in the ________ price of a stock.

A) increase; current B) increase; expected sales C) decrease; current D) decrease; expected sales Answer: A

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

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

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

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

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

A) irrational. B) rational. C) adaptive. D) reasonable. Answer: C

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

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

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

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

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

A) it will tend to go unnoticed for some time. B) it will be quickly eliminated. C) financial analysts are your best source of this information. D) all profits will be eliminated through taxation. Answer: B

A corporation's dividend payment is set by

A) its board of directors. B) its debtholders. C) the corporation's CFO (chief financial officer). D) the stockholders themselves. Answer: A

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

A) liquidity. B) risk. C) capital. D) policy. Answer: B

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

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

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

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

The January effect refers to the fact that

A) most stock market crashes have occurred in January. B) stock prices tend to fall in January. C) stock prices have historically experienced abnormal price increases in January. D) the football team winning the Super Bowl accurately predicts the behavior of the stock market for the next year. Answer: C

The small-firm effect refers to the

A) negative returns earned by small firms. B) returns equal to large firms earned by small firms. C) abnormally high returns earned by small firms. D) low returns after adjusting for risk earned by small firms. Answer: C

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

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

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

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

The global financial crisis lead to a decline in stock prices because

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

Tests used to rate the performance of rules developed in technical analysis conclude that technical analysis

A) outperforms the overall market. B) far outperforms the overall market, suggesting that stockbrokers provide valuable services. C) does not outperform the overall market. D) does not outperform the overall market, suggesting that stockbrokers do not provide services of any value. Answer: C

When using rational expectations, forecast errors will, on average, be ________ and ________ be predicted ahead of time.

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

The value of any investment is found by computing the

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

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

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

If future changes in stock prices are unpredictable, then we say that the stock prices follow a

A) random walk. B) straight and narrow path. C) meandering path. D) generalized walk. Answer: A

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

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

On rainy days, Jennifer's commute time to work averages 45 minutes. Before leaving, Jennifer hears on the radio that a street on her route is closed due to high water. She plans to add an additional 15 minutes to her commute because of the detour. This decision represents

A) rational expectations. She is changing her expectations to reflect new information. B) adaptive expectations. She is adapting her plan to what she heard. C) irrational expectations. Everyone knows that radio news is unreliable. D) irrational expectations. She should just call in sick and not get out in the bad weather. Answer: A

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

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

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

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

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

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

A phenomenon closely related to market overreaction is

A) the random walk. B) the small-firm effect. C) the January effect. D) excessive volatility. Answer: D

People have a strong incentive to form rational expectations because

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

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

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

Psychologists have found that people tend to be ________ in their own judgments.

A) underconfident B) overconfident C) indecisive D) insecure Answer: B

Another way to state the efficient markets hypothesis is: in an efficient market

A) unexploited profit opportunities will be quickly eliminated. B) unexploited profit opportunities will never exist. C) all prices can be accurately predicted. D) every financial market participant must be well informed about securities. Answer: A

When we describe stock prices as following a random walk, we mean that future changes in stock prices are

A) unpredictable. B) increasing. C) decreasing. D) constant. Answer: A

The efficient markets hypothesis implies that future changes in exchange rates should for all practical purposes be

A) unpredictable. B) set by each country. C) increasing. D) pegged to a standard such as the U.S. dollar or the Euro. Answer: A

If expectations are formed adaptively, then people

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

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

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

If expectations are formed rationally, then individuals

A) will have a forecast that is 100% accurate all of the time. B) change their forecast when faced with new information. C) use only the information from past data on a single variable to form their forecast. D) have forecast errors that are persistently low. Answer: B

The number and availability of discount brokers has grown rapidly since the mid-1970s. The efficient markets hypothesis predicts that people who use discount brokers

A) will likely earn lower returns than those who use full-service brokers. B) will likely earn about the same as those who use full-service brokers, but will net more after brokerage commissions. C) are going against evidence suggesting that full-service brokers can help outperform the market. D) are likely to outperform the market by a wide margin. Answer: B

Your best friend calls and gives you the latest stock market "hot tip" that he heard at the health club. Should you act on this information? Why or why not?

No, if this information is readily available, it will already be reflected in the stock price.

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

No, this prediction is not using rational expectations. Although Barbara based her guess on the information that was available to her at the time, additional information was readily available that could have been used to improve her prediction.

24) What rights does ownership interest give stockholders?

Stockholders have the right to vote on issues brought before the stockholders, be the residual claimant, that is, receive a portion of any net earnings of the corporation, and the right to sell the stock.

If a corporation announces that it expects quarterly earnings to increase by 25% and it actually sees an increase of 22%, what should happen to the price of the corporation's stock if the efficient markets hypothesis holds, everything else held constant?

The stock's price should fall. The price had adjusted based on the statement of expected earnings. When the actual number turned out to be lower than expected, the stock price changes to reflect the additional information.

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

Use the Gordon Growth Model. $5(1 + .05)/(.12 - .05) = $75