Exam #2
10. What is a "bubble" in the stock market and what causes bubbles?
A bubble is a situation in which the price of an asset differs from its fundamental market value, which is caused by the demand phenomena.
9. If you had to describe the trend in stock prices for forecasting purposes, how would you describe it?
A random walk with drift; unpredictable.
Shifters of Supply of money:
Assuming the supply of money is controlled by the central bank; an increase in the money supply engineered by the Federal Reserve will shift the supply curve for money to the right.
The significance of the bond market to the U.S. economy; why interest rates in capital markets fluctuate.
Bond market allows firms to maximize research and development ideas in a more timely matter. Interest rates fluctuates because supply and demand fluctuates.
What are stocks' "cash flows"?
Cash payments to the holder of a security. Dividend payments.
The perceived risk of holding stock is (negatively/positively) related to stock price?
Negative related.
Know how to identify the area of risk-premium on the supply/demand models for corporate bonds and U.S. Treasury securities
The spread between the interest rates on bonds with default risk and the interest rates on treasury bonds (same maturity)
Keynes' liquidity preference framework in terms of the income and price-level effects.
a) Income effect: • Higher income causes demand for money and interest rates to increase, and demand shifts right. • When income rises during business expansion, interest rates rises. b) Price-level effect: • Rise in price level causes demand for money at each interest rate to increase and demand curve shifts right. • Price level increases, with the supply of money, interest rates rise. c) Liquidity Preference framework: • Determines the equilibrium interest rate in terms of supply and demand for money. • As the interest rate increases; the opportunity cost of holding money increases, the relative expected return of money decreases; therefore, the quantity demanded of money increases.
The impact upon bond prices and interest rates of an increase in expected inflation:
shifts the bond demand curve to the left, and shifts the bond supply curve right; causing the price of bonds to fall and the equilibrium interest rate to rise.
The impact upon bond prices and interest rates of a business cycle expansion:
will shift the bond supply curve to the right, and the demand curve for bond to the right (less amount); therefore the price of bonds will fall and the equilibrium interest rate will rise.
The model of supply and demand for money, and indicate how a shift in either demand or supply will affect short-term interest rates.
• A one-time increase in the money supply will cause prices to rise to a permanently higher level by the end of the year. The interest rate will rise via the increased prices. • A rising price level will raise interest rates because people will expect inflation to be higher over the course of the year. When the price level stops rising, expectations of inflation will return to zero.
8. What is the Efficient Market Hypothesis, and what does it imply about the effectiveness of exploiting "hot tips" for certain stocks?
• Current prices in a financial market will be set so that the optimal forecast of a security's return using all available information equals the security's equilibrium return. • It tells us that in an efficient market a security price fully reflects all available information. • The application of the theory of rational expectations to financial markets. • R = (Pt + 1 - Pt + C)/ Pt • R = rate of return on the security. • Pt+1 = price of security at time t+1 at the end of the holding period. • Pt = price of security at the beginning of the holding period. • C = cash payment (coupon or dividend)
Know how to determine the risk of default on bonds; against what standard is this risk measured?
• Default risk: probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face value.
factors that will shift the Supply Curve for bonds?
• Expected profitability of investment opportunities: in an expansion, the supply curve shifts to the right. • Expected inflation: an increase in expected inflation shifts the supply curve for bonds to the right. • Government budget: an increase in budget deficits shifts the supply curve to the right.
The "Fisher Effect" (nominal versus real rates) and its impact upon the effects of monetary policy. Implies that there is a real interest rate. When expected inflation rises, interest rates rises.
• If we think inflation will be positive, lenders (demand) will be less willing to lend. • If you have money available to lend, you could either spend now or get paid later. • But with inflation, prices will rise and you will want to spend now. • Borrower (supply) will be more willing to borrow. • Borrowers can buy now from borrowing, or wait, borrow and buy later. • But prices will be higher later, so you want to borrow and buy now. • Inflation leads to rising interest rates in the long-run.
Shifters of Demand for money:
• Income effect: a higher level of income causes the demand for money at each interest rate to increase and the demand curve to shift to the right. • Price level effect: a rise in the price level causes the demand for money at each interest rate to increase and the demand curve to shift to the right.
Default risk: probability that the issuer of the bond is unable or unwilling to make interest payments or pay off the face value. U.S. treasury bonds are considered default free HOW THEY AFFECT bond prices and interest rates on bonds.
• Increase in default risk shifts demand curve for corporate bonds to the left and the demand for treasury bonds to the right. Raising price for treasury bonds and lowering price of corporate bonds will lower interest rate in treasury bonds and raise the interest rate on corporate bonds.
What role does information play in determining stock prices?
• Increase its value by reducing its perceived risk • When new information is released about a firm, expectations and prices changes. • Market participants constantly receive information and revise their expectations, so stock prices change frequently.
relatively flat yield curve.
• Indicates that short run interest rates are expected to fall moderately in the future. • Short and long term rates are the same
inverted yield curve
• Indicates that short run interest rates are expected to fall sharply in the future. • Long term rates are below short term rates
Steeply upward sloping yield curve
• Indicates that short run interest rates are expected to rise in the future.
Upward sloping yield curve
• Indicates that short run interest rates are not to rise or fall much in the near future. • Long-term rates are above short-term rates
The secondary (and undesirable) economic effect of a decrease in short-term interest rates which results from an increase in the supply of money? ? Why do we say that the Fed can target either inflation or interest rates, but not both?
• Inflation • The Fed cannot do both because when you increase the money supply inflation rise. When inflation goes up, interest rate goes down in order to get the economy moving before inflation rises again
Which of the following (Expectations, Segmented Markets, and Liquidity Premium/Preferred Habitat theories) best explains why yield curves are generally upward-sloping?
• Liquidity premium theory The interest rate on long-term bond will equal an average short-term interest rates expected to occur over the life of the long-term bond plus a liquidity premium that responds to supply and demand conditions for that bond. Bonds of different maturities are partial (not perfect) substitutes. Investors have a preference of one maturity over another. They will be willing to buy bonds of different maturities only if they earn a somewhat higher expected return. Investors are likely to prefer short-term over long-term bonds; explained by the first term in the equation.
Liquidity: an increase in the money supply leads to lower interest rates. An increased liquidity of bonds results in demand curve shifting right HOW THEY AFFECT bond prices and interest rates on bonds.
• Lower liquidity of corporate bonds increases the risk premium between the interest rate of these 2 bonds because corporate bonds are less liquid than treasury bonds.
Understand the two ways in which investors formulate their beliefs about future stock prices.
• Rational expectations: expectations that reflect optimal forecasts using all available information. Is not always accurate. • Adaptive expectations: expectations of a variable based on an average of past values, occur slowly.
What rights to stockholders have with respect to the corporation in which they own stock?
• Right to vote and be residual claimant of all funds flowing into the firm. • The right to any dividends from the net earnings of the company. • Right to sell the stock.
Know how to calculate tax-equivalent yield on a municipal bond.
• Tax-equivalent = tax exempt yield(whole number)/(1-tax(decimal))
Income tax considerations: interest payments on municipal bonds are exempt for federal income taxes HOW THEY AFFECT bond prices and interest rates on bonds.
• Tax-free status shifts demand for municipal bonds to the right and decreases demand for treasury bonds, municipal bonds end up with a higher price and lower interest rate than treasury bonds.
Understand the accepted stock-valuation formula, and why holding period is not incorporated into the formula. Be able to calculate the price of a stock. From the resulting price you calculate, explain how k and g help interpret economic conditions as well as investors' beliefs.
• The holding period is not incorporated into the formula because (1) stocks are long-term investments and (2) forecasting errors, over and under estimating cancel out. • Gordon Growth Model: Po=Do(1+g)/(Ke-g) = D1/Ke-g Do= recent dividend payment g= growth rate in dividends Ke= required returns on investment Dividends are assumed to continue growing forever at a constant rate Growth rate is assumed to be less than the required return on equity If k is rising price of stock should fall If g is increasing price should rise
The Theory of Asset Demand; (know in which direction an increase/decrease will shift the curve.)
• The quantity demanded of an asset is positively related to wealth • The quantity of a demanded asset is positively related to its expected return relative to alternative assets. • The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets. • The quantity demanded of an asset is positively related to its liquidity relative to alternative assets.
Factors that will shift the Demand Curve for bonds
• Wealth: in an expansion with growing wealth, the demand curve for bonds shifts to the right. • Expected Interest Rate: higher expected interest rates in the future lower the expected return for long-term bonds, shifting the demand curve to the left. On the contrary, if expected interest rates go down in the future, long-term bond prices would rise, and have a higher expected return, shift demand to the right. • Expected Inflation: an increase in the expected rate of inflations lowers the expected return for bonds, demand curve shift to the left. • Risk: an increase in the riskiness of bonds causes demand curve to shift to the left. • Liquidity: increased liquidity of bonds results in demand curve shifting right.
What are the effect of expansionary and contractionary monetary policy upon stock prices?
• When interest rate decreases, return on bonds decline; investors accept lower rate of return in equity (Ke), this lowers denominator in Gordon growth model, and increase stock prices (Po) • Lowering interest rates stimulates economy, so growth rates in dividends (g) will be higher also causing denominator of GG model to decline and Po to rise. • Either way Po rises
7. Yield curves; the macroeconomic interpretation of origin and slope of
• Yield curves contains info about future interest rate • Forecast inflation • Forecast business cycle • Steep yield curve predicts future increase in inflation • Useful indicator of monetary policy: steep curve indicates loose policy, flat or downward indicate a tight policy. • Flat or downward yield curve future, short term interest rates are expected to fall and economy is more likely to enter a recession.