Money & Banking Chapter 7 Stocks and Other Assets

Formula to estimate value of a firm's stock

(P/E) X E = P

An investor buys stock for $10,000 and earns dividends of $250 during the course of the year. At the end of the year, the stock is worth $9,300. The dividend yield for the year is 2.5 percent −2.5 percent. −4.5 percent. −7.0 percent.

2.5 percent.

The equity premium puzzle refers to the difficulty of calculating the total annual return on equity shares.

False

The lock in effect refers to company restrictions on when a shareholder can realize capital gains.

False

A stockholder is a partial owner of the corporation that issued the stock.

True

An index fund is a mutual fund that attempts to mimic the behavior of a stock index.

True

arbitrage-pricing theory (APT)

a model of stock prices that allows for more sources of risk than just the stock market's excess return

capital asset pricing model (CAPM)

a model of stock prices that explains the returns to a stock as depending on how risky the stock is compared with the market average

index fund

a mutual fund that tries to mimic a stock index, such as the S&P 500

stock exchange

a place where people buy or sell stocks; also called a stock market

undervalued

a situation in which stock prices are below their fundamental value

overvalued

a situation in which stock prices exceed their fundamental value

irrational expectations

a theory that investors do not have rational expectations, so the stock market goes through periods in which stock prices rise higher than their fundamental value and other periods in which stock prices fall below their fundamental value

rational expectations

a theory that investors use all the information available to them about companies' future prospects in determining their buying and selling decisions, in which case stock prices always equal their fundamental value; the notion that people use all available information in making their economic decisions

Which of the following indexes does not contain stocks of small companies? a. The DOW Jones Index. b. The NASDAQ Index. c. The Russell 2000 Index. d. The Wilshire 5000 Index.

a. The DOW Jones Index.

Which of the following does not have a fixed location? a. The NASDAQ stock exchange. b. The New York Stock Exchange. c. The Tokyo Stock Exchange. d. The London Stock Exchange.

a. The NASDAQ stock exchange.

12. Incidents of predictable patterns to stock prices that investors could exploit, even accounting for risk aversion, are called ________. a. anomalies b. guesses c. exceptions d. miracles

a. anomalies

19. People will not pay much to avoid risk in everyday situations, but when it comes to the stock market, people are willing to give up large potential returns to stocks in order to buy safer Treasury securities. This surprising result is called the ________. a. equity-premium puzzle b. Treasury-security puzzle c. random walk d. irrational expectation

a. equity-premium puzzle

An observation that does not fit a model is called a martingale. an anomaly. a random walk. a beta coefficient

an anomaly.

mutual fund

an investment company that pools the funds of many investors and buys a large number of different stocks (or other securities)

A mutual fund is a hedge fund that only wealthy people may invest in. an investment company that pools the funds of many investors and buys a large number of different stocks or other securities. a fund that buys a share of each stock in the entire stock market. an investment company that buys stocks in companies that are not growing strongly

an investment company that pools the funds of many investors and buys a large number of different stocks or other securities.

9. In the last half of the 1990s, returns to the stock market averaged ________ percent each year. a. 100 b. 25 c. 0 d. 10

b. 25

Which of the following is correct regarding the beta in the CAPM? a. A company with a higher beta has lower systematic risk. b. A company with a higher beta has higher systematic risk. c. A company with a higher beta has lower unsystematic risk. d. A company with a higher beta has higher unsystematic risk.

b. A company with a higher beta has higher systematic risk.

Which of the following describes the fundamental value of a stock? a. It is the average of the stock's price during the past year. b. It is the discounted present value of the company's earnings. c. It is the return calculated using the capital asset pricing model, CAPM. d. It is the return calculated using the arbitrage-pricing theory.

b. It is the discounted present value of the company's earnings.

14. A model of stock prices that allows for more sources of risk than just the stock market's excess return is known as the ________. a. capital asset pricing model b. arbitrage-pricing theory c. efficient markets hypothesis d. random walk

b. arbitrage-pricing theory

2. The average price of a collection of stocks is called a stock ________. a. collection b. index c. market d. exchange

b. index

3. A mutual fund that tries to mimic a stock index, such as the S&P 500, is called a(n) ________ fund. a. NASDAQ b. index c. stock d. 500

b. index

17. The theory of ________ argues that the stock market goes through periods in which stock prices rise higher than their fundamental value and other periods in which stock prices fall below their fundamental value. a. rational expectations b. irrational expectations c. optimistic expectations d. realistic expectations

b. irrational expectations

6. The idea that investors who own a stock that has appreciated significantly feel compelled to hold that stock forever to avoid capital-gains taxes is known as the ________ effect. a. explicit capital gains b. lock-in c. implicit capital gains d. realized

b. lock-in

15. Fundamental value is the ________ value of ________ earnings of a company or of all companies in the stock market as a whole. a. future; expected b. present; expected c. present; past d. future; past

b. present; expected

20. Over the last 25 years, the returns to owning stocks are ________ than the average annual appreciation of housing prices. a. significantly lower b. significantly higher c. slightly higher d. slightly lower

b. significantly higher

1. Shareholders are investors who own ________ in a corporation. a. property b. stock c. capital equipment d. bonds

b. stock

7. When an investor in the stock market is well-diversified, the risk that the investor faces is basically the risk that ________. a. foreign stocks will fall b. the entire stock market will rise or fall c. computer stocks will crash d. nominal interest rates will rise

b. the entire stock market will rise or fall

13. The risk to a stock's return that is not explained by movements in the market is called ________ risk. a. asset b. unsystematic c. market d. systematic

b. unsystematic

Which of the following describes how the total annual return for a stock is calculated? a. It is the change in price over the past year divided by the beginning of the year price. b. It is the dividend paid divided by the beginning of the year price. c. It is the sum of a. and b. d. It is the result of a. minus b.

c. It is the sum of a. and b.

5. Capital gains that have been accrued but not yet realized are called ________ capital gains. a. explicit b. locked-in c. implicit d. realized

c. implicit

11. The ________ walk is the idea that movements of stock prices from day to day, year to year, or decade to decade are not predictable. a. serpentine b. efficient c. random d. realized

c. random

4. Profits that an investor receives by actually selling stock are known as ________ capital gains. a. explicit b. locked-in c. realized d. implicit

c. realized

Implicit capital gains

capital gains that have been accrued but not yet realized

Predictability of stock prices results from which of the following? a. Anomalies in stock prices. b. Risk aversion on the part of stock owners. c. Inefficient stock markets. d. All of the above for the predictability of stock prices.

d. All of the above for the predictability of stock prices.

8. The financial crisis of 2008 caused real stock prices to ________. a. remain unchanged b. increase significantly c. increase slightly d. decline

d. decline

10. The idea that stock prices fully reflect all available information is called the ________ markets hypothesis. a. random b. reflective c. inefficient d. efficient

d. efficient

18. The average amount (in terms of percentage return) by which the return on stocks exceeds the return on debt securities is called the equity ________. a. yield b. gain c. bonus d. premium

d. premium

16. If the value of the stock market is below its fundamental value, the market is ________. a. minus-valued b. rationally valued c. overvalued d. undervalued

d. undervalued

Anomalies

incidents of predictable patterns to stock prices that investors could exploit, even accounting for risk aversion

shareholders

investors who own stock in a corporation; also called stockholders

The biggest disadvantage to a stockholder of receiving dividends is receiving cash flow. depositing dividend checks. hiring accountants. paying taxes.

paying taxes.

realized capital gains

profits that an investor receives by actually selling stock

equity premium

the average amount (in terms of percentage return) by which the return on stocks exceeds the return on debt securities

stock index

the average price of a collection of stocks

lock-in effect

the idea that investors who own stock that has appreciated significantly feel locked into holding that stock forever to avoid paying capital-gains taxes

random walk

the idea that movements of stock prices from day to day, year to year, or decade to decade are not predictable

efficient markets hypothesis

the idea that stock prices fully reflect all available information

fundamental value

the present value of expected earnings of a company or of all companies in the stock market as a whole

systematic risk

the risk to a stock's return that is attributable to the fluctuations in the market; also called market risk

unsystematic risk

the risk to a stock's return that is not explained by movements in the market; also called idiosyncratic risk

If stock prices exceed their fundamental values, the stock market is overvalued. the stock market is undervalued. investors have rational expectations. mutual funds will be worth more than their price.

the stock market is overvalued.

equity-premium puzzle

the surprising result that people will not pay much to avoid risk in everyday situations, but when it comes to the stock market, people are willing to give up large potential returns to stocks in order to buy safer Treasury securities