Chapter 7: Stock Market

Question 1

What is the relationship between high-interest rates and stocks?

Answer 1

instant gratification, future worth less

Question 2

What is the relationship between low-interest rates and stocks?

Answer 2

delayed gratification, future worth more

Question 3

What does higher interest rates lead to?

Answer 3

decrease value, change in distribution

Question 4

How do higher interest rates change investment decision timelines?

Answer 4

1. investments that payoff earlier are more valuable than investments that pay off later
2. reinvest profits or dividend payouts: what are the timings of cash flow
3. don’t repay callable bonds
4. don’t prepay fixed rate mortgages (payments have already fallen in value)

Question 5

how does money affect the stock market?

Answer 5

personal wealth (when wealth is down, consumption is down), business investment decisions

Question 6

One-period valuation model

Answer 6

buy stock, hold for 1 period, collect dividend, sell stock

Question 7

One-period valuation equation

Answer 7

P_0 = Div_1/(1+K) + P_1/(1+K)

Question 8

generalized dividend valuation model

Answer 8

value is present value of all future cash flows

Question 9

generalized dividend valuation equation

Answer 9

P_0 = D_1/(1+K)^1 + … + D_n/(1+K)^n + P_n/(1+K)^n

Question 10

What must you know to predict future dividends?

Answer 10

level of Dt+1 and risk of Dt+1

Question 11

Gordon growth

Answer 11

assume dividends grow at a constant growth rate g which is less than K

Question 12

Gordon growth equation

Answer 12

P_0 = D_0(1+g)^1/(1+K)^1 + … = D_0(1+g)/(K - g)

Question 13

how does monetary policy affect stock prices

Answer 13

1. when i is down, return on bonds is down, relative return on stocks is up, k is down, and P_0 is up
2. when i is down, borrowing is up, investment is up, GDP is up, g is up, and P_0 is up

Question 14

How does rising inflation affect the Gordon growth model?

Answer 14

as g goes up, P_0 goes up

Question 15

stockholders

Answer 15

those who hold stock in a corporation

Question 16

residual claimant

Answer 16

the stockholder receives whatever remains after all other claims against the firm’s assets have been satisfied

Question 17

dividends

Answer 17

payments made periodically, usually every quarter, to stockholders

Question 18

adaptive expectations

Answer 18

suggests that changes in expectations will occur slowly over time, as data for variable evolve

Question 19

rational expectations

Answer 19

expectations will be identical to optimal forecasts (the best guess of the future) using all available information

Question 20

are rational expectations always accurate

Answer 20

even though a rational expectation equals the optimal forecast using all available information, a prediction based on it may not always be perfectly accurate

Question 21

What are the two implications of the rational expectations theory?

Answer 21

1. If there is a change in the way a variable moves, the way in which expectations of this variable are formed will change as well
2. the forecast errors of expectations will, on average, be zero and cannot be predicted ahead of time

Question 22

arbitrage

Answer 22

occurs when a security is purchased in one market and simultaneously sold in another market, for a higher price

Question 23

unexploited profit opportunities

Answer 23

returns on a security that are larger than what is justified by the
characteristics of that security

Question 24

In an efficient market, what happens to unexploited profit opportunities?

Answer 24

unexploited profits opportunities will be eliminated

Question 25

random walk

Answer 25

describes the movements of a variable whose future values
cannot be predicted (are random) because, given today’s value, the value of the variable
is just as likely to fall as it is to rise

Question 26

Are future changes in stock price predictable?

Answer 26

In an efficient market, no

Question 27

market fundamentals

Answer 27

items that have a direct impact on future
income streams of the securities

Question 28

short sales

Answer 28

they must borrow stock from brokers and then
sell it in the market, with the aim of earning a profit by buying the stock back again after it has fallen in price

Question 29

efficient market hypothesis

Answer 29

expectations in financial markets are equal to optimal forecasts using all available information

Question 30

do stock prices always rise when there is good news?

Answer 30

no, if the information is expected by the market, the price won’t change

Question 31

under what conditions
do stock prices change?

Answer 31

stock prices will respond to announcements only when the information being announced is new and unexpected

Question 32

behavioral finance

Answer 32

applies concepts from social sciences to explain the behavior of securities prices

Question 33

optimal forecast

Answer 33

the best guess of the future using all available information

Question 34

how does monetary expansion affect stocks?

Answer 34

stock prices increase because of a decrease in the required rate of return and an increase in the dividend growth rate