Deck 6: The Stock Market, information, and Financial Market Efficiency

Question 1

In what way do owners of stocks have limited liability?

Answer 1

Limited liability is the legal provision that shields owners of a corporation from losingmore than they have invested in the firm.

Question 2

The fundamental value of a stock equals

A) the future value of all future dividends.
B) the present value of all future dividends.
C) the present value of current and future dividends.
D) the present value of all future capital gains.

Answer 2

B

Question 3

A corporation's market capitalization is best described as

A) the total value of its stocks and bonds.
B) the total value of its common and preferred stock.
C) its total profit for a particular year.
D) its average profit over a period of years.

Answer 3

B

Question 4

In what way can the stock market affect the overall economy?

A) It's an important source of funds for corporations.
B) It can affect consumer and business sentiment.
C) It is an important factor affecting consumer wealth and thus consumer spending.
D) All of the above

Question 5

Which of the following is NOT a popular stock market index?

A) Dow Jones Industrial Average
B) NASDAQ
C) S&P 500
D) Moody's Market Index

Question 6

What are the differences between common stock and preferred stock?

Question 7

According to the Gordon-Growth model,what is the value of a stock with a dividend of $1,required return on equity of 10% and expected growth rate of dividends of 5%?

A) $2
B) $10
C) $20
D) $21

Question 8

In Wall Street Jargon,a "Bear Market" typically means

A) stock prices have declined by at least 20%.
B) stock prices have declined by at least 50%.
C) stock prices have risen by at least 20%.
D) stock prices have risen by at least 50%.

Question 9

As of 2009,which of the following was the largest stock exchange in terms of total value traded?

A) the New York Stock Exchange
B) London Stock Exchange
C) Shanghai Stock Exchange
D) Tokyo Stock Exchange

Question 10

The required return on equity for an individual stock includes which of the following?

A) systemic risk
B) idiosyncratic risk
C) risk-free interest rate
D) all of the above

Question 11

Dividends are

A) payments made to stock holders.
B) payments made to bond holders.
C) the total profit earned by a corporation.
D) payments to holders of common stock, not preferred stock.

Question 12

The rate of return of a stock held for one year equals

A) the change in the price of the stock.
B) the dividend yield plus the rate of capital gain.
C) the rate of capital gain minus the dividend yield.
D) the dividend yield minus the rate of capital gain.

Question 13

If a corporation pays a dividend,which group receives priority in receiving the dividend?

A) bond holders
B) holders of common stock
C) holders of preferred stock
D) dividends are evenly divided by holders of common and preferred stock

Question 14

Limited liability can best be defined as the legal provision that

A) shields owners of a corporation from losing more than what they invested in a firm.
B) protects bond holders from being sued by other creditors.
C) gives holders of preferred stock priority over holders of common stock.
D) reduces the exposure of sole proprietorships to law suits.

Question 15

How can stock prices affect spending by businesses and households?

Question 16

Which group of investors vote for a corporation's board of directors?

A) bond holders
B) holders of preferred stock
C) holders of common stock
D) both holders of common and preferred stock

Question 17

Financial securities are exchanged by dealers linked by computers in a

A) stock exchange.
B) public exchange.
C) financial exchange.
D) over the counter market.

Question 18

A key point made by the Gordon-Growth model is that the

A) value of a stock depends on investor's expectations about the future profitability of a firm.
B) past trends in a stock's behavior indicate future price trends.
C) dividends have little to do with a stock's value.
D) risk has little effect on a stock's value.

Question 19

According to the Gordon-Growth model,what is the value of a stock with a dividend of $2,required return on equity of 8% and expected growth rate of dividends of 4%?

A) $25
B) $26
C) $50
D) $52

Question 20

Suppose you plan to hold a stock for one year.You expect that,in one year,it will sell for $30 and pay a dividend of $3 per share.If your required return on equity is 10%,what is the most you should be willing to pay for the share today?

A) $3.30
B) $23
C) $30
D) $33

Question 21

When market participants have adaptive expectations

A) they use all information available to them.
B) they only slowly adjust their expectations to news which could affect prices or returns.
C) they are more likely to make accurate forecasts than if they have rational expectations.
D) they are able to forecast interest rates more accurately than inflation rates.

Question 22

According to the Gordon-Growth model,what will be the percentage change in the value of the stock of a company whose current dividend is $10.00 and whose dividends had been expected to grow by 3% per year but now are expected to grow by 1% per year?

A) -4.0%
B) -23.7%
C) -31.1%
D) -66.0%

Question 23

What are the effects of the double taxation of dividends?

Question 24

Suppose you buy a stock that sells for $20.It's expected annual dividend is $2 and you expect its price to be $25 in one year.What is your expected rate of return on the stock?

Question 25

According to the Gordon-Growth model,an increase in the required return on equity

A) increases the future value of the stock.
B) reduces the current dividend.
C) reduces the value of a stock.
D) reduces the expected growth rate of the dividend.

Question 26

Expectations of asset values by participants in financial markets

A) are not possible to model, given the current state of economic knowledge.
B) determine market prices, but are not related to changes in market prices.
C) generally do not change.
D) determine current market prices and changes in market prices.

Question 27

Suppose 3M pays a dividend of $2 per share which the investor is expected to receive immediately.The dividend is expected to grow by 5% per year and the investor has a required rate of return of 8%.What should be the current price of the stock according to the Gordon-Growth model?

Question 28

Explain what is meant by the "double taxation of dividends"?

Question 29

According to the Gordon-Growth model,what will be the percentage change in the value of a stock of a company whose current dividend is $10.00 and whose dividends had been expected to grow by 3% but now are expected to grow by 4% per year?

A) 4.0%
B) 17.8%
C) 25.0%
D) 33.3%

Question 30

George is trying to forecast the future price of IBM's common stock.To do so he makes use only of past prices of IBM stock.George

A) has adaptive expectations.
B) has rational expectations.
C) is likely to rapidly adjust his forecast to news affecting the future profitability of IBM.
D) is likely to make forecasts that reflect closely IBM stock's fundamental value.

Question 31

If market participants rely only past stock prices to forecast future stock prices,

A) they will be better able to forecast future price increases than future price decreases.
B) they will be better able to forecast future price decreases than future price increases.
C) they have adaptive expectations.
D) they have rational expectations.

Question 32

The double taxation of dividends typically refers to

A) dividends being taxed first as corporate profits and then as income after being paid to stock holders.
B) stock holders paying both income and social security taxes on dividends.
C) stock holders paying an income tax and dividend surtax on dividends.
D) dividends being taxed at both the state and local level.

Question 33

According to the Gordon-Growth model,which of the following can cause the value of a stock to decline?

A) higher expected growth rate of dividends
B) increase in the current dividend
C) increased systemic risk
D) decreased required return on equity

Question 34

Suppose you are considering buying shares of a stock to hold for one year.The stock has an expected annual dividend of $2 and an expected price at the end of the year of $25.If your required rate of return is 10%,what is the most that you should be willing to pay for the stock? Round off to the nearest cent.

Question 35

Why do some economists think that taxing capital gains results in a locked-in effect?

Question 36

If you buy 100 shares of 3M at $86 a share and sell all shares one year later for $99 a share.During the year,you earned a dividend of $2.10 a share.What was your rate of return? Report your answer in percentages with one decimal point.

Question 37

When market participants have rational expectations,

A) they use all information available to them.
B) they only slowly adjust their expectations to news which could affect prices or returns.
C) they are less likely to make accurate forecasts than if they have adaptive expectations.
D) they are able to forecast interest rates more accurately than inflation rates.

Question 38

According to the Gordon-Growth model,if the stock price is $21,required return on equity is 10% and the current dividend is $1,what is the expected growth rate of dividends?

A) 2%
B) 5%
C) 10%
D) 15%

Question 39

Which of the following expressions gives the present value of future dividends for a company whose current dividend is $5.00 and whose future dividends are expected to grow at rate g?

A) [$5.00(1 - g)]/(i - g)
B) [$5.00(1 + g)]/(i + g)
C) [$5.00(1 - g)]/(i + g)
D) [$5.00(1 + g)]/(i - g)

Question 40

When market participants have rational expectations,

A) the information they use contains only past experiences.
B) the information they use contains not only past experiences, but also their expectations for the future.
C) the information they use contains only their expectations for the future.
D) their forecasts are always correct.

Question 41

An implication of the efficient markets hypothesis is that

A) only sophisticated investors will be able to earn above-normal profits from financial investments.
B) above-normal profits are available only to major traders.
C) above-normal profits will be eliminated in the trading process.
D) unless he or she acts recklessly, the average investor should be able to make above-normal profits.

Question 42

An asset's fundamental value equals

A) its face value.
B) its maturity value.
C) the market's best guess of the present value of the asset's expected future returns.
D) the weighted sum of its market price over the recent past.

Question 43

If the prices of financial assets follow a random walk,then

A) they should be easy to forecast, provided market participants have rational expectations.
B) they should be easy to forecast, provided market participants have adaptive expectations.
C) the change in price from one trading period to the next is not predictable.
D) major traders in the market must not be making use of all available information about the assets.

Question 44

The efficient markets hypothesis

A) assumes that market participants form their expectations adaptively.
B) applies rational expectations to the pricing of assets.
C) applies to the stock market, but not to the bond market.
D) indicates that the stock market is efficient, but not rational.

Question 45

Under the efficient markets hypothesis,what would be the price per share of a company whose current dividend is $10.00 and whose dividends are expected to grow by 3% per year (assume the risk-adjusted interest rate is 10%)?

A) $74.62
B) $79.23
C) $142.86
D) $147.14

Question 46

Rational expectations involve the assumption that

A) market participants make use only of information on the past performance of an asset in determining what they believe its price should be.
B) market participants rarely change their minds about the correct price of an asset.
C) financial markets are good at increasing liquidity, but poor at transmitting information.
D) market participants makes use of all available information.

Question 47

When market participants have rational expectations,the deviation of the expected price from the actual future price is

A) zero.
B) predictable, provided all relevant information is made use of.
C) not predictable.
D) predictable under certain circumstances, but not under others.

Question 48

If traders in a market have rational expectations,then

A) the price of an asset equals its fundamental value.
B) prices of riskier assets are higher than prices of less risky assets.
C) past prices of assets do not affect market participants' expectations of future asset prices.
D) they make use of less information than they would if they had adaptive expectations.

Question 49

One implication of the efficient markets hypothesis is that investors should

A) concentrate their investments in just a few well-chosen assets.
B) hold a diversified portfolio of assets.
C) buy stocks rather than bonds.
D) buy bonds rather than stocks.

Question 50

According to the efficient markets hypothesis,who is most likely to benefit from frequently moving funds from one asset to another?

A) your broker
B) small investors
C) big investors
D) only those who consistently beat the market

Question 51

Which of the following statements is true of rational expectations?

A) Rational expectations forecasts are always correct.
B) For a trader with rational expectations, the expectation of an asset's price equals the optimal price forecast.
C) If traders have rational expectations, any announcement by a company will have an effect on its stock price, even if the market was already aware of the facts being announced.
D) If a trader really has rational expectations, he or she was always earn a greater than normal return on his or her financial portfolio.

Question 52

If market participants have rational expectations,then the best forecast of the price of a stock in the next period is

A) equal to an average of the prices of the stock in previous periods.
B) equal to the price of the stock in the current period.
C) dependent upon all information available in the current period, including, but not limited to, the price of the stock in the current period.
D) dependent on information available in the previous period.

Question 53

According to the efficient markets hypothesis,

A) the equilibrium price of an asset equals the optimal forecast of fundamental value based on available information.
B) the actual and expected prices of an asset will be equal.
C) the actual price of an asset reflects only information on past returns on the asset.
D) the expected price of an asset incorporates only information on past returns on the asset.

Question 54

According to the efficient markets hypothesis,

A) common stock prices should be constant.
B) the price of a corporation's stock is likely to fluctuate substantially in response to news about changes in the company's short-term prospects.
C) the price of a corporation's stock will fluctuate significantly only in response to news about changes in the company's long-term prospects.
D) price fluctuations in common stock are a response to fads and are only infrequently the result of changes in the expected profitability of the companies involved.

Question 55

Under the efficient markets hypothesis,for news about a company's prospects to have a large impact on the price of the company's stock the news must

A) have an impact on the company's profitability in the short term.
B) have an impact on the company's profitability in the long term.
C) significantly increase the likelihood that the company will go bankrupt.
D) significantly reduce the liquidity of the company's stock.

Question 56

In an efficient market with rational expectations,the actual price of an asset

A) will equal its expected price.
B) will often be below its expected price.
C) will often be above its expected price.
D) equals its expected price plus a random error term.

Question 57

If major traders believe the price of a stock should be higher than its current market price,

A) they have an incentive to sell the stock.
B) their actions will result in the information they possess being incorporated into the price of the stock.
C) there is little they can do because government regulation precludes their acting on what they know.
D) they should petition the Securities and Exchange Commission to authorize an adjustment in the price of the stock.

Question 58

Above-normal returns on stock investments can be expected by investors who

A) possess insider information.
B) are wealthy enough to hold the stock of many different companies in their portfolios.
C) are risk seeking.
D) concentrate their investments in one or two stocks.

Question 59

An investor will generally find that hiring an investment firm to actively manage his or her portfolio will

A) result in a higher return than would be received from an index mutual fund.
B) be less expensive than simply placing money in an index mutual fund.
C) result in a higher return, but will be more expensive than placing money in an index mutual fund.
D) result in about the same return, but be more expensive than placing money in an index mutual fund.

Question 60

According to the Efficient Markets Hypothesis,prices of securities

A) change infrequently.
B) change frequently to reflect news about changes in the fundamental values of the securities.
C) change frequently as evaluations of existing information about the securities change.
D) are not allowed, under federal securities laws, to change more frequently than once a month.

Question 61

The small-firm effect

A) shows that investments in the stocks of small firms would have earned a below-normal return during the period beginning in the mid-1920s.
B) may be the result of the low liquidity and high information costs of small-firm stock.
C) was stronger during the 1980s than in previous decades.
D) is the tendency for stocks of large firms to outperform those of small firms.

Question 62

In comparing actively managed mutual funds with those funds that simply buy and hold a large market portfolio (index funds),we would expect that

A) the actively managed funds provide a higher return than the index funds.
B) the index funds provide a higher return after expenses than the actively managed funds.
C) actively managed funds and index funds provide the same returns.
D) index funds provide a lower return than actively managed funds only if taxes are taken into consideration.

Question 63

Suppose Exxon-Mobil announces that its profits in the third quarter of 2011 were $40 billion.This will cause the price of Exxon-Mobil stock to

A) rise.
B) fall.
C) remain unchanged.
D) rise, fall, or remain unchanged depending on the expectations of market participants before the announcement.

Question 64

The January effect

A) largely disappeared after receiving attention in the 1980s.
B) refers to the gap between futures prices and the prices of the underlying securities that occurs each January.
C) was stronger during the 1980s than during previous decades.
D) is the observation that stocks tend to be sold off in January.

Question 65

Mean reversion refers to the tendency for

A) futures prices to revert to the prices of the underlying securities.
B) the long-run mean return on stocks to equal the long-run mean return on bonds.
C) stocks with high returns today to experience low returns in the future and for stocks with low returns today to experience high returns in the future.
D) financial analysts whose stock picks have earned above-normal returns in the past to be unable to pick stocks that will perform as well in the future.

Question 66

Suppose Apple announces that its earnings for the fourth quarter of 2011 rose to $2 billion.As a result of this announcement the price of Apple's stock does not change.The best explanation of this is

A) market participants were expecting Apple's earnings to be greater than $2 billion.
B) market participants expected Apple's earnings to be $2 billion.
C) market participants expected Apple's earnings to be less than $2 billion.
D) market participants have adaptive expectations.

Question 67

The efficient markets hypothesis predicts that an investor

A) will not be able consistently to earn above-normal profits from buying or selling stocks.
B) will be able consistently to earn above-normal profits from buying or selling stocks so long as he or she makes use of rational expectations.
C) will be able consistently to earn above-normal profits from buying or selling stocks so long as he makes us of adaptive expectations.
D) will be able consistently to earn above-normal profits so long as stock prices in general are rising.

Question 68

What should affect the fundamental value of a stock according to the efficient markets hypothesis?

Question 69

The efficient markets hypothesis implies that stock investments should have the same expected return after adjusting for

A) risk.
B) information costs.
C) liquidity.
D) all of the above.

Question 70

Suppose that research shows that by buying stocks issued by companies whose names begin with the letter G investors can earn above-normal returns in even-numbered years.From the perspective of the efficient markets hypothesis,

A) this is further evidence that the hypothesis is correct.
B) this would be considered a pricing anomaly.
C) investors must have insider information on these companies.
D) purchasers of these stocks must have been noise traders.

Question 71

In the context of the evaluation of the efficient markets hypothesis,pricing anomalies refer to

A) the existence of trading strategies that appear to have offered above-normal returns.
B) the gap between actual and expected prices.
C) the spread between the price at which a broker will purchase stock from an investor and the price at which the broker will sell stock to an investor.
D) the difficulty in practice of computing stock prices on the basis of expectations of future dividends.

Question 72

The economist known for his early empirical work supporting the efficient markets hypothesis is

A) Milton Friedman.
B) John Muth.
C) Eugene Fama.
D) Glenn Hubbard.

Question 73

Suppose that Google announces that its profits for the third quarter of 2011 were $1.6 billion.As a result of this announcement the price of Google's stock declines.The best explanation of this is

A) market participants expected Google's profits to be greater than $1.6 billion for the third quarter.
B) market participants expected Google's profits to be less than $1.6 billion for the third quarter.
C) the stock market is not an efficient market.
D) market participants have adaptive expectations.

Question 74

How can the Gordon Growth model help explain the major decline in stock indexes during 2007-2009?

A) There was an increase in the required return on equities and a decrease in the expected growth rate of dividends.
B) There was a decrease in the required return on equities and a decrease in the expected growth rate of dividends.
C) There was an increase in the required return on equities and an increase in the expected growth rate of dividends.
D) There was a decrease in the required return on equities and a decrease in the expected growth rate of dividends.

Question 75

"Tips" published in leading commercial or financial publications are unlikely to lead to profitable trades because

A) only wealthy individuals can buy stocks in the volume necessary to take advantage of tips.
B) whatever is gained by trading on the basis of tips will be taxed away by the government.
C) the news will already be reflected in the market prices of the assets.
D) the news contained in the tips is usually inaccurate.

Question 76

Excess volatility refers to

A) the unwillingness of financial analysts to consistently recommend the same stocks.
B) the greater volatility of futures prices compared to the volatility of prices of the underlying assets.
C) the tendency for stocks with high rates of returns also to have quite variable returns.
D) the larger movements in market prices of stock than in their fundamental values.

Question 77

What is the difference between adaptive expectations and rational expectations?

Question 78

Momentum investing can be described as

A) consistent with the efficient markets hypothesis.
B) similar to mean reversion.
C) follow the picks of investors who have been successful in the past.
D) the trend is your friend.

Question 79

According to the efficient markets hypothesis,the difference between today's price for a share of stock and tomorrow's price is

A) predictable given currently available information.
B) equal to today's price minus yesterday's price.
C) unforecastable.
D) zero.

Question 80

According to the efficient markets hypothesis,who should earn the highest risk-adjusted return on stocks?

A) a financial expert who can devote considerable time to research
B) the average investor who doesn't do too much research
C) someone throwing darts at possible stock picks
D) all of the above should earn the same average return