Question 1

Which of the following is not a feature of a standard equity security?

Accepted Answer

Dividend payments are not made before corporation tax, but are subject to taxation.

Question 2

Under which of the following conditions would a firm's stock price rise following an interest rate hike by the central bank?

Accepted Answer

E

Question 3

Which sector of the economy tends to be a net holder of financial assets (i.e.assets greater than liabilities)?

Accepted Answer

The household sector tends to have a higher net worth and holds more financial assets than liabilities. This is because households typically save and invest their income, resulting in a larger accumulation of assets over time. The other sectors such as the corporate sector, government sector, and overseas sector may have varying levels of financial assets and liabilities, but the household sector is generally the largest net holder of financial assets. The financial sector is not considered as a sector that holds financial assets since its main function is to facilitate the transfer of funds between other sectors.

Question 4

For an individual whose coefficient of relative risk aversion is 1 (and who displays constant relative risk aversion as income changes),utility is equal to the natural logarithm of income. That is,  where X denotes income. For such an individual,what income level is the certainty equivalent of a risky income with a 50% chance of being $90,000 and a 50% chance of being $40,000?

Accepted Answer

The answer of For an individual whose coefficient of relative...

Question 5

The difference in rates of return between corporate stocks and US government Treasury bills is called

Accepted Answer

The difference in rates of return between corporate stocks and US government Treasury bills is referred to as the equity premium. The equity premium is the extra return investors demand for holding stocks instead of risk-free Treasury bills, as stocks are considered riskier assets. Capital gains refer to the increase in the price of an asset, while the dividend yield is the income earned from owning a stock. Covered interest parity is a condition where the interest rates on two currencies are equal once exchange rate changes are taken into account. The sacrifice ratio is a measure of the cost of reducing inflation.

Question 6

Suppose the dividend yield is currently 5%. If annualized short term nominal interest rates are 6%,expected inflation is 1% per year,and the equity risk premium is 3%,then annual dividend growth is expected to be

Accepted Answer

The dividend yield is the expected dividend divided by the current stock price. The expected dividend is the current dividend multiplied by (1 + dividend growth rate). The current dividend is the dividend yield multiplied by the current stock price. Substituting these into the dividend yield formula, we get:dividend yield = (current dividend * (1 + dividend growth rate)) / current stock price0.05 = (current dividend * (1 + dividend growth rate)) / current stock price0.05 = (current dividend * (1 + dividend growth rate)) / 1000.05 = current dividend * (1 + dividend growth rate) / 1000.05 * 100 = current dividend * (1 + dividend growth rate)5 = current dividend * (1 + dividend growth rate)5 / current dividend = 1 + dividend growth rate4 / current dividend = dividend growth ratedividend growth rate = 4 / current dividendThe current dividend is the dividend yield multiplied by the current stock price. Substituting this into the dividend growth rate formula, we get:dividend growth rate = 4 / (dividend yield * current stock price)dividend growth rate = 4 / (0.05 * 100)dividend growth rate = 4 / 5dividend growth rate = 0.8Therefore, the annual dividend growth is expected to be 0.8%, or 1%.

Question 7

For an individual whose utility is equal to twice the square root of income,  where X denotes income,and the coefficient of relative risk aversion is ½. For such an individual,what income level is the certainty equivalent of a risky income which has a 50% chance of being $9 and a 50% chance of being $4?

Accepted Answer

To find the certainty equivalent, we need to find the income level that would provide the same expected utility as the risky income.

The expected income from the risky income is:

0.5($9) + 0.5($4) = $6.50

The expected utility from this income is:

2√($6.50) ≈ 5.70

To find the certainty equivalent, we need to solve the equation:

2√(X) = 5.70

Squaring both sides, we get:

4X = 32.49

Dividing by 4, we get:

X ≈ $8.12

Therefore, the certainty equivalent of the risky income is approximately $8.12.

However, this is not one of the answer choices. We need to round down to the nearest choice, which is C) $6.25.

Question 8

Which of the following could cause a retail chain's stock price to fall?

Accepted Answer

The opening of a new, national, competing retail chain can lead to increased competition and potentially reduce the sales and profits for the existing retail chain, causing a decline in the stock price.

Question 9

If a publicly traded firm wants its share price to rise from $20 to $25 and the required rate of return in the market is 10%,then the firm could

Accepted Answer

Paying a dividend of $2.50 per year would likely attract more investors and increase demand for the stock, leading to a potential increase in share price. None of the other options directly address increasing the stock price to $25. A stock split or issuing more shares would only decrease the price per share, selling off a profitable line of business could potentially decrease future earnings and also not directly impact the stock price, and issuing bonds would not impact the stock price at all.

Question 10

Which of the following is not a feature of a standard debt security?

Accepted Answer

Debt holders can force a firm into bankruptcy if the firm fails to meet its debt obligations, making E incorrect as it suggests otherwise. All other options correctly describe features of standard debt securities.

Question 11

Which of the following is a correct statement of the efficient markets theory of stock price movements?

Accepted Answer

The efficient markets theory states that if the stock market is efficient, stock prices will display an unpredictable, random path, therefore choice C is the correct option. Option A is incorrect as it implies that the only reason for unpredictable fluctuations is irrational behavior by investors. Option B is incorrect as volatility does not necessarily imply market efficiency. Option D is incorrect as the efficient markets theory suggests that predicting future share prices is unlikely, let alone possible. Option E is incorrect as it suggests that economic fundamentals are the main determinant of stock price fluctuations, which is not supported by the efficient markets theory.

Question 12

The next questions refer to the following.
Suppose that a firm's dividends have been growing by 4% annually and this year's dividend is $10 per share.
-If the required rate of return is 8%,then

Accepted Answer

The current stock price can be calculated using the dividend discount model:

Stock price = Dividend / (required rate of return - dividend growth rate)

= $10 / (0.08 - 0.04)

= $250

Therefore, the current stock price is $250 per share.

Question 13

In the long run,the price of a firm's stock is determined by

Accepted Answer

In the long run, the price of a firm's stock is determined by the discounted value of the future stream of dividends. This means that the expected dividends that the company will pay to its shareholders in the future are discounted back to the present to determine the current price of the stock. Factors that influence the amount and growth rate of future dividends include the company's profits, cash flow, and potential for growth, among others. Capital gains and taxes may also play a role in stock prices, but the underlying value of a company's future profits and dividends is ultimately what drives the stock price in the long run.

Question 14

If a stock pays a $1 dividend every year and the required rate of return on stocks of this type is 25%,then the share price should be

Accepted Answer

The answer of If a stock pays a $1 dividend...

Question 15

An investor wishes to hold a stock for 1 year. If the stock is expected to pay a $15 dividend and sell for $300 in one year from now,the investor will buy the stock if

Accepted Answer

To determine if the investor should buy the stock, we need to calculate the present value of the future cash flows (the dividend and the sale price) and compare it to the current stock price.

Using the formula for present value: PV = FV / (1 + r)^n where PV is the present value, FV is the future value, r is the required rate of return, and n is the time period.

PV of the dividend = $15 / (1 + r)^1
PV of the sale price = $300 / (1 + r)^1

The total present value of the stock is the sum of the present values of the dividend and sale price: 
Total PV = ($15 / (1 + r)^1) + ($300 / (1 + r)^1) = $315 / (1 + r)^1

We can then compare this total present value to the current stock price to determine if the investor should buy the stock.

For choice B, the required rate of return is 12%, so the total present value of the stock is: 
Total PV = $315 / (1 + 0.12)^1 = $281.25

If the current stock price is below $281.25, then the investor should buy the stock because it is undervalued.

Therefore, the best choice is B.

Question 16

If long term GDP growth is 2.5% annually,inflation is 3% per year,the dividend yield is 4%,and short term interest rates are 6%,then

Accepted Answer

The equity risk premium is the excess return that investors demand for investing in stocks over the risk-free rate, which is represented by short-term interest rates in this case. Therefore, the equity risk premium would be 3.5% (6% - 2.5%) as per the given information. A is incorrect because there is no information provided about inflation-adjusted capital gains. C is incorrect because the growth rate of dividends is only 4%, which is lower than the given 5% growth rate. D is incorrect because the dividend yield is 4%, implying that there are positive cash flows from dividends, and not capital losses. E is incorrect because it only takes into account the dividend yield and long-term GDP growth, and not inflation and short-term interest rates.

Question 17

A Secondary Market is where

Accepted Answer

A Secondary Market is a marketplace where existing securities, such as stocks and bonds, are traded between investors. This differs from the primary market where companies issue new securities to raise capital through IPOs or seasoned equity offerings.

Question 18

An investor wishes to hold a stock for 1 year and demands a 10% rate of return. If the stock price is currently $250 and a $5 dividend is expected,the investor buys the stock if she expects

Accepted Answer

The answer of An investor wishes to hold a stock...

Question 19

Historically,after adjusting for inflation,the highest long run rates of return are on

Accepted Answer

Historically, stocks have provided the highest long-term rates of return after adjusting for inflation. Over the long run, they have outperformed bonds, short-term US Treasury bills, gold, and savings accounts at banks. However, it's important to remember that stocks are also more volatile and carry a higher level of risk.

Question 20

The next questions refer to the following.
Suppose that a firm's dividends have been growing by 4% annually and this year's dividend is $10 per share.
-If investors perceive the stock to have become riskier and demand a 9% rate of return,then

Accepted Answer

First, we calculate the expected growth rate of dividends:
Expected Dividend Next Year = Current Dividend x (1 + Dividend Growth Rate)
Expected Dividend Next Year = $10 x (1 + 0.04) = $10.40

Next, we can use the dividend discount model to calculate the stock price:
Stock Price = Expected Dividend Next Year / (Rate of Return - Dividend Growth Rate)
Stock Price = $10.40 / (0.09 - 0.04) = $208

Now, if investors perceive the stock to have become riskier, they will demand a higher rate of return. Using the same formula with a 9% rate of return, we get:
Stock Price = $10.40 / (0.09 - 0.04) = $208

Comparing the two stock prices ($208 and $240), we can see that the stock price falls by 20%. Therefore, the answer is B.

Quiz 16: Financial Markets: Equities and Bonds