Question 1

As the interest rate increases, what happens to the present value of a future payment? Explain why changes in the interest rate will lead to changes in the quantity of loanable funds demanded and investment spending.

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Question 2

Give two conditions that are important to the efficient market theory. List one implication of the efficient market theory.

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Question 3

If you wish to rely on fundamental analysis to choose a portfolio of stocks, then you have no choice but to do all the necessary research yourself.

Accepted Answer

Fundamental analysis can be conducted by individuals themselves or they can rely on research and analysis done by financial analysts, investment firms, or financial advisors, who provide reports, recommendations, and insights based on their own fundamental analysis.

Question 4

If you believe the stock market is informationally efficient, then it is a waste of time to engage in fundamental analysis.

Accepted Answer

If the stock market is truly informationally efficient, then all available information has already been incorporated into the price of the stock, making it impossible to gain an edge through fundamental analysis. However, there is debate among economists and investors as to whether the market is truly efficient, so some may still engage in fundamental analysis as a means of trying to gain an advantage.

Question 5

What's the difference between firm-specific risk and market risk? Will diversification eliminate one or both? Explain.

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Question 6

Available evidence indicates that stock prices, even if not exactly a random walk, are very close to a random walk.

Accepted Answer

Studies have shown that stock prices have a high degree of randomness and exhibit characteristics of a random walk. While there may be some predictable trends and factors that influence stock prices, overall they are very close to a random walk.

Question 7

Give an example of adverse selection and an example of moral hazard using homeowners insurance.

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Question 8

Managed mutual funds usually outperform mutual funds that are supposed to follow some stock index.

Accepted Answer

Studies have shown that over the long term, index funds tend to outperform managed mutual funds due to their lower fees and less frequent trading. While some managed funds may have short term outperformance, it is difficult for fund managers to consistently beat the market over the long term.

Question 9

Write the rule of 70. Suppose that your great-great-grandmother put $50 in a savings account 100 years ago and the account is now worth $1,600. Use the rule of 70 to determine about what interest rate she earned.

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Question 10

In the 15 years ending June 2010, most active portfolio managers failed to beat the market.

Accepted Answer

According to multiple studies, including the S&P Indices Versus Active (SPIVA) reports, the majority of active portfolio managers underperformed their respective benchmarks over the 15-year period ending June 2010.

Question 11

Discuss the statistical evidence concerning the efficient markets hypothesis.

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Question 12

Demonstrate that whether you would prefer to have $225 today or wait five years for $300 depends on the interest rate. Show your work.

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Question 13

In the 1990s, several stocks had very, very high price to earnings ratios. These stocks appeared overvalued to many observers. What might the people who bought them have been thinking?

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Question 14

Actively managed mutual funds usually fail to outperform index funds, and this fact provides evidence in favor of the efficient markets hypothesis.

Accepted Answer

Studies have shown that the majority of actively managed mutual funds fail to beat their benchmark index over the long term, providing support for the efficient markets hypothesis which suggests that it is difficult to consistently beat the market due to the speed at which information is incorporated into stock prices.

Question 15

Draw graphs showing the following three relationships.1. The relation between utility and wealth for a risk averse consumer.2. The relation between standard deviation and the number of stocks in a portfolio.3. The relation between return and risk.

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Question 16

Speculative bubbles may arise in part because the value of the stock to a stockholder depends on the final sale price.

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Speculative bubbles occur when the price of an asset, such as a stock, rises beyond its fundamental value. In many cases, the value of a stock to a stockholder is based on the perceived future price and not necessarily its current fundamental value. As more and more investors buy into the stock, driving up the price, others are attracted by the prospect of profit and also buy in, creating a self-fulfilling prophecy and inflating the bubble even further. Therefore, the value of the stock to a stockholder does depend on the final sale price during speculative bubbles.

Question 17

According to the efficient markets hypothesis, the number of people who think a stock is overvalued exactly balances the number of people who think a stock is undervalued.

Accepted Answer

According to the efficient markets hypothesis, stock prices reflect all publicly available information and are therefore always correctly valued, meaning that the number of people who think a stock is overvalued exactly balances the number of people who think it is undervalued. This is often represented as "price always equals value" in efficient markets.

Question 18

List three different ways that a risk-averse person can reduce financial risk.

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Question 19

Studies find that mutual fund managers who do well in one year are likely to do well the next year.

Accepted Answer

Studies have found that mutual fund managers who outperform their peers in one year are no more likely to outperform in the following year than other funds. In fact, past performance has been shown to be a poor predictor of future performance in the mutual fund industry.

Quiz 14: The Basic Tools of Finance