Money, Banking, and the Financial System (Hubbard/O’Brien)
Chapter 6 The Stock Market, Information, and Financial Market Efficiency
6.1 Stocks and the Stock Market
1) 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.
2) 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
3) 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
4) 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.
5) 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.
6) 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
7) 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
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%.
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
10) 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.
11) In what way do owners of stocks have limited liability?
12) What are the differences between common stock and preferred stock?
13) How can stock prices affect spending by businesses and households?
6.2 How Stock Prices are Determined
1) 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
2) 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
3) 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.
4) 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.
5) 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
6) 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
7) 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.
8) 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
9) 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%
10) 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.
11) 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)
12) 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%
13) 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%
14) 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.
15) 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.
16) 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?
17) 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.
18) Explain what is meant by the “double taxation of dividends”?
19) What are the effects of the double taxation of dividends?
20) Why do some economists think that taxing capital gains results in a locked-in effect?
21) 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?
6.3 Rational Expectations and Efficient Markets
1) 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.
2) 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.
3) 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.
4) 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.
5) 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.
6) 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.
7) 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.
8) 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.
9) 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.
10) 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.
11) 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.
12) 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.
13) 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.
14) 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.