Economics Special Topic 3—The Stock Market: Its Function, Performance, and
Potential as an Investment Opportunity
MULTIPLE CHOICE
1. Which of the following is true?
a.
Most stockholders own stock because they want to run the business.
b.
The shareholders of a large well-established firm can be reasonably sure that they will
earn a real rate of return of about 7 percent in the future.
c.
Ownership of a corporate bond provides the bondholder with an ownership right to a
fraction of the firm’s future profits.
d.
Stock ownership makes it possible for investors to own a fractional share of a firm’s future
profits even if they do not participate in the operation of the firm.
2. Compared to other investments such as bonds, historically a diverse set of stocks held over a lengthy
time period (for example, 30 or 40 years) has yielded a
a.
low average real rate of return, and the variation in that return has been extremely high.
b.
high average real rate of return, and the variation in that return has been relatively small.
c.
low average real rate of return, and the variation in that return has been relatively small.
d.
high average real rate of return, and the variation in that return has been extremely high.
3. Stock market analysts often argue that lower interest rates are good for the stock market. Does this
argument make sense?
a.
No; lower interest rates will tend to slow down the economy, and this will be bad for the
stock market.
b.
Yes; the lower rates of interest will increase the value of future income (and capital gains),
and stock prices will rise to reflect this factor.
c.
No; the lower rates of interest will reduce the value of future income (and capital gains),
and this will cause stock prices to fall.
d.
Yes; the lower interest rates will cause inflation, and inflation is generally good for the
stock market.
4. The random walk theory of stock prices indicates that
a.
if they are willing to do a little research, even beginning investors will be able to pick the
stocks that will increase most in price in the future.
b.
managed mutual funds will persistently earn a higher rate of return than indexed funds.
c.
current stock prices already reflect information about factors influencing future stock
prices that can be forecast with any degree of accuracy.
d.
stock market investors can expect to earn a steady real rate of return of about 7 percent
annually.
5. Which of the following is an advantage of an indexed equity mutual fund relative to a managed equity
fund?
a.
Indexed funds generally have better stock pickers.
b.
Indexed funds engage in more detailed research.
c.
Indexed funds have lower operating costs because they engage in less stock trading.
d.
Indexed funds earn a significantly higher rate of return than a broad portfolio that
represents the entire stock market.
6. Currently, about ____ of U.S. households own stock, either directly or through an equity mutual fund.
a.
10 percent
b.
20 percent
c.
50 percent
d.
80 percent
7. Which of the following indicates why the role of vigilant investors and investment fund managers is
important for the efficient operation of an economy?
a.
These investors generally serve on the boards of directors of corporations.
b.
These investors tend to buy and sell stocks in a way that rewards good management.
c.
These investors help allocate capital efficiently among firms and among investment
projects.
d.
Both b and c are true.
8. Which of the following is true?
a.
The buyer of a firm’s stock is purchasing a fractional share in the firm’s future net
revenues.
b.
When investors believe that a business decision by the management of a firm will increase
the firm’s future earnings, the price of the firm’s stock will tend to rise.
c.
Changing stock prices provide the board of directors and managers of a firm with a strong
incentive to make good decisions and undertake productive projects.
d.
All of the above are true.
9. Which of the following is true?
a.
The stock market provides investors with an opportunity to own a fractional share of the
firm’s future profits.
b.
A new stock issue is often an excellent way for a firm to raise funds for future expansion.
c.
Changes in stock prices provide information about what investors think of various
business decisions.
d.
All of the above are true.
10. Which of the following is true?
a.
Most stockholders own stock because they want to participate in the daily decision making
of the firms that they own.
b.
The shareholders of a large well-established firm can be reasonably sure that they will
earn a real rate of return of about 7 percent in the future.
c.
The potential losses of shareholders are limited to the amount of their investment.
d.
Ownership of a corporate bond provides the bondholder with an ownership right to a
fraction of the firm’s future profits.
11. The market for new issues of stock is called the
a.
primary market.
b.
secondary market.
c.
The New York Stock Exchange (NYSE).
d.
The Chicago Board of Trade.
12. During the last two centuries, after adjustment for inflation,
a.
corporate bonds have yielded a real return of approximately 7 percent annually, compared
to a real return of about 3 percent for corporate stocks.
b.
corporate stocks have yielded a real return of approximately 7 percent annually, compared
to a real return of about 3 percent for bonds.
c.
both corporate stocks and bonds have yielded a real rate of return of about 3 percent.
d.
both corporate stocks and bonds have yielded a real rate of return of about 7 percent.
13. Historically, which of the following has had the highest average annual rate of return?
a.
corporate bonds
b.
money market mutual funds
c.
corporate stocks
d.
U.S. Treasury bonds
14. Since 1802, the average annual compound return for stock holdings, adjusted for inflation, has been
approximately
a.
2 percent.
b.
7 percent.
c.
15 percent.
d.
30 percent.
15. During the last sixty years, the broad stock market (Standard and Poor’s 500 Index) yielded an average
annual nominal rate of return of approximately ____ and real rate of return of approximately ____.
a.
5 percent; 2 percent
b.
10 percent; 7 percent
c.
17 percent; 9 percent
d.
9 percent; 17 percent
16. Which of the following is a risk that investors undertake when purchasing stocks?
a.
An individual stock can rise and fall unpredictably.
b.
Nearly all stocks in the stock market may rise or fall together, when expectations about the
entire economy change.
c.
Both a and b are true.
d.
Neither a nor b is true.
17. Which of the following is true of stocks?
a.
Stock ownership is risky because the investor can never be sure what return they will earn
or what the value of their stock holdings will be in the future.
b.
The riskiness of stocks is one reason why their average rate of return has been higher than
investments like bonds that guarantee a specified nominal amount in the future.
c.
Both a and b are true.
d.
Neither a nor b is true.
18. Which of the following is true?
a.
An increase in the interest rate will tend to increase stock prices.
b.
A reduction in the interest rate will tend to increase stock prices.
c.
An increase in the inflation rate will tend to increase stock prices.
d.
There is no reason to believe that changes in interest rates will influence stock prices.
19. Which of the following would tend to increase the value of a future stream of income?
a.
an increase in the rate of inflation
b.
an increase in the interest rate
c.
a reduction in the interest rate
d.
a reduction in the size of the expected future income
20. A firm’s stock price will be higher when the interest rate is ____ and the value of the firm’s expected
future profits are ____.
a.
lower; larger
b.
lower; smaller
c.
higher; larger
d.
higher; smaller
21. Suppose that monetary policy becomes more expansionary, and as a result, the future rate of inflation
is higher. Will this be good for the stock market?
a.
Yes; the inflation will lead to higher wages, and this will be good for both the economy
and the stock market.
b.
No; the inflation will lead to higher nominal interest rates, and this will reduce the present
value of the future net earnings derived from stocks.
c.
Yes; the inflation rate will reduce the long-run rate of unemployment, and this will be
good for the stock market.
d.
No; the expansionary monetary policy will lead to lower real interest rates, and this is
generally bad for both the economy and the stock market.
22. If the interest rate were 10 percent, how much would people be willing to pay for a stock that was
certain to yield a $2 per share stream of net earnings continuously in the future?
a.
$2
b.
$10
c.
$20
d.
$100
23. If the interest rate were 5 percent, how much would people be willing to pay for a stock that was
certain to yield a $10 per share stream of net earnings continuously in the future?
a.
$10
b.
$20
c.
$200
d.
$400
e.
$2,000
24. Consider a stock with a 50 percent probability of zero net earnings and a 50 percent probability of net
earnings equal to $20 per share each year continuously in the future. Furthermore, assume that people
are risk averse. That is, they will have to be compensated for uncertainty accompanying variation in
their future wealth. If the interest rate were 5 percent, how much would people be willing to pay for a
share of this stock?
a.
$10
b.
$200
c.
less than $200
d.
more than $200
e.
$400
25. Which of the following would be most likely to push stock prices higher?
a.
higher interest rates and the expectation of larger future corporate profits
b.
higher interest rates and the expectation of smaller future corporate profits
c.
lower interest rates and the expectation of larger future corporate profits
d.
lower interest rates and the expectation of smaller future corporate profits
26. Which of the following would be most likely to cause the price/earnings ratio of stocks to rise?
a.
the expectation of a recession in the near future
b.
the expectation of inflation in the near future
c.
higher interest rates
d.
lower interest rates
27. To the extent that current profits are directly related to future profits, a high price/earnings ratio would
indicate that stocks are
a.
inexpensive.
b.
expensive.
c.
going to increase in value in the future.
d.
most likely to fall in value if interest rates decline.
28. The stock price of a firm is primarily a reflection of the
a.
firm’s current net earnings per share.
b.
firm’s expected future net earnings per share.
c.
discounted value of the firm’s expected future net earnings per share.
d.
firm’s current net earnings per share multiplied by the interest rate.
e.
book value of the firm.
29. During the 1970s, the price/earnings ratio of stocks in the S&P 500 was relatively low. This low P/E
ratio was
a.
surprising because the inflation rate was high during the 1970s.
b.
not surprising because interest rates were low during the inflationary 1970s.
c.
not surprising because interest rates were high during the inflationary 1970s.
d.
surprising because the inflation rate was low during the 1970s.
30. During 1982-1997, stock prices increased substantially. Which of the following helped to boost stock
prices during this period?
a.
higher interest rates and rapid growth of corporate profits
b.
lower interest rates and rapid growth of corporate profits
c.
higher interest rates and slow growth of corporate profits
d.
lower interest rates and slow growth of corporate profits
31. Investors are often willing to pay positive prices for shares of firms that have never earned a profit
because the investors
a.
do not know the firms have never earned a profit.
b.
expect the firms to have positive net earnings in the future.
c.
expect that interest rates will rise in the future.
d.
expect that higher rates of inflation will push stock prices higher in the future.
32. The theory that stock prices reflect all available information and that the future movement of stock
prices is unpredictable is called the
a.
random walk theory.
b.
inefficient market theory.
c.
technical analysis theory.
d.
charting theory.
33. The random walk theory indicates that
a.
investors can make money by purchasing stocks that are widely expected to earn
substantial profits in the future.
b.
while changes in the prices of specific stocks are difficult to predict, experts are able to
forecast the future direction of broad stock market indexes with a high degree of accuracy.
c.
changes in stock prices are driven by surprise occurrences that are difficult for anyone to
predict accurately.
d.
managed mutual funds will persistently outperform indexed funds.
34. The random walk theory implies that stock prices
a.
go down, then up, and then down again.
b.
follow systematic trends.
c.
can be forecast accurately by experts who are knowledgeable about how the stock market
works.
d.
will change as the result of unexpected factors that are virtually impossible to forecast
accurately.
35. Which of the following is an implication of the random walk theory?
a.
Experts will be able to make money by picking and choosing the best stocks.
b.
There is a systematic pattern to the movement of prices in the stock market.
c.
Stock market investors can expect to earn a fairly steady real rate of return of about 7
percent annually.
d.
Even experts will be unable to predict the future movement of stock prices with any
degree of accuracy.
36. Which of the following is true?
a.
Investment in the stock market is a relatively foolproof method for an investor to earn a
high rate of return during the next five years.
b.
Current stock prices already reflect information that is known with a high degree of
certainty.
c.
Experts are able to predict changes in the direction of the broad stock market indexes with
a high degree of accuracy.
d.
While changes in the prices of specific stocks are difficult to predict, it is relatively easy to
predict the future direction of the broad stock market.
e.
Both c and d are true.
37. Historically, when a diverse set of stocks is held over a lengthy time period, stocks have yielded a
____ rate of return, and the variation in the rate of return has been ____.
a.
low; low
b.
low; high
c.
high; low
d.
high; high
38. Which of the following provides the strongest argument for young people making regular payments
into a retirement program that invests these funds in a diverse set of stocks?
a.
The prices of stocks tend to fluctuate more than the prices of bonds.
b.
Over short periods of time, variation in the real rate of return of stocks is greater than
bonds.
c.
When held over lengthy periods like 30 or 40 years, historically, the rate of return on
stocks has been both higher and less variable than that of bonds.
d.
Lower interest rates will lead to higher bond prices.
39. Which of the following will reduce the risk accompanying equity (stock) investments?
a.
the purchase of shares of a mutual fund that holds the stocks of many diverse corporations
b.
the purchasing and holding of equities over a lengthy period of time
c.
the purchase of shares in firms doing business in a wider variety of industries and markets
d.
all of the above
40. Which of the following will tend to result in the least variation in the expected real rate of return from
the ownership of stocks?
a.
ownership of a single stock for a short period of time
b.
ownership of a single stock over a lengthy period of time
c.
ownership of stocks from a specific sector (for example, the automobile industry) over a
lengthy period of time
d.
ownership of a diverse set of stocks (the Standard & Poor’s 500, for example) over a
lengthy period of time
41. Investment in a broad portfolio of stocks is most attractive for
a.
short-term investors.
b.
long-term investors.
c.
investors seeking a steady rate of return.
d.
investors who will need the funds for other purposes in about 10 years.
42. The variation in the rate of return one can expect from ownership of stocks will generally be smaller if
a.
all of the funds are invested in a specific sector of the economy such as the automobile
industry.
b.
a diverse set of stocks is held over a lengthy period of time such as 30 or 40 years.
c.
all of the funds are invested in a single stock.
d.
the funds are invested for a relatively short period of time.
43. Buying shares of corporate stock tends to be more risky when
a.
the stock of a single corporation is purchased.
b.
the stock may have to be sold within a few months.
c.
all stocks bought are in the same industry.
d.
all of the above are true.
44. If Apple Computer Corporation constitutes a sizeable share of your current stock holdings, the
purchase of which of the following stocks would provide you with the greatest reduction in risk?
a.
Hewlett-Packard
b.
IBM
c.
Dell Computer Corporation
d.
Wal-Mart
45. Which of the following has enhanced the ability of investors, without any special business skills, to
benefit from the ownership of corporate America?
a.
the increased availability of mutual funds that make it possible for even small investors to
purchase a diverse stock portfolio at a low cost
b.
an increased tendency of small investors to buy and sell stock frequently, using stock tips
from investment experts
c.
the virtual disappearance of business failures among corporations with publicly traded
stock shares
d.
all of the above
46. Which of the following is true?
a.
Managed equity funds generally outperform indexed equity mutual funds.
b.
Managed equity funds merely hold stocks in the same proportion they are represented in a
broad stock market index such as the Standard & Poor’s 500.
c.
Indexed equity funds generally have lower management and operating costs than managed
funds.
d.
Indexed equity funds generally engage in more stock trading than managed funds.
47. Which of the following is true?
a.
Managed equity funds that have yielded attractive returns during the last 5 or 10 years can
generally be counted on to yield similar returns in the future.
b.
Managed funds generally outperform indexed equity mutual funds.
c.
An investment strategy that yielded a high rate of return in the past will often be disastrous
in the future.
d.
Indexed equity mutual funds are usually tied directly to either the Consumer Price Index
or the GDP deflator.
48. If an investor’s primary stock holding is currently Exxon Mobil, the purchase of which of the following
stocks would provide the investor with the largest reduction in risk?
a.
BP / Amoco.
b.
Shell Oil Corporation.
c.
General Motors.
d.
Texaco.
49. An indexed equity mutual fund
a.
is directly tied to either the consumer price index or the GDP deflator.
b.
is a fund that hires a manager who will try to pick the stocks that will increase most in
value in the future.
c.
merely holds stocks in the same proportion as they exist in a broad stock market index like
the Standard & Poor’s 500.
d.
will have high operating costs because these funds engage in a substantial amount of stock
trading.
50. The present value of $1 million to be received in the future will
a.
increase if the interest rate rises.
b.
increase if the payment is received at a more distant time in the future.
c.
be greater than $1 million.
d.
increase if the interest rate were to fall from 8 percent to 4 percent.
51. The random walk theory implies that stock prices
a.
go down, then up, and then down again.
b.
go up and then down in a predictable pattern.
c.
follow systematic trends.
d.
are unpredictable based on past trends.
52. Which of the following is true?
a.
People who invest in the stock market are virtually certain to make money.
b.
Investors in the stock market can reduce their risk if they hold shares of specific stocks for
only short periods of time.
c.
The risk of stock market investments can be reduced through the holding of a diverse
portfolio of unrelated stocks over long periods of time.
d.
In the long run, corporate bonds can be expected to yield a higher real rate of return than
ownership of stocks.
53. Which of the following is true?
a.
The stock market helps channel the savings of individuals into business activities that
create wealth.
b.
Individual investors can reduce their risk by holding a large share of their wealth in the
form of the stock ownership of a single company.
c.
Historically, the long-term real rate of return of stocks has generally been less than that of
bonds.
d.
Mutual funds that have done well in the past are more likely to outperform the market
average in the future.
54. Since 1802, the American stock market has yielded an average annual real return (the return adjusted
for inflation) of approximately
a.
3 percent.
b.
5 percent.
c.
7 percent
d.
11 percent.
55. Stock analysts often argue that lower interest rates are good for the stock market. Does this argument
make sense?
a.
No; lower interest rates will tend to slow down the economy and this will be bad for the
stock market.
b.
Yes; the lower rates of interest will increase the value of future income (and capital gains)
and stock prices will rise to reflect this factor.
c.
No; the lower rates of interest will reduce the value of future income (and capital gains)
and this will cause stock prices to fall.
d.
Yes; the lower interest rates will cause inflation and inflation is generally good for the
stock market.
56. If the interest rate were 12.5 percent, how much would people be willing to pay for a stock that was
certain to yield a $20 per share stream of net earnings continuously in the future?
a.
$20
b.
$25
c.
$160
d.
$250
ESSAY
57. “My broker studies the stock market and the management of specific firms. When he advises me to
buy, I listen because he is an expert.” Analyze this view.
58. Jane is a 22-year-old college graduate. She has just started working at a job that pays her $75,000 per
year. Since you have had an economics course, Jane asks you for advice on where to invest the money
she is saving for her retirement. What do you recommend?
59. Many personal finance magazines such as Money and Smart Money routinely give advice as to which
stocks to buy. Should you take their advice?
60. Does it ever make sense to purchase a stock that has never paid a dividend? Explain.