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Solutions to the End-of-Chapter Questions, Problems, and Data
Exercises
6.1 Stocks and the Stock Market
Learning objective: Understand the basic operations of the stock market.
Review Questions
1.1 Stocks are called equities because equity is the difference between the value of a firm’s assets and
1.2 Dividends are the distribution of profits to stockholders. Dividends are similar to coupons in the
1.3 A stock exchange is a physical place where stocks are bought and sold face-to-face.
Over-the-counter markets are markets where dealers are linked by computers to sell stock and
1.4 Stock prices can affect the spending of households and firms. As stock prices rise, households’
Problems and Applications
1.5 Disagree. Like other indexes—such as the Consumer Price Index—indexes of stock prices are
set equal to 100 in an arbitrarily chosen base year. The absolute values of index numbers cannot
1.6 If these shares of stock were newly issued by GE and sold to the public in a public offering, then
1.7 a. Preferred stock does not carry voting rights, but it does receive a fixed dividend that is set when
b. Companies would be more likely to buy back their preferred shares when their stock prices have
1.8 There may be a psychological element in investors being unwilling to invest after a bear market.
But a bear market could provide information to stock investors that the market is riskier than
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Chapter 6 The Stock Market, Information, and Financial Market Efficiency 65
6.2 How Stock Prices Are Determined
Learning objective: Explain how stock prices are determined.
Review Questions
2.2 The required return on equities is the expected return necessary to compensate investors for the
Chapter 6 The Stock Market, Information, and Financial Market Efficiency 66
2.9 Although the firm is promising to pay the $5 dividend for 50 years rather than forever, we can
still use the perpetuity formula from Problem 2.8 to calculate an upper bound on the price you
2.10 Some firms, such as Facebook, reinvest profits back into their companies rather than
2.12 a. A “flight to safety” means that investors move their funds into assets with less risk. Investors
b. The equation on page 168 of the text for determining the price of a stock shows that an increase
6.3 Rational Expectations and Efficient Markets
Learning objective: Explain the connection between the assumption of rational expectations and the
efficient markets hypothesis.
Review Questions
3.1 Adaptive expectations is the assumption that people make forecasts of future values of a variable
3.3 Stock prices are not predictable because stock prices incorporate all currently available
Problems and Applications
3.4 If the efficient markets hypothesis is correct, all the available information—including the current
3.5 a. “Priced in” means that the effect of the deal on Crown Castle’s profits had already been
b. You would not likely earn above-average returns on your investment because the higher
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Chapter 6 The Stock Market, Information, and Financial Market Efficiency 67
3.6 A believer in the efficient market hypothesis would argue that all of the available information
3.7 a. If expected future profits decrease, then the firm’s stock price should also decrease. A firms’
b. If the decrease in Burberry’s profits had not been a surprise, the price would not have changed
3.8 Under the efficient markets hypothesis, Apple’s stock would not be a better investment than
3.9 Stock picking involves an individual investor purchasing stocks he or she believes are
undervalued. The investor hopes to earn an above-average return by beating the return for the
3.10 You should agree with Burry’s reasoning. According to the efficient markets hypothesis,
attempting to beat average market returns is a futile exercise. If a school had such a strategy for
3.11 a. If the efficient markets hypothesis holds, it is likely that the people managing the mutual funds
b. No, this new information reinforces the answer that the managers of these funds were lucky,
3.12 Investors did not plan on negative real returns. Few investors saw the severity of the 2007–2009
6.4 Actual Efficiency in Financial Markets
Learning objective: Discuss the actual efficiency of financial markets.
Review Questions
4.1 A pricing anomaly refers to the possibility that investors can use trading strategies to earn
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Chapter 6 The Stock Market, Information, and Financial Market Efficiency 68
4.2 Mean reversion is the tendency of stocks that have recently been earning high returns to earn low
returns in the future and for stocks that have recently been earning low returns to earn high
4.3 The basic conclusion of the efficient markets hypothesis is that investors cannot consistently earn
above-average returns without accepting above-average risk (or accepting below-average
Problems and Applications
c. According to the efficient markets hypothesis, you would not be able to make above-average
4.5 If stock prices have consistently gone up more in July than any other month, this would be a
pricing anomaly. If the pricing anomaly held, then you would be able to earn a
4.6 a. During the dot-com stock bubble, investors overvalued the prices of Internet stocks for an
extended period of time despite having a lot of information about these firms. Mortgaged-backed
b. Rational expectations does not mean perfect foresight. It is possible that even with full
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Chapter 6 The Stock Market, Information, and Financial Market Efficiency 69
4.7 Momentum trading strategies are strategies that follow the momentum of the market. For
example, if the market is going up, mutual funds will buy. Mutual fund managers may make an
4.8 a. To forecast future industrial stock prices, the Dow Theory presumably uses historical patterns
b. The investor would not be able to earn an above-average return on her stock investments once
other investors recognized the same relationship. Many investors selling industrial stocks
6.5 Behavioral Finance
Learning objective: Discuss the basic concepts of behavioral finance.
Review Questions
5.1 Behavioral finance applies the ideas of behavioral economics to financial decision making.
5.2 Behaving rationally means investors are taking actions that are appropriate to reach their goals,
5.3 Noise trading involves investors overreacting to good or bad news. Herd behavior is when
Problems and Applications
5.4 If the mutual fund trading strategy based on insights from behavioral finance consistently yields
5.5 A bubble is an increase in the price of an asset to levels far above the asset’s fundamental value.
Many times, asset bubbles are the result of bad forecasts that are reinforced by investor
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Chapter 6 The Stock Market, Information, and Financial Market Efficiency 70
5.6 The efficient markets hypothesis assumes people are rational, whereas animal spirits
5.7 a. The bottom of the market is a point where many stocks have hit their lows, and the market is
b. Selling stocks at the bottom of the market is a bad idea because stock prices will go up
c. Under the efficient market hypothesis, stock prices follow a random walk, so it isn’t possible to
5.8 The analysis of the investment analyst is consistent with behavioral finance. The classic mania
Data Exercises
D6.1 The two graphs below show the S&P 500 stock index from 1957 to 1985 and from 1985 to 2013.
Dividing the period into two graphs allows us to see more clearly changes in S&P 500 stock
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Chapter 6 The Stock Market, Information, and Financial Market Efficiency 71
Date of Recession
Stock Prices
Before Recession
Stock Prices During
Recession
Stock Prices After
Recession
2009
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Chapter 6 The Stock Market, Information, and Financial Market Efficiency 72
D6.2 The two graphs that follow show the Dow Jones Industrial Average and the Dow Jones
D6.3 This answer will be different because the dividend per share has the potential to change from quarter
to quarter. On January 22, 2013: Microsoft paid a dividend of $0.23 per share for a dividend
yield of 3.39%; Apple paid a dividend of $2.65 per share for a dividend yield of 2.10%;
© 2014 Pearson Education, Inc.
