Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 102
Chapter 7
ANSWERS TO QUESTIONS
1. What basic principle of finance can be applied to the valuation of any investment asset?
2. What are the two main sources of cash flows for a stockholder? How reliably can these cash
flows be estimated? Compare the problem of estimating stock cash flows to the problem of
estimating bond cash flows. Which security would you predict to be more volatile?
There are two cash flows from stock: periodic dividends and a future sales price. Dividends
are frequently changed when a firm’s earnings either rise or fall, which can make them
3. Some economists think that central banks should try to prick bubbles in the stock market
before they get out of hand and cause later damage when they burst. How can monetary
policy be used to prick a market bubble? Explain using the Gordon growth model.
A stock market bubble can occur if market participants either believe that dividends will have
rapid growth or if they substantially lower the required return on their equity investments,
4. If monetary policy becomes more transparent about the future course of interest rates, how
will stock prices be affected, if at all?
With more certainty over the course future interest rates will follow, uncertainty and risk
would likely be reduced, which will lower the required return on investment ke and lead to a
5. Suppose that you are asked to forecast future stock prices of ABC Corporation, so you
proceed to collect all available information. The day you announce your forecast,
competitors of ABC Corporation announce a brand new plan to merge and reshape the
structure of the industry. Would your forecast still be considered optimal?
Your forecast is still considered to be optimal, since it was made with all available
6. “Anytime it is snowing when Joe Commuter gets up in the morning, he misjudges how long it
will take him to drive to work. When it is not snowing, his expectations of the driving time are
perfectly accurate. Considering that it snows only once every ten years where Joe lives, Joe’s
expectations are almost always perfectly accurate.” Are Joe’s expectations rational? Why or
why not?
7. If Suppose that you decide to play a game. You buy stock by throwing a dice a few times,
using that method to select which stock to buy. After ten months you calculate the return on
your investment and the return earned by someone who followed “expert” advice during the
same period. If both returns are similar, would this constitute evidence in favor of or against
the efficient market hypothesis?
If both returns are similar, this would constitute evidence in favor of the efficient market
8. “If stock prices did not follow a random walk, there would be unexploited profit
opportunities in the market.” Is this statement true, false, or uncertain? Explain your answer.
True, as an approximation. If large changes in a stock price could be predicted, then the
9. Suppose that increases in the money supply lead to a rise in stock prices. Does this mean that
when you see that the money supply has sharply increased in the past week, you should go
out and buy stocks? Why or why not?
10. If the public expects a corporation to lose $5 per share this quarter and it actually loses $4,
which is still the largest loss in the history of the company, what does the efficient market
hypothesis predict will happen to the price of the stock when the $4 loss is announced?
11. If you read in the Wall Street Journal that the “smart money” on Wall Street expects stock
prices to fall, should you follow that lead and sell all your stocks?
12. If your broker has been right in her five previous buy and sell recommendations, should you
continue listening to her advice?
13. Can a person with rational expectations expect the price of a share of Google to rise by 10%
in the next month?
No, if the person has no better information than the rest of the market. An expected price rise
of 10% over the next month implies over a 100% annual return on Google stock, which
14. Suppose that in every last week of November stock prices go up by an average of 3%. Would
this constitute evidence in favor of or against the efficient market hypothesis?
If there is a phenomenon that takes place regularly and it is not incorporated into people’s
expectations, then these expectations are not optimal (since they are not including all
15. “An efficient market is one in which no one ever profits from having better information than
the rest of the market participants.” Is this statement true, false, or uncertain? Explain your
answer.
16. If higher money growth is associated with higher future inflation, and if announced money
growth turns out to be extremely high but is still less than the market expected, what do you
think will happen to long-term bond prices?
17. “Foreign exchange rates, like stock prices, should follow a random walk.” Is this statement
true, false, or uncertain? Explain your answer.
True, in principle. Foreign exchange rates are a random walk over a short interval such as a
18. Assume that the efficient market hypothesis holds. Marcos has been recently hired by a
brokerage firm and claims that he now has access to the best market information. However,
he is the “new guy,” and no one at the firm tells him much about the business. Would you
expect Marcos’s clients to be better or worse off than the rest of the firm’s clients?
If the efficient market hypothesis holds, then Marcos’ clients would technically not be at any
disadvantage with respect to other clients of the same firm. However, information flows
19. Suppose that you work as a forecaster of future monthly inflation rates and that your last six
forecasts have been off by minus 1%. Is it likely that your expectations are optimal?
For your expectations to be optimal, they have to include all available information up to date,
20. In the late 1990s, as information technology advanced rapidly and the Internet was widely
developed, U.S. stock markets soared, peaking in early 2001. Later that year, these markets
began to unwind and then crashed, with many commentators identifying the previous few
years as a “stock market bubble.” How might it be possible for this episode to be a bubble
but still adhere to the efficient market hypothesis?
It may be considered a bubble in that stock market prices rose well above true fundamental
values. However, given the relatively new and rapid technology advances during the time,
21. Why might the efficient market hypothesis be less likely to hold when fundamentals suggest
stocks should be at a lower level?
Behavioral finance suggests that when stock prices rise, market participants are less likely to
ANSWERS TO APPLIED PROBLEMS
22. Compute the price of a share of stock that pays a $1 per year dividend and that you expect to
be able to sell in one year for $20, assuming you require a 15% return.
23. After careful analysis, you have determined that a firm’s dividends should grow at 7%, on
average, in the foreseeable future. The firm’s last dividend was $3. Compute the current
price of this stock, assuming the required return is 18%.
24. The current price of a stock is $65.88. If dividends are expected to be $1 per share for the
next five years, and the required return is 10%, then what should the price of the stock be in
5 years when you plan to sell it? If the dividend and required return remain the same, and
the stock price is expected to increase by $1 five years from now, does the current stock price
also increase by $1? Why or why not?
The price five years from now should be $100. This can be found by solving for P5 below:
25. A company has just announced a 3-for-1 stock split, effective immediately. Prior to the split,
the company had a market value of $5 billion with 100 million shares outstanding. Assuming
the split conveys no new information about the company, what are the value of the company,
the number of shares outstanding, and the price per share after the split? If the actual market
price immediately following the split is $17.00 per share, what does this tell us about market
efficiency?
Prior to the split, each share was worth $5 billion/100 million, or $50/share. If the split
conveys no new information, the market value of the company does not change, remaining at
ANSWERS TO DATA ANALYSIS PROBLEMS
1. Go to the St. Louis Federal Reserve FRED database and find data on the Dow Jones
Industrial Average (DJIA). Assume the DJIA is a stock that pays no dividends. Apply the one-
period valuation model, using the data from one year prior up to the most current date
available, to determine the required return on equity investment. In other words, assume the
most recent stock price of DJIA is known one year prior. What rate of return would be
required in order to “buy” a share of DJIA? Suppose that a $100 dividend is paid out
instead. How does this change the required rate of return?
The DJIA on July 7, 2017, was 21,414.34, and one year prior on July 7, 2016, was 17,895.88.
2. Go to the St. Louis Federal Reserve FRED database and find data on net corporate dividend
payments (B056RC1A027NBEA). Adjust the units setting to “Percent Change from Year
Ago,” and download the data into a spreadsheet.
a. Calculate the average annual growth rate of dividends from 1960 to the most recent year
of data available.
b. Find data on the Dow Jones Industrial Average (DJIA) for the most recent day of data
available. Suppose that a $100 dividend is paid out at the end of next year. Use the
Gordon growth model and your answer to part (a) to calculate the rate of return that
would be required for equity investment over the next year, assuming you could buy a
share of DJIA.