Economics Multiple Choice Questions
Question Description
I’m working on a economics practice test / quiz and need an explanation and answer to help me learn.
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1. A bubble occurs when
inside
2. information is used to make profits from trading a company’s stock.
a company reports profits that are significantly above or below the expectations of financial
analysts.
the price of a stock is above its fundamental value.
the futures price is greater than the price of the underlying asset.
1 points
QUESTION 2
1. A futures contract is
an agreement
2.
that specifies the delivery of a commodity or financial instrument at a
currently agreed-upon price, with date of delivery to be negotiated subsequently.
an agreement that specifies the delivery of a commodity or financial instrument, with the
price and date of delivery to be negotiated subsequently.
an agreement that specifies the delivery of a commodity or financial instrument at an
agreed-upon future date at a currently agreed-upon price.
an agreement that specifies the delivery of a commodity or financial instrument at an
agreed-upon future date, with the price to be negotiated at the time of delivery.
1 points
QUESTION 3
1. A swap is
an agreement
2.
between two or more counterparties to exchange sets of cash flows over
some future period.
another name for a call option.
the name for the replacement of a futures contract by an options contract.
another name for a put option.
1 points
QUESTION 4
1. 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?
2% 2.
5%
10%
15%
1 points
QUESTION 5
1. 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%?
$2 2.
$10
$20
$21
1 points
QUESTION 6
1. 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%?
$252.
$26
$50
$52
1 points
QUESTION 7
1. According to the efficient markets hypothesis
the2.expected price of an asset incorporates only information on past returns on the asset.
the actual price of an asset reflects only information on past returns on the asset.
the actual and expected prices of an asset will be equal.
the equilibrium price of an asset equals the optimal forecast of fundamental value based
on available information.
1 points
QUESTION 8
1. As the time of delivery in a futures contract gets closer
the2.futures price generally falls further below the spot price.
the futures price generally rises further above the spot price.
the futures price gets closer to the spot price.
the futures and spot prices remain the same as they were when the contract was first
created.
1 points
QUESTION 9
1. Behavioral economics can best be described as
the2.basis for efficient markets.
the study of human economic behavior.
the study of how the economy affects human behavior.
the study of situations in which people’s choices do not appear to be economically rational.
1 points
QUESTION 10
1. Forward transactions
allow
2. savers and borrowers to postpone a transaction from now to the future.
allow savers and borrowers to conduct a transaction now and settle in the future.
always involve increased risk compared with spot transactions.
may not be conducted on organized exchanges.
1 points
QUESTION 11
1. Herd behavior can best be described as
informed
2.
investors can outperform relatively uninformed investors.
how large participation in financial markets increase market efficiency.
relatively uninformed investors follow the behavior of other investors instead of
considering fundamentals.
the large number of investors involved in the stock market.
1 points
QUESTION 12
1. If traders in a market have rational expectations, then
prices
2. of riskier assets are higher than prices of less risky assets.
the price of an asset equals its fundamental value.
past prices of assets do not affect market participants’ expectations of future asset prices.
they make use of less information than they would if they had adaptive expectations.
1 points
QUESTION 13
1. In a call options contract, the
buyer
2. has the obligation to receive the instrument at a specified time.
buyer will choose to exercise his option only if the value of the underlying security falls.
seller has the obligation to deliver the instrument at a specified time.
seller may choose whether or not to deliver the instrument at a specified time.
1 points
QUESTION 14
1. In a put options contract, the
seller
2. has the obligation to receive the instrument at a specified time.
buyer has the obligation to receive the instrument at a specified time.
seller has the obligation to deliver the instrument at a specified time.
buyer has the obligation to deliver the instrument at a specified time.
1 points
QUESTION 15
1. In an efficient market with rational expectations, the actual price of an asset
will2.often be below its expected price.
equals its expected price plus a random error term.
will often be above its expected price.
will equal its expected price.
1 points
QUESTION 16
1. In derivative markets, trade takes place in
assets
2. which are not allowed to be traded on organized exchanges.
assets that derive their value from underlying assets.
assets such as bonds or common stock that derive their value from the value of the
companies which issue them.
assets whose rates of returns must be derived from information published in financial
tables.
1 points
QUESTION 17
1. Mean reversion refers to the tendency for
futures
2. prices to revert to the prices of the underlying securities.
stocks with high returns today to experience low returns in the future and for stocks with
low returns today to experience high returns in the future.
financial analysts whose stock picks have earned above-normal returns in the past to be
unable to pick stocks that will perform as well in the future.
the long-run mean return on stocks to equal the long-run mean return on bonds.
1 points
QUESTION 18
1. Momentum investing can be described as
consistent
2.
with the efficient markets hypothesis.
similar to mean reversion.
the trend is your friend.
follow the picks of investors who have been successful in the past.
1 points
QUESTION 19
1. One implication of the efficient markets hypothesis is that investors should
buy2.bonds rather than stocks.
buy stocks rather than bonds.
concentrate their investments in just a few well-chosen assets.
hold a diversified portfolio of assets.
1 points
QUESTION 20
1. 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?
$3.30
2.
$23
$30
$33
1 points
QUESTION 21
1. The January effect
refers
2. to the gap between futures prices and the prices of the underlying securities that
occurs each January.
is the observation that stocks tend to be sold off in January.
largely disappeared after receiving attention in the 1980s.
was stronger during the 1980s than during previous decades.
1 points
QUESTION 22
1. The buyer of a futures contract
may
2.not sell the contract without the permission of the original seller.
assumes the short position.
assumes the long position.
has the obligation to deliver the underlying financial instrument at the specified future
date.
1 points
QUESTION 23
1. The buyer of a futures contract
has2.the obligation to receive the underlying financial instrument at the specified future
date.
may, at his or her option, deliver or receive the underlying financial instrument at the
specified date.
assumes the short position.
has the obligation to deliver the underlying financial instrument at the specified date.
1 points
QUESTION 24
1. The efficient markets hypothesis predicts that an investor
will2.not be able consistently to earn above-normal profits from buying or selling stocks.
will be able consistently to earn above-normal profits from buying or selling stocks so long
as he or she makes use of rational expectations.
will be able consistently to earn above-normal profits so long as stock prices in general are
rising.
will be able consistently to earn above-normal profits from buying or selling stocks so long
as he makes use of adaptive expectations.
1 points
QUESTION 25
1. The existence of counterparty risk
has2.no effect on the contracting parties.
is disallowed under current government regulations.
results in information costs for buyers and sellers when analyzing the potential
creditworthiness of potential trading partners.
reduces the risk introduced by forward contracts.
1 points
Money, Banking, and the Financial System
Third Edition
Chapter 6
The Stock Market,
Information, and Financial
Market Efficiency
Copyright © 2018, 2014, 2012, Pearson Education, Inc. All Rights Reserved.
Learning Objectives
After studying this chapter, you should be able to:
6.1 Describe the basic operations of the stock market
6.2 Explain how stock prices are determined
6.3 Explain the connection between the assumption of rational
expectations and the efficient markets hypothesis
6.4 Discuss the actual efficiency of financial markets
6.5 Describe the basic concepts of behavioral finance
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Are You Willing to Invest in the Stock Market?
Date
April 2000
December 2000
February 2005
November 2007
February 2009
May 2015
June 2016
Price per share of
Apple stock
$4.08
0.98
5.90
23.96
11.74
127.67
95.33
Value of 1,000 shares
of Apple stock
$4,080
980
5,900
23,960
11,740
127,670
95,330
The table shows that someone who purchased shares of Apples stock
in April 2000 would have earned a lot of returns, but there were also
periods of losses.
An average of stocks, such as the Dow Jones Industrial average,
reveals the same pattern of volatility.
Movements in stock prices during the past 15 years have been
particularly large.
Will this volatility affect peoples willingness to invest in stocks?
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Key Issue and Question
Issue: Stock prices go through large swings up and down.
Question: Does the volatility of the stock market affect the broader
economy?
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6.1 Learning Objective
Describe the basic operations of the stock market.
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Stocks and the Stock Market (1 of 2)
A stockholder (or shareholder) has a legal claim on the firms profits and
on its equity (assets minus liabilities).
Stocks are called equities because ownership of stocks represents
partial ownership of a firm.
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Stocks and the Stock Market (2 of 2)
A sole proprietor (sole owner) is someone who owns a firm and has
unlimited liability for the firms debts.
An investor who owns stock in a firm organized as a corporation is
protected by limited liability.
A corporation is a legal form of business that provides owners with
protection from losing more than their investment if the business fails.
Limited liability is the legal provision that shields owners of a
corporation from losing more than they have invested in the firm.
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Common Stock Versus Preferred Stock
Corporations are run by boards of directors who appoint officers, such
as the CEO, the CFO, and the COO.
Dividend is a payment that a corporation makes to stockholders.
Two types of stockholders:
1. Preferred stockholders receive a fixed dividend that is set when the
corporation issues the stock.
2. Common stockholders receive a dividend that fluctuates as the
profitability of the corporation varies over time.
A firms market capitalization is the total market value of a firms
common and preferred stock.
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How and Where Stocks Are Bought and Sold
(1 of 3)
A publicly traded company is a corporation that sells stock in the U.S.
stock market.
Only 5,100 of the 5 million U.S. corporations are publicly traded; other
companies are private firms (no stock issued).
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How and Where Stocks Are Bought and Sold
(2 of 3)
The NYSE is an example of a stock exchange.
A stock exchange is a physical location where stocks are bought and
sold face-to-face on a trading floor.
An over-the-counter market is a stock exchange in which financial
securities are bought and sold by dealers linked by computers (e.g.,
NASDAQ).
Today much of the trading on the NYSE has been done electronically,
although some trading still takes place on the floor of the exchange.
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How and Where Stocks Are Bought and Sold
(3 of 3)
Figure 6.1 World Stock Exchanges, 2015
Source: www.world-exchanges.org.
The New York Stock Exchange remains the largest stock exchange in the world, but other
exchanges have been increasing in size.
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Measuring the Performance of the Stock
Market (1 of 2)
A stock market index is an average of stock prices that is used to
measure the overall performance of the stock market.
Indexes are not measured in dollars or any other units; they are set
equal to 100 in a particular period, called the base period.
The values of index numbers arent meaningful by themselves;
changes in their values are important.
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Measuring the Performance of the Stock
Market (2 of 2)
Figure 6.2 Fluctuations in the Stock Market, January 1999May 2016
All three indexes followed roughly similar patterns, but the NASDAQ reached a peak in
early 2000 that it has not come close to reaching again.
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Does the Performance of the Stock Market
Matter to the Economy?
Fluctuations in stock prices can affect the economy by affecting the
spending of households and firms.
The stock market is an important source of funds for corporations.
Stocks also make up a significant portion of household wealth.
Households spend more when their wealth increases and less when
their wealth decreases.
Stock market fluctuations can heighten uncertainty and lead
households and firms to postpone their spending.
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Making the Connection: Did the Stock Market Crash
of 1929 Cause the Great Depression? (1 of 2)
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Making the Connection: Did the Stock Market Crash
of 1929 Cause the Great Depression? (2 of 2)
The Great Depression of the 1930s was the worst economic downturn
in U.S. history.
John Kenneth Galbraith and later Christina Romer and Martha Olney
argued that the stock market crash in October 1929 not only reduced
wealth and consumption spending, particularly on durable goods, but it
also increased the severity of the economic downturn by reducing the
confidence of households and firms in future economic prosperity.
Nobel Laureate Milton Friedman and Anna Schwartz argued instead
that it was the collapse of the U.S. banking system that explains the
severity of the Great Depression.
Such disagreements reflect the wider differences of opinion among
economists over the interactions between the financial system and the
real economy.
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6.2 Learning Objective
Explain how stock prices are determined.
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How Stock Prices Are Determined
The price of a financial asset is equal to the present value of the
payments to be received from owning it.
Investing in Stock for One Year
(1 of 4)
The required return on equities (rE) is the expected return necessary to
compensate for the risk of investing in stocks.
From the viewpoint of firms, this is the rate of return they need to pay to
attract investors, so it is called the equity cost of capital.
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Investing in Stock for One Year (2 of 4)
The equity premium is the additional return investors must receive in
order to invest in equities rather than Treasury bills.
The equity premium for an individual stock has two components:
1. Systematic risk price fluctuations in the stock market that affect all
stocks
2. Unsystematic (idiosyncratic) risk movements in the price of that
particular stock.
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Investing in Stock for One Year (3 of 4)
Example:
You expect that Microsoft will pay a dividend of $0.60
The expected price of the stock at the end of the year is $32
The return you require in order to invest is 10%
The present value of the two dollar amounts:
$0.60
$32
+
= $29.64
1 + 0.10 1 + 0.10
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Investing in Stock for One Year (4 of 4)
For investors as a group, the price of a stock today, Pt, equals the sum of
the present value of the dividend expected to be paid at the end of the
??
year, ????+1
, and the expected price of the stock at the end of the year,
??
????+1
, discounted by the markets required return on equities, rE, or
??
??
????+1
????+1
???? =
+
1 + ????
1 + ????
The superscript e indicates that investors do not know with certainty
either the dividend the firm will pay or the price of the firms stock at the
end of the year.
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The Rate of Return on a One-Year Investment
in a Stock
Dividend yield is the expected annual dividend divided by the current
price of a stock.
The expected rate of return from investing in a stock equals the dividend
yield plus the expected rate of capital gain:
Rate of return =
Expected annual dividend Expected change in price
+
Initial price
Initial price
??
??
????+1
????+1
? ????
??=
+
.
????
????
Example: You purchased a share for $30, with a dividend of $0.60, and
the stock price at the end of year is $33.
$0.60
$33 ? $30
??=
+
= 0.12, or 12%.
$30
$30
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Making the Connection: In Your Interest How Should
the Government Tax Your Investment in Stocks? (1 of 2)
Dividends are subject to double taxation because dividends are taxed
at both the firm level and the individual level.
Double taxation of dividends reduces investors incentive to buy stocks
and gives firms an incentive to retain profits, which may be inefficient.
Taxing capital gains creates a lock-in effect because investors may be
reluctant to sell stocks that have substantial capital gains.
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Making the Connection: In Your Interest How Should
the Government Tax Your Investment in Stocks? (2 of 2)
In 2003, Congress reduced the tax rate from 35% to 15% on tax
dividends and capital gains. This rate cut reduced inefficiencies but
might adversely affect the distribution of after-tax income.
In early 2017, President Trump proposed cutting tax rates on both
dividends and capital gains to improve financial market efficiency and
increase economic growth.
The trade-off between efficiency and equity is a recurring issue in
economic policy.
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The Fundamental Value of Stock
The price of the stock held for two years should be equal to the sum of:
the present values of the dividend payments the investor expects to
receive during the two years
the present value of the expected price of the stock at the end of two
years
??
??
????+1
????+2
???? =
+
1 + ????
1 + ????
??
????+2
+
2
1 + ????
2
.
So, the fundamental value of a share of stock equals the present value of
all the dividends expected to be received into the indefinite future:
??
??
????+1
????+2
???? =
+
1 + ????
1 + ????
??
????+3
+
2
1 + ????
3
+
.
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The Gordon Growth Model (1 of 2)
The Gordon growth model (or dividend-discount model) is a model
that uses the current dividend paid (D), the expected growth rate (g) of
dividends, and the required return on equities (rE) to calculate the price of
a stock:
1+??
???? = ???? ×
.
???? ? ??
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The Gordon Growth Model (2 of 2)
Key features of the model:
1. The growth rate of dividends is constant.
2. The required rate of return must be greater than the dividend growth
rate.
3. Investors expectations of the future profitability of firms (thus future
dividends) are crucial in determining the prices of stocks.
Example: The price of a stock with an annual dividend of $0.60 and
expected dividend growth rate of 7%:
$0.60 ×
1 + 0.07
= $21.40
0.10 ? 0.07
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Solved Problem 6.2: Using the Gordon Growth
Model to Evaluate GE Stock (1 of 3)
a. If General Electric (GE) is currently paying an annual dividend of
$0.40 per share, its dividend is expected to grow at a rate of 7% per
year, and the return investors require to buy GEs stock is 10%,
calculate the price per share for GEs stock.
b. In June 2016, the price of IBMs stock was $155 per share. At the
time, IBM was paying an annual dividend of $5.60 per share. If the
return investors required to buy IBMs stock was 0.10, what growth
rate in IBMs dividend must investors have been expecting?
Copyright © 2018, 2014, 2012, Pearson Education, Inc. All Rights Reserved.
Solved Problem 6.2: Using the Gordon Growth
Model to Evaluate GE Stock (2 of 3)
Solving the Problem
Step 1 Review the chapter material.
Step 2 Calculate GEs stock price by applying the Gordon growth
model equation to the numbers given in part (a).
1+??
1 + 0.07
???? = ???? ×
, or, $0.40 ×
= $14.27
???? ? ??
0.10 ? 0.07
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Solved Problem 6.2: Using the Gordon Growth
Model to Evaluate GE Stock (3 of 3)
Solving the Problem
Step 3 Calculate the expected growth rate of IBMs dividend by
applying the Gordon growth model equation to the numbers given
in part (b).
1+??
$155 = $5.60 ×
. Solving for ??: $155 × 0.10 ? ??
0.10 ? ??
= $5.60 × (1 + ??)
$9.90
$15.50 ? $155?? = $5.60 + $5.60??. Then ?? =
= 0.062, or 6.2%.
$160.60
Investors must have been expecting IBMs dividend to grow at an annual
rate of 6.2%.
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6.3 Learning Objective
Explain the connection between the assumption of rational
expectations and the efficient markets hypothesis.
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Rational Expectations and Efficient Markets
Expectations are important in the economy because many transactions
require participants to forecast the future.
Adaptive Expectations versus Rational Expectations
Adaptive expectations: People make forecasts of future values of a
variable using only past values of the variable.
Rational expectations: People make forecasts of future values of a
variable using all available information; formally, the assumption that
expectations equal optimal forecasts, using all available information.
??
If ????+1 is the actual stock price and ????+1
is the optimal forecast, then no
one can accurately forecast the size of the forecast error:
??
????+1 ? ????+1
= Unforcastable error??+1
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The Efficient Markets Hypothesis
The efficient markets hypothesis:
Applies rational expectations to financial markets
Implies that the equilibrium price of a security is equal to its
fundamental value
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An Example of the Efficient Markets
Hypothesis (1 of 2)
10:14 Monday morning
Price of Microsoft stock is $32.10 per share
Dividend of $0.90 per share and expected to grow at a rate of 7%
10:15 same morning
Microsoft releases new sales information that sales of latest version of
Windows is higher than expected
Investors revise upward forecast of the growth rate from 7% to 8%
Present value of future dividend rises from $32.1 to $48.6
Investors with rational expectations buy shares of Microsoft
Increased demand causes the price of Microsofts shares to rise until
they reach the new fundamental value of the stock at $48.6
Self-interested actions of informed traders cause available information to
be incorporated into the market prices.
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An Example of the Efficient Markets
Hypothesis (2 of 2)
Financial arbitrage is the process of buying and selling securities to
profit from price changes over a brief period of time.
The profits made from financial arbitrage are called arbitrage profits.
As long as there are some traders with rational expectations, the
arbitrage profits give them the incentive to push stock prices to their
fundamental values.
Because stock prices reflect all available information on their
fundamental value, their prices constantly change as news affects
fundamental value.
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What about Inside Information?
Inside information is relevant information about a security that is not
publicly available.
A strong version of the efficient markets hypothesis holds that even
inside information is incorporated into stock prices.
Trading on inside information (insider trading) is illegal.
Employees of a firm may not buy and sell the firms stocks and bonds
on the basis of information that is not publicly available.
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Are Stock Prices Predictable?
A key implication of the efficient markets hypothesis is that stock
prices are not predictable. The price today reflects all available
information.
Rather than being predictable, stock prices follow a random walk.
Random walk is the unpredictable movements of the price of a security.
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Efficient Markets and Investment Strategies
(1 of 2)
Portfolio Allocation
The efficient markets hypothesis implies that we should hold a
diversified portfolio of stocks and other assets, instead of only one
stock.
News that may unfavorably affect the price of one stock can be offset
by news that will favorably affect the price of another stock.
Trading
It is better to buy and hold a diversified portfolio over a long period of
time than to churn a portfolio by moving funds repeatedly between
stocks.
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Efficient Markets and Investment Strategies
(2 of 2)
Financial Analysts and Hot Tips
The efficient markets hypothesis indicates that the stocks that financial
analysts recommend as hot tips are unlikely to outperform the market.
So buying index funds, which buy a set portfolio of stocks, is likely to
earn an investor a higher return than he or she could earn though any
other investing strategy.
Burton Malkiel of Princeton University made this observation in his
book A Random Walk Down Wall Street: Taken to its logical extreme
the theory means that a blindfolded monkey throwing darts at a
newspapers financial pages could select a portfolio that would do just
as well as one carefully selected by the experts.
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Making the Connection: In Your Interest If Stock Prices
Cant Be Predicted, Why Invest in the Market? (1 of 2)
The financial crisis of 20072009 devastated the U.S. stock market.
Between October 2007 and March 2009, the Dow dropped over 50%.
The value of the mutual funds held by households declined by almost
$2 trillion.
The period from 1999 to 2009 was also very poor for investors.
Investors willingness to participate in the stock market is affected by
the returns they have experienced.
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Making the Connection: In Your Interest If Stock Prices
Cant Be Predicted, Why Invest in the Market? (2 of 2)
As a young investor, should you stay out of the stock market?
Results of Investing $100 per Month Beginning at Age 22
Blank
CDs (at 1.5%)
Treasury bills (at 2.5%)
Stocks (at 10.0%)
At age 45
$33,076
$37,429
$107,543
At age 67
$77,253
$99,985
$1,057,086
At age 67, after inflation
$25,430
$32,913
$347,966
Based on data of historical returns, the longer your time horizon, the
greater the gap between investments in CDs, Treasury bills, and
stocks.
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Solved Problem 6.3: In Your Interest Should You
Follow the Advice of Investment Analysts? (1 of 2)
A Bloomberg News article describes how well stock market analysts
succeeded in predicting prices during one year:
Shares of JDS Uniphase, the company with the most sell
recommendations among analysts, has been a more profitable
investment this year than Microsoft, the company with the most buys.
The article goes on to say, Investors say JDS Uniphase is an example of
Wall Street analysts basing recommendations on past events, rather than
on earnings prospects and potential share gains. Briefly explain whether
you agree with the analysis of these investors.
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Solved Problem 6.3: In Your Interest Should You
Follow the Advice of Investment Analysts? (2 of 2)
Solving the Problem
Step 1 Review the chapter material.
Step 2 Use your understanding of the efficient markets hypothesis
to solve the problem.
At the beginning of the year, investors must have been expecting to get
similar returns by investing in the stock of either firm. But unforeseen
events were more favorable toward JDS Uniphase.
The analysis of the investors is not correct from the efficient markets
point of view. Because all the available information on the firms earnings
prospects was already incorporated into the firms stock prices, analysts
would have been no more successful even if they based their forecasts
on earning prospects.
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6.4 Learning Objective
Discuss the actual efficiency of financial markets.
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Actual Efficiency in Financial Markets
Economists have provided support for the conclusion of the efficient
markets hypothesis that changes in stock prices are not predictable.
But the actual behavior of financial markets raises doubts about the
validity of the efficient markets hypothesis:
1. Pricing anomalies allow investors to earn consistently above-average
returns.
2. Some price changes are predictable using available information.
3. Changes in stock prices sometimes appear to be larger than changes
in the fundamental values of the stocks.
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Pricing Anomalies (1 of 2)
Some analysts believe they have identified stock trading strategies that
can result in above-average returns.
Examples of anomalies:
1. small firm effect Over the long run, investment in small firms has
yielded a higher return than has investment in large firms.
2. January effect Rates of return on stocks have been abnormally
high during January.
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Pricing Anomalies (2 of 2)
Pricing anomalies are inconsistent with the efficient markets
hypothesis for several reasons:
Data mining It is always possible to search through the data and
construct trading strategies that would have earned aboveaverage returns.
Risk, liquidity, and information costs Higher returns on
investments are just compensation for investors
