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1.1 Stocks are called equities because equity is the difference between the value of a firm’s assets and the value of its liabilities, and stocks represent a legal claim on that value as well as on the firm’s profits. Bonds are loans and are not claims on a firm’s equity or its profits. So, bonds are not equities.
1.2 Dividends are the distribution of profits to stockholders. Dividends are similar to coupons in the sense that they are payments firms make on a regular schedule to investors, but, unlike coupons, dividends on common stock are not fixed but change as the issuing firm’s profits change.
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 bonds. The three most important stock market indexes are the Dow Jones Industrial Average, the S&P 500, and the NASDAQ Composite Index.
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 be compared to each other. In addition, each stock index is calculated using a different methodology and has a different number of stocks in the index. Stock price indexes can only be used to analyze movements over time in the average prices of the stocks included in the index.
1.6 If these shares of stock were newly issued by GE and sold to the public in a public offering, then this statement would be true. However, it is likely that these were already existing shares traded in the secondary market, in which case GE does not receive any of the money. The transactions take place between the stockowners and the new buyers.
2.1 The price of a financial asset is equal to the present value of the payments to be received from owning it.
2.2 The required return on equities is the expected return necessary to compensate investors for the risk of investing in stocks. The required return on equities and the cost of equity capital are the same thing just looked at from the differing perspectives: What investors consider the required return on equities, firms consider the equity cost of capital.
2.3 R =[pic]
This equation states that, for a holding period of one year, the rate of return on a stock is equal to the dividend yield plus the expected rate of capital gain.
2.4 The fundamental value of a share of stock is the present value of the dividend payments expected to be received into the indefinite future.
2.5 [pic]
The key assumption is that the growth rate of dividends is constant.
2.6 The present value of the payments you expect to receive from owning the stock is: (($1.40/(1 + 0.08)) + ($160/(1 + 0.08)) = $149.44. Because the present value of the payments you expect to receive is greater than the $142 purchase price of the stock, you should buy the stock.
2.7 You received a $2.50 dividend and $10 capital gain on your investment during the year. So, your rate of return, calculated as a percentage of your purchase price of $120 is: (($2.50 + $10.00)/$120) ( 100 ’ 10.42%.
2.8 If the company is paying a dividend per share of $20 per year forever, then the stock is similar to the perpetuity type of coupon bond discussed in Chapter 3, page 65. Therefore, we can calculate the price of the bond by dividing the payment (dividend) by the required return on equities (interest rate): ($20/0.1) ’ $200.
3.1 Adaptive expectations is the assumption that people make forecasts of future values of a variable using only past values of the variable, whereas rational expectations is the assumption that people make forecasts of future values of a variable using all available information.
3.2 The efficient markets hypothesis is the application of rational expectations to financial markets. It is the hypothesis that the equilibrium price of a security is equal to its fundamental value.
3.3 Stock prices are not predictable because stock prices incorporate all currently available information. The changes in stock prices come from new information that cannot be forecast. A random walk is the unpredictable movements of the price of a security that occur when the conditions for the efficient market hypothesis are met.
3.7 a. If expected future profits decrease, then the firm’s stock price should also decrease. A firms’ expected future profits affect the firm’s expected future dividends and, therefore, the firm’s stock price.
b. If the decrease in Burberry’s profits had not been a surprise, the price would not have changed because the information would have already been reflected in the price of the stock.
4.1 A pricing anomaly refers to the possibility that investors can use trading strategies to earn
above-average returns, which is inconsistent with the efficient markets hypothesis. With the
small firm trading strategies, investors could buy stocks issued by small firms and receive
higher returns than with stocks issued by large firms. With the January effect, investors could
buy stocks in December and sell them in January when their prices increase. Many
economists are skeptical, however, that any trading strategy exists that would allow
investors to earn above-average returns without taking on above-average risk.
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 returns in the future. In principle, an investor could earn above-average returns on his or her portfolio by buying stocks whose returns have recently been low and selling stocks whose returns have recently been high. Excess volatility refers to movements in stock prices that are not explained by changes in the fundamental values of the stocks. In principle, an investor could earn above-average returns by selling stocks when they are above their fundamental values and buying them when they are below their fundamental value. In practice, however, attempts to use trading strategies based on mean reversion or excess volatility have not been able consistently to produce above-average returns.
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 liquidity). Trading strategies that appear to offer above-average returns without above-average risk often result from data mining or fail to take into account the costs of buying and selling stocks and the tax implications of the strategies. Although the stock market may not be as efficient as economists at one time thought, most economists still accept the basic conclusion of the efficient markets hypothesis.
4.4 a. A bull market is a period during which stock prices are increasing by 20% or more.
b. If the statement were correct, it would represent a pricing anomaly.
c. According to the efficient markets hypothesis, you would not be able to make above-average returns. Once investors recognize this pattern, it is unlikely that the pattern will persist over time. The increased demand to buy tech stocks in the second year of a bull market would drive up prices, eliminating the above-average returns.
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