ECO 3223 02 EVANS STUDY GUIDE FOR EXAM 2 CHAPTER 7 Know all of the key terms for this chapter Adaptive expectations expectations of a variable based on an average of past based of the variables Arbitrage elimination of a riskless profit opportunity in a market Behavioral finance a subfield of finance that applies concepts from other social sciences such as anthropology sociology and particularly psychology to understand the behavior of the securities prices Bubble a situation in which the price of an asset differs from its fundamental market value Cash flows the difference between cash receipts and cash expenditures Dividends periodic payments made by equities to shareholders Efficient market hypothesis the application of the theory of rational expectations to financial markets Generalized dividend model calculates that the price of stock is determined only by the PV of the dividends Market fundamentals items that have a direct impact on future income streams of a security Optimal forecast the best guess of the future using all available information Rational expectations expectations that reflect optimal forecasts the best guess of the future using all available information the firm s assets have been satisfied Residual claimant the right as a stockholder to receive whatever remains after all other claims against Short sales borrowing stock from brokers and then selling the stock in the market with the hope that a profit will be earned by buying the stock back again covering the short after it has fallen in price Stockholders those who hold stock in a corporation Theory of efficient capital markets see efficient market hypothesis p 155 Unexploited profit opportunity A situation in which an investor can earn a higher than normal return 1 What rights to stockholders have with respect to the corporation in which they own stock The right to vote residual claimant of all funds flowing into the firm cash flows dividends right to sell the stock Pg 147 1 1 What are stocks cash flows Cash flows Cash payments to the holder of a security 2 Understand the three stock valuation models and the appropriate application of each Be able to calculate the price of a stock From the resulting price you calculate interpret what the market price is telling you about investors beliefs and how they may differ There is a lot of info in these pages make sure to read understand One period valuation Model pg148 Generalized Dividend Model pg149 Gordon Growth Model pg149 3 What role does information play in determining stock prices Superior information about an asset can increase its value by reducing its risk The buyer who has the best information about a stocks cash flows will discount them at a lower interest rate than will a buyer who is very uncertain 4 The perceived risk of holding stock is negatively positively related to stock price 6 What is the effect of expansionary and contractionary monetary policy upon stock prices Positively Expansionary increase stock price Contraction lower stock price 7 What are the two ways in which investors formulate their beliefs about future stock prices How are they different Rational expectations Expectations will be identical to optimal forecasts using all available information 2 Adaptive expectations Expectations are formed from past experience only this data changes slowly over time as data changes 8 What is the Efficient Market Hypothesis and what does it tell us about prices in financial markets The application of the theory of rational expectations to financial markets current prices in a financial market will be set so that the optimal forecast of a security s return using all available information equals the security s equilibrium price 9 Is it likely that there are many unexploited profit opportunities in the stock market Why or why not What is the best overall strategy for investing in the stock market and why In an efficient all unexploited profit opportunities will be eliminated This happens because if there are a few unexploited market opportunities when the first people to jump on these occur they in turn force the prices to move an equilibrium level and eliminate the unexploited market The best strategy for investing is A buy and hold strategy this is because when you hold a security for a long period of time you have increased net profits because you avoid brokerage commotions for constant turning of your portfolio 10 If you had to describe the trend in stock prices for forecasting purposes how would you describe it Stock prices are generally going up 11 What is a bubble in the stock market and what causes bubbles A situation in which the price of an asset differs from its fundamental market value a bubble is caused by overconfidence and social contagion they believe someone else will buy it for a higher price the security CHAPTER 10 Know all of the key terms for this chapter Asset management the acquisition of assets that have a low rate of default and diversification of assets holdings to increase profits total liabilities plus capital A L OE then acquisition of the needed capital a checking account at the lending bank Balance sheet a list of the assets and liabilities of a bank or firm that balances Total assets equal Capital adequacy management a bank s decision about the amount of capital it should maintain and Compensating balance a required minimum amount of funds that a firm receiving a loan must keep in 3 Credit rationing a lender s refusal to make loans even though borrowers are willing to pay the stated interest rate or even a higher rate or restriction of the size of loans made to less than the full amount sought Credit risk the risk arising from the possibility that the borrower will default Deposit outflows losses of deposits when depositories make withdrawals or demand payment Discount loans a bank s borrowings from the Federal Reserve System also known as advances Discount rate the interest rate that the Federal Reserve charges banks on discount loans Duration analysis a measurement of the sensitivity of the market value of a bank s assets and liabilities to changes in interest rates or autonomous spending Equity multiplier EM the ratio of a change in aggregate output to a change in investment spending Excess reserves reserves in excess of required reserves Gap analysis a measurement of the sensitivity of banks profits to changes in interest rates calculated by subtracting the amount of rate sensitive liabilities from the amount of rate