ECO 3223 EVANS STUDY GUIDE FOR EXAM 2 Note This is intended to direct you to the relevant topics that will be covered on the exam Questions will be worded differently so don t MEMORIZE this content use it to help you understand the concepts CHAPTER 7 Know all of the key terms for this chapter o adaptive expectations p 147 Expectations of a variable based on an average of past values of the variable value o arbitrage p 151 Elimination of a riskless profit opportunity in a market o behavioral finance p 156 A subfield of finance that applies con cepts from other social sciences such as anthropology sociology and particularly psychology to understand the behavior of securities prices o bubbles p 155 A situation in which the price of an asset differs from its fundamental market o cash flows p 141 The difference between cash receipts and cash expenditures o dividends p 141 Periodic payments made by equities to shareholders o efficient market hypothesis p 149 The application of the theory of rational expectations to o generalized dividend model p 143 Calculates that the price of stock is determined only by o Gordon growth model p 143 A simplified model to compute the value of a stock by financial markets the present value of the dividends assuming constant dividend growth security o market fundamentals p 155 Items that have a direct impact on future income streams of a o optimal forecast p 147 The best guess of the future using all avail able information o rational expectations p 147 Expectations that reflect optimal forecasts the best guess of the future using all available information o residual claimant p 141 The right as a stockholder to receive what ever remains after all other claims against the firm s assets have been satisfied o short sales p 157 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 o unexploited profit opportunity p 151 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 Residual claimant the stockholder receives whatever remains after all other claims against the firm s assets have been satisfied Receives dividends payments made periodically usually every quarter to stockholders The board of directors of the firm sets the level of the dividend usually based on the recommendation of management the stockholder has the right to sell the stock 2 What are stocks cash flows 1 Dividends 3 Understand the stock valuation model and the appropriate application 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 present One Period valuation model not very practical because most securities are held for more than one period P0 div1 1 Ke P1 1 Ke o Ke the required return on investments in equity o P0 the current price of the stock The zero subscript refers to time period zero or the o Div1 the dividend paid at the end of year 1 o P1 the price at the end of the first period the predicted sales price of the stock Generalized Dividend Valuation Model P0 Dt 1 Ke t o Buyers of the stock expect that the firms will pay dividends someday Most of the time a firm institutes dividends as soon as it has completed the rapid growth phase of its life cycle o Computing an infinite stream of dividends can be difficult so simplified models exist Gordon Growth Model P0 D0 1 g Ke g D1 Ke g o Use either formula depending on whether the problem gives you D0 or D1 o Dividends are assumed to grow at a constant rate forever o Growth rate assumed to be less than required return on equity D0 the most recent dividend paid g the expected constant growth rate in dividends Ke the required return on an investment in equity Falling interest rates causes the stock price to increase Lower g lowers stock price 4 What role does information play in determining stock prices o The price of the stock is set by The buyer willing to pay the highest price The buyer who will use it most productively The buyer with the most information Adaptive expectations expectations based on the past Rational expectations expectations will be identical to optimal forecasts using all available information o Doesn t need to be accurate just best possible o Even though a rational expectation equals the optimal forecast using all available information a prediction based on it may not always be accurate o Expectations may fail because People know information but it takes too much effort to use it People may be unaware of the information o Implications If there is a change in the way a variable moves the way in which expectations of the variable are formed will change The forecast errors of expectations will on average be zero and can t be predicted ahead of time difference between realization of a variable and expectations of one 2 o Because market participants are constantly receiving new information and revising their expectations it is reasonable that stock prices are constantly changing as well Basically people use the information they have to determine how much they believe a stock price to be worth If someone has more information that allows them to determine that the price of that stock is too low currently they will buy the stock and if the information they have tells them that the price is too high they will sell it 5 The perceived risk of holding stock is negatively positively related to stock price Lower risk means people are willing to pay a higher stock price If I have more information about the future of a company and know for certain that it is going to do well I will be willing to pay more and require a lower return than someone who may think the company will fail 6 What is the effect of expansionary and contractionary monetary policy upon stock prices If the fed lowers interest rates expansionary the return on bonds will decrease people will accept a lower Ke return on equity This leads to higher prices of stocks Also g growth rate of dividends may increase which would also raise prices If the fed raises interest rates contractionary the return on bonds will increase so people will accept a higher Ke This leads to lower prices of stocks Also g will decrease which would also lower prices 7 What is the Efficient Market Hypothesis and what does it tell us