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 6 1 Understand how default risk liquidity and income tax considerations affect bond prices and interest rates on bonds As a bonds default risk increases the risk premium on that bond the spread between its interest rate and the interest rate on a default free Treasury Bond rises The greater liquidity of Treasury bonds also explains why there interest rates are lower than those on less liquid bonds If a bond has a favorable tax treatment as do municipal bonds whose interest payments are exempt from federal income taxes its interest rate will be lower Know how to calculate tax equivalent yield on a bond 2 Tax Equivalent Yield TEY TEYM CM 1 t CM coupon rate on municipal bond t federal income tax rate Know how to identify the area of risk premium on the supply demand 3 models for corporate bonds and U S Treasury securities Know how to determine the risk of default on bonds against what 4 standard is this risk measured Determine risk by comparing to us government bonds since they have no default risk 5 a Yield curves the macroeconomic interpretation of origin and slope of an upward sloping yield curve indicates that short term interest rates are not expected to rise or fall much in the future b a steeply upward sloping yield curve indicates that short term interest rates are expected to rise in the future c a relatively flat yield curve indicates that short term interest rates are expected to fall moderately in the future d an inverted yield curve indicates that short term interest rates are expected to fall sharply in the future 6 Which of the following Expectations Segmented Markets and Liquidity Premium Preferred Habitat theories best explains why yield curves are generally upward sloping The liquidity premium preferred habitat theory best explains why yield curve are upward sloping because it combines both the the expectations and segmented markets theory The liquidity premium theory and preferred habitats theory explain 1 how interest rates on bonds of different maturities tend to move together over time 2 when short term interest rates are low yield curves are more likely to have a steep upward slope 3 yield curves usually slope upward but when short term interest rates are high yield curves are more likely to be inverted CHAPTER 7 1 What rights do stockholders have with respect to the corporation in which they own stock Stockholders own and interest in the corporation proportional to the percentage of outstanding shares they own This ownership gives them a bundle of rights The most important are the right to vote and to be the residual claimant of all funds flowing into the firm known as cash flows meaning that the stockholder receives whatever remains after all other claims against the firms assets have been satisfied Stockholders may receive dividends from the net earnings of the corporation Dividends are payments made periodically usually every quarter to stockholders Stockholder also has the right to sell the stock Stockholders have the right to vote and to be the residual claimant of all funds flowing into the firm meaning that the stockholder receives whatever remains after all other claims against the firm s assets have been satisfied 2 What are stocks cash flows We value common stock as as the value in todays dollars of all future cash flows The cash flows a stockholder might earn from stock are dividends the sales price or both The cash flows are all of the funds flowing into the firm of which the stockholder is the residual claimant to 3 Understand stock valuation formula and why holding period is not price of a incorporated into the formula Be able to calculate the stock From the resulting price you calculate explain how k and g help interpret economic conditions as well as investors beliefs Po the current price of the stock K and g help interpret economic conditions as well as investors beliefs as K decreases decrease in interest rates stock prices rise G decreases stock prices fall investors want to see higher stock prices so an increase in g or a decrease in k is ideal 4 What role does information play in determining stock prices Superior information about an asset can increase its value by reducing its perceived risk Information is important for individuals to value each asset When new information is released about a firm expectations and prices change Market participants constantly receive information and revise their expectations so stock prices change frequently In an efficient market a security s current price fully reflects all available information Information in newspapers and in the published reports of investment advisers is readily available to many market participants and is already reflected in market prices Acting on this information will not yield abnormally high returns A hot tip is probably information already contained in the price of the stock Stock prices respond to announcements only when the information is new and unexpected EX If two investors have different information about a stock they may price the stock differently New information can cause changes in expectations about the level of future dividends or the risk of those dividends The perceived risk of holding stock is negatively positively related to 5 stock price Negatively as it raised K If its riskier you demand a higher return in order for it to be worth buying 6 What is the effect of expansionary and contractionary monetary policy upon stock prices Expansionary monetary policy will raise stock prices k will decrease and g will increase higher interest rates make it more expensive for companies to borrow Contractionary monetary policy will lower stock prices k will increase and g will decrease 1 Understand the two ways in which investors formulate their beliefs about future stock prices Under adaptive expectations changes in expectations will occur slowly over time as past data changes Under rational expectations expectations will be identical to optimal forecasts the best guess of the future using all available information incorporates old and new info They differ because the theory of adaptive expectations does not take into account that people use more than just past data on a single variable to form expectations They use all