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Chapter 08 - Stocks, Stock Markets, and Market Efficiency

Chapter 8
Stocks, Stock Markets, and Market Efficiency

Chapter Overview

The goal of this chapter is to try to make sense of the stock market, to show what
fluctuations in stock value mean for individuals and for the economy as a whole, and to
look at a critical connection between the financial system and the real economy. The
chapter will also explain how it is that things sometimes go awry, resulting in bubbles and
crashes.

Reading this chapter will prepare students to:


Describe stocks and stock markets.
Explain how to value stocks.
Assess the risks involved in buying stock.

Important Points of the Chapter

For individuals, stocks are a key instrument for holding wealth; for companies, they are
one of several ways to obtain financing. Beyond that, stocks and stock markets are one
of the central links between the financial world and the real economy. Contrary to
popular mythology, stock prices tend to rise steadily and slowly, collapsing only on those
rare occasions when normal market mechanisms are out of alignment. The danger is that
if we are preoccupied with the potential short-term losses associated with crashes, we
lose sight of the gains we could realize if we took a longer-term view.

Application of Core Principles

Principle #4: Markets. We need to understand the dynamics of the stock market, both to
manage our personal finances and to see the connections between stock values and
economic conditions.

Principle #1: Time. Present value analysis can be used to find the value of a stock. The
price of the stock today should be equal to the present value of the selling price and of the
dividend payments made while the stock is held.

Principle #2: Risk. Stockholders require compensation for the risk they face, and the
higher the risk the higher the compensation.

Principle #4: Markets. The stock market plays a crucial role in every modern capitalist
economy. The prices determined in the stock market tell us the market value of
companies, which determines the allocation of resources.

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Teaching Tips/Student Stumbling Blocks

Pay attention to the texts careful explanation of the difference between price-
weighted and value-weight stock indices. The text provides excellent examples
illustrating the concepts presented.
This chapter continues the use of present value analysis to analyze how bond
prices are determined. You may wish to begin with a review of the tools from
Chapter 5.
Spend time going carefully through the examples given in the text, paying
particular attention to the assumptions made, and reinforce these concepts by
assigning end-of-chapter problems.

Features in this Chapter

Your Financial World: A Home is a Place to Live

When you own a stock, the issuing firm either pays you dividends or reinvests its profits
to make the business grow. Bonds pay interest. In either case, you receive an explicit
return on your investment. When you buy a house and move in, you get a roof over your
head without paying rent to someone else. When you sell it, you should expect to get
back the original purchase price and no more. The return on your investment was the
housing services you consumed.

Tools of the Trade: Reading Stock Indexes in the Business News

This section provides an illustration of the way business news reports on the performance
of various indices.

Your Financial World: Beware Percentage Changes

Sometimes investment reports imply that it is possible to evaluate a funds overall


performance simply by adding the percentage loss over one period to a subsequent
percentage gain. But, as this section illustrates, nothing could be further from the truth.
In fact, as the percentage decline increases, the percentage increase needed to bring a
losing investment back to its original value rises rapidly.

Applying the Concept: The Chinese Stock Market

China reopened its stock market in the early 1990s, and since then the market has grown
rapidly. In the early 1990s the stock exchanges in Shanghai and Shenzhen were primarily
concerned with transferring ownership of state-owned enterprises into private hands.
Because of government restrictions on stock holdings, stock prices were very high.
When the government reversed course and made shares available to the market, prices
collapsed. This is an example of how changing institutional constraints result in
changing stock prices through the basic mechanism of supply and demand.

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Your Financial World: Should You Own Stocks?

This section points out that there are five issues to think about when buying stock:
affordability, liquidity, diversification, management, and costs. The recommendation in
the section is that people consider these issues with regard to choosing an index fund.

In The News: Efficient Market Theory and the Crisis

The Efficient Market Hypothesis (EMH) was originally put forth by Eugene Fama of the
University of Chicago in the 1960s and states that the prices of securities reflect all
known information that impacts their value. The theory does not claim that price is
always right, rather it implies that prices are always wrong, but it is difficult to tell
whether they are too high or too low. The EMH can show how so many people were so
wrong about the failed financial firms or the sub-prime mortgage market.
Lessons of the Article: Markets may use available information efficiently and still face
setbacks if the information is incomplete or incorrect. An important source of the
financial crisis of 2007-2009 was the failure to understand risks in the U.S. housing
market. The efficient market hypothesis does not rule out large swings in market prices
when new informationsuch as heightened mortgage default riskbecomes widely
available.

Applying the Concept: What Was the Internet Bubble All About?

The Internet bubble changed the way that new companies obtain financing by replacing
venture capitalists with the capital markets. But the distortions caused by unjustifiably
high stock prices warped investors decisions, leaving many worthwhile projects
unfunded.

Additional Teaching Tools

In Drop in energy stocks punctures early market rally (Business Week, June 9, 2010),
Tim Paradis talks about the changes in the stock market given information gleaned over
the previous few days of information gathering by investors. First, Mr. Paradis discusses
comments made by Ben Bernanke, Chairman of the Federal Reserve, about the overall
state of the economy. Then the effect of the BP oil spill on energy stocks. The oil spill is
expected to increase the costs of these companies doing business.

Virtual Tools

For more about the Dow Jones Industrial Average (and other indices) visit this site from
Dow Jones:
http://www.djindexes.com/jsp/industrialAverages.jsp?sideMenu=true.html

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More good material from Dow Jones, including information on indices in other countries
can be found at:
http://averages.dowjones.com/jsp/index.jsp

The current components of the DJIA can be found at:


http://www.djindexes.com/mdsidx/downloads/fact_info/Dow_Jones_Industrial_Average_
Fact_Sheet.pdf

A history of the Dow can be found on this site from The Motley Fool:
http://www.fool.com/Ddow/HistoryOfTheDow3.htm

The most recent changes in the components of the DJIA are discussed in the article at:
http://money.cnn.com/2004/04/01/markets/dow/

Visit this site from Investopedia.com for information on other countries indexes and
some useful links:
http://www.investopedia.com/terms/i/index.asp

For a look at the kind of stock charts used by chartists go to:


http://www.stockta.com/

Learn more about charting or technical analysis at this site:


http://www.equis.com/Education/TAAZ/

For More Discussion

In the video entitled Dow Jones Changes Industrial Index: Honeywell and Altria Are
Out (February 11, 2007) Business Week talks about a recent change in the Dow
Jones Industrial Average. The video can be found at:
http://www.businessweek.com/mediacenter/video/marketreports/5475ac8c79a2eb0ce
9dd9fab057e64125048c3ec.html.

Chapter Outline

I. The Essential Characteristics of Common Stock


A. Stocks, also known as common stock or equity, are shares in a firms
ownership.
B. From their early days, stocks had two important characteristics that today are
taken for granted: the shares are issued in small denominations and the shares
are transferable.
C. Until recently, stockowners received a certificate from the issuing company,
but now it is a computerized process where the shares are registered in the
names of brokerage firms that hold them on the owners behalf.

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D. The ownership of common stock conveys a number of rights:


1. A stockholder is entitled to participate in the shares of the enterprise,
but this is a residual claim (meaning the leftovers after all other
creditors have been paid).
a. Stockholders also have limited liability, meaning that even if a
company fails, the maximum amount that the stockholder can
lose is the initial investment.
2. Stockholders are entitled to vote at the firms annual meeting. This
includes voting to elect (or remove) the firms board of directors.
E. Todays thriving trade in stock is possible because:
1. An individual share represents only a small fraction of the value of the
company that issued it;
2. A large number of shares are outstanding;
3. Prices of individual shares are low, allowing individuals to make
relatively small investments;
4. As residual claimants, stockholders receive the proceeds of a firms
activities only after all other creditors have been paid;
5. Because of limited liability, investors losses cannot exceed the price
they paid for the stock; and
6. Shareholders can replace managers who are doing a bad job.
II. Measuring the Level of the Stock Market
A. Stocks are one way in which we choose to hold our wealth, so when stock
values rise we get richer and when they fall we get poorer.
B. These changes affect our consumption and saving patterns, causing general
economic activity to fluctuate.
C. We need to understand the dynamics of the stock market, both to manage our
personal finances and to see the connections between stock values and
economic conditions.
D. Stock market indexes are designed to give us a sense of the extent to which
stock prices are going up or down.
E. Stock indexes can tell us both how much the value of an average stock has
changed, and how much total wealth has gone up or down.
F. Stock market indexes provide benchmarks for performance of money
managers, comparing how they have done to the market as a whole.
A. The Dow Jones Industrial Average
1. The first, and still the best known, stock market index is the Dow Jones
Industrial Average (DJIA).

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2. It began as an index of 11 stocks, and today is based on the stock prices of 30


of the largest companies in the United States.
3. The index is calculated by adding up the prices of all 30 stocks and dividing
by 30, so the percentage change in the DJIA over time is the percentage
change in the sum of the 30 prices.
4. The DJIA measures the return to holding a portfolio of a single share of each
of the stocks included in the average.
5. The DJIA is a price-weighted average, giving greater weight to shares with
higher prices.
6. The stocks included in the average have changed in order to reflect the
changes in the structure of the American economy.
7. Of the original 11 stocks only General Electric remains in the index.
B. The Standard & Poors 500 Index
1. The Standard & Poors 500 Index differs from the DJIA in two major
respects; first, it is constructed from the prices of many more stocks and
second, it uses a different weighting scheme.
2. The S&P 500 is based on the value of 500 firms, the largest firms in the U.S.
economy.
3. Unlike the DJIA, the S&P 500 tracks the total value of owning the entirety of
those firms.
4. In the indexs calculation, each firms stock price receives a weight equal to its
total market value, so the S&P 500 is a value-weighted index.
5. Larger firms are more important in the S&P 500.
6. The S&P 500 is neither better nor worse than the DJIA; rather, the two types
of index simply answer different questions.
C. Other U.S. Stock Market Indices
1. Besides the DJIA and the S&P 500, the most prominent indices in the United
States are the Nasdaq Composite Index or Nasdaq and the Wilshire 5000.
2. The Nasdaq is a value-weighted index of over 5000 companies traded on the
over-the-counter market (OTC) through the National Association of Securities
Dealers Automatic Quotations service.
3. The Nasdaq is composed mainly of smaller, newer firms and in recent years
has been dominated by technology and Internet companies.
4. The Wilshire 5000 is the most broadly based index in use and covers all
publicly traded stocks in the United States, including all the stocks on the New
York Stock Exchange, the American Stock Exchange and the OTC (together
these total to more than 6,500 stocks, contrary to the name).

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5. Like the Nasdaq and the S&P 500 the Wilshire 5000 is value-weighted.
D. World Stock Indices
1. Every major country in the world has a stock market, and each of these
markets has an index.
2. For the most part, these are value-weighted indices.
3. To analyze the performance of these different markets it is useful to look at
percentage changes, but percentage change isnt everything.
III. Valuing Stocks
1. People differ in their opinions of how stocks should be valued.
2. Chartists believe that they can predict changes in a stocks price by looking at
patterns in its past price movements.
3. Behavioralists estimate the value of stocks based on their perceptions of
investor psychology and behavior.
4. Still others estimate stock values based on a detailed study of the
fundamentals, which can be analyzed by examining the firms financial
statements. In this view the value of a firms stock depends both on its current
assets and estimates of its future profitability.
5. The fundamental value of stocks can be found by using the present value
formula to assess how much the promised payments are worth, and then
adjusting to allow for risk.
6. Chartists and Behavioralists focus instead on estimates of the deviation of
stock prices from those fundamental values.
A. Fundamental Value and the Dividend-Discount Model
1. As with all financial instruments, a stock represents a promise to make
monetary payments on future dates, under certain circumstances.
2. With stocks the payments are in the form of dividends, or distributions of the
firms profits.
3. The price of a stock today is equal to the present value of the payments the
investor will receive from holding the stock, which in the example given in
the text is the selling price of the stock in one years time and the dividend
payments received while the stock is held.
4. This can be extended for longer holding periods.
5. If a stock does not pay dividends the calculation can still be performed; a
value of zero is used for the dividend payments.
6. Future dividend payments can be estimated assuming that current dividends
will grow at a constant rate per year.

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7. Assuming that the firm pays dividends forever solves the problem of knowing
the selling price of the stock; the assumption allows us to treat the stock as we
did a consol.
8. This relationship is the dividend-discount model.
B. Why Stocks Are Risky
1. Stockholders receive profits only after the firm has paid everyone else,
including bondholders.
2. It is as if the stockholders bought the firm by putting up some of their own
wealth and borrowing the rest.
3. This borrowing creates leverage, and leverage creates risk.
4. Stocks are risky, therefore, because shareholders are residual claimants.
5. Any variation in the firms revenue flows through to stockholders dollar for
dollar, making their returns highly volatile.
C. Risk and the Value of Stocks
1. The dividend-discount model must be adjusted to include compensation for a
stocks risk.
2. The required return a shareholder needs is the sum of the risk-free interest rate
and the risk premium, sometimes called the equity risk premium.
3. Recall that the risk-free rate can be thought of as the interest rate on a U.S.
Treasury security with a maturity of several months.
4. The higher the risk premium investors demand to hold a stock, the lower its
price; the higher the risk-free return, the lower the stocks price.
D. The Theory of Efficient Markets
1. There are two explanations for why stock prices change continuously.
2. One is based on fundamental values; when fundamentals change, prices must
change with them.
3. This line of reasoning gives rise to the theory of efficient markets. The basis
of the theory is the notion that the prices of all financial instruments, including
stocks, reflect all available information.
4. As a result, markets adjust immediately and continuously to changes in
fundamental values.
5. If the theory is correct, chartists are doomed to failure, because future price
movements are unpredictable.
6. If the theory is correct then no one can consistently beat the market average;
active portfolio management will not yield a return that is higher than that of a
broad stock-market index.

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7. If managers claim to exceed the market average year after year, they must be
taking on risk, be lucky, have private information (which is illegal), or
markets are not efficient.
8. Pure chance can, in fact, explain that a few achieve higher than expected
returns.
IV. Investment in Stocks for the Long Run
1. Stocks appear to be risky, and yet many people hold substantial proportions of
their wealth in the form of stock.
2. The explanation for this is the difference between the short term and the long
term; investing in stocks is risky only if you hold them for a short time.
3. In fact, according to the analysis presented in the chapter, when held for the
long term, stocks are less risky than bonds.
V. The Stock Markets Role in the Economy
1. The stock market plays a crucial role in every modern capitalist economy.
2. The prices determined there tell us the market value of companies, which
determines the allocation of resources.
3. So long as stock prices accurately reflect fundamental values, this resource
allocation mechanism works well. At times, however, stock prices deviate
significantly from the fundamentals and prices move in ways that are difficult
to attribute to changes in the real interest rate, the risk premium, or the growth
rate of future dividends.
4. Shifts in investor psychology may distort prices; both euphoria and depression
are contagious.
5. When investors become unjustifiably exuberant about the markets future
prospects, prices rise regardless of the fundamentals, and such mass
enthusiasm creates bubbles.
6. Bubbles are persistent and expanding gaps between actual stock prices and
those warranted by the fundamentals.
7. Bubbles inevitably burst, creating crashes.
8. Bubbles affect all of us because they distort the economic decisions
companies and consumers make.
9. If bubbles result in real investment that is both excessive and inefficiently
distributed, crashes do the opposite; the shift to excessive pessimism causes a
collapse in investment and economic growth.
10. When bubbles grow large enough and result in crashes the stock market can
destabilize the real economy.

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Terms Introduced in Chapter 8

bubble
common stock
dividend-discount model
dividends
Dow Jones Industrial Average
equity
fundamental value
limited liability
market capitalization
mutual fund
Nasdaq Composite Index
price-weighted average
residual claimant
Standard & Poors 500 Index
stock market
stock-market indexes
theory of efficient markets
value-weighted index
Wilshire 5000

Lessons of Chapter 8

1. Stockholders own the firms in which they hold shares.


a. They are residual claimants, which means they are last in line after all
other creditors.
b. They have limited liability, so their losses cannot exceed their initial
investments.

2. There are two basic types of stock market index.


a. The Dow Jones Industrial average is a price-weighted index.
b. The S&P 500 is a value-weighted index.
c. For every stock market in the world, there is a comprehensive index that is
used to measure overall market performance.

3. There are several ways to value stocks.


a. Some analysts examine patterns of past performance; others follow
investor psychology.
b. The fundamental value of a stock depends on expectations for a firm's
future profitability.

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c. To compensate for the fact that stocks are risky investments, investors in
stock require a risk premium.
d. The dividend-discount model is a simple way to assess fundamental value.
According to this model, stock prices depend on the current level of
dividends, the growth rate of dividends, the risk-free interest rate, and the
equity risk premium.
e. According to the theory of efficient markets, stock prices reflect all
available information.
f. If markets are efficient, then stock price movements are unpredictable, and
investors cannot systematically outperform a comprehensive stock market
index like the S&P 500.

4. Stock investments are much less risky when they are held for long periods than
when they are held for short periods.

5. Stock prices are a central element in a market economy, because they ensure that
investment resources flow to their most profitable uses. When occasional bubbles
and crashes distort stock prices, they can destabilize the economy.

Conceptual Problems

1. Explain why being a residual claimant makes stock ownership risky.

Answer: Stockholders do not receive dividends unless all of the firms creditors
have been paid. If the firm does poorly, stockholders may receive nothing. The
result is that returns to stockholders have high variance. In the event that the firm
goes bankrupt, stockholders lose their entire investment.

2. Check the business section of a recent newspaper (or a financial Web site) to find
the current level of each of the following indices, along with its change over the
last 12 months:
a. Dow Jones Industrial Average
b. Standard & Poors 500 Index
c. Nasdaq Composite
d. Wilshire 5000
Comment on what you have found, including the differences among the indices.

Answer: Data are for close of business on March 10, 2010. DJIA, S&P500 and
Nasdaq data are from the Wall Street Journals Market Data Center. Data for the
Wilshire 5000 are from www.wilshire.com.
a. 10,567.33; +52.56%
b. 1,145.61; +59.20%
c. 2,358.95; +73.67%
d. 11,998.46; +63.94%

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All of the indices increased significantly over the past year, as stocks recovered
from the crash associated with the financial crisis of 2007-2009. The actual
numerical values of the indices are all very different, reflecting differences in the
number of stocks included in each index, how long each index has existed, and
whether the index is a price-weighted or value-weighted average.

3. A stock that sells for $100 entitles you to a dividend payment of $4 today. You
estimate that the growth rate of the firms dividends is about 2 percent per year,
and that the risk-free rate is 3 percent. What is the risk premium suggested by
the price of this stock? Does it strike you as high or low? How would your
answer change if the stock price were $150 instead of $100?

Answer:
$4(1.02)
If the price is $100: $100 = rp=2.58%
3.5% + rp - 2%
The risk premium is lower than the historical average of 4%.
$4(1.02)
If the price is $150: $150 = rp=1.22%
3.5% + rp - 2%
The risk premium is much lower than the historical average of 4%.

4. As you flip through The Wall Street Journal you notice advertisements by
investment firms wanting you to sell you their products. Common among all of
the ads is the claim that the firm has a track record of performing above average.
Explain how they can all be above average. Is this inconsistent with the efficient
markets theory?

Answer: The fact is all of the mutual funds that are currently in existence could
have performed above average because the ones that were below average went out
of existence. If a below-average fund dies, then the only ones left will be those
that were above average. This is completely consistent with the theory of
efficient markets, which concludes that performance relative to the average is
completely random. That means that the advertisements are for mutual funds that
were lucky, not ones that were skillful. There is also the possibility that the funds
reporting above-average performance took more risk to get it. Again, this is
consistent with the theory of efficient markets because risk requires
compensation. It is only after adjusting for risk, removing the risk premium that
the fund will not perform better than average.

5. Explain why an investment portfolio composed of all the stocks in the Standard
and Poors 500 Index is less risky than an investment portfolio composed of 20
stocks chosen randomly.

Answer: Because returns to different stocks are not perfectly correlated, the more
stocks you invest in, the lower the overall risk of your portfolio. (See Chapter 5).

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6. *What are the advantages of holding stock in a company versus holding bonds
issued by the same company?

Answer: Stocks represent a share of ownership in the company and give the
holder a share in the future profits of the company. If the company, for example,
makes a great discovery, invents the next great product etc., stock holders get to
participate in those gains whereas a bond holder receives the coupon payments
and principal associated with the bond regardless. The potential upside is
unlimited while, like bond holders, the potential loss is limited to the initial
investment made in the company.
The right to vote at annual meetings is another advantage of holding stock rather
than bonds in a company.

7. Return to the example summarized in Table 8.3, in which a firm purchases a


$1,000 computer. Assume that the firm has only 20 percent equity outstanding, so
it needs an $800 loan. Managers expect revenue of $200 in good times and $100
in bad times. Compute the percentage change in revenue and profits (revenue
minus interest payments) if revenue is $200 in the first year and $100 in the
second year. Then compute the return to the stockholders in each year.

Answer:
Year 1: Revenue=$200 Profit=$200-10%*($800)=$120
Year 2: Revenue=$100 Profit=$100-10%*($800)=$20

Revenue falls by 50%; profits fall by 83%


Year 1 Return to Stockholders=$120/$200=60%
Year 2 Return to Stockholders=$20/$200=10%

8. If Professor Siegel is correct that stocks are less risky than bonds, then the risk
premium on stock may be zero. Assuming that the risk-free interest rate is 3
percent, the growth rate of dividends is 2 percent and the current level of
dividends is $30, use the dividend-discount model to compute the level of the
S&P 500 that is warranted by the fundamentals. Compare the result to the current
S&P 500 level, and comment on it.

Answer:
$30(1.02)
P= = 2040
3.5% - 2%

On March 10, 2010, the S&P 500 was at 1145.61. This suggests either that the
stocks in the index are undervalued, or that that the equity risk premium is
positive.

9. *Why is a booming stock market not always a good thing for the economy?

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Answer: If stock prices are rising for reasons that are not related to economic
fundamentals, there may be a misallocation of resources in the economy.
Companies invest in projects that may not be the most productive and do not add
to economic growth. As investors wealth increases, they change their
consumption patterns, leading to increased demand for certain goods and services
that cannot be sustained when the stock market readjusts.

10. The financial press tends to become excited when the Dow Jones Industrial
Average rises or falls sharply. After a particularly steep rise or fall, newspapers
may publish tables ranking the days results with other large advances or declines.
What do you think of such reporting? If you were asked to construct a table of
the best and worst days in stock market history, how would you do it, and why?

Answer: This type of reporting can be misleading because it ignores the level of
the index itself. A 100 point rise or fall means one thing when an index is at 5000,
but quite something else when it is at 10,000. Expressing changes as percentage
changes is the best solution.

Analytical Problems

11. You are thinking about investing in stock in a company who paid a dividend of
$10 this year and whose dividends you expect to grow at 4% a year. The risk free
rate is 3% and you require a risk premium of 5%. If the price of the stock in the
market is $200 a share, should you buy it?

Answer: Yes. Using the dividend discount model, you are willing to pay:
P = 10(1.04)/(0.08-.04) = $260 per share. As the asking price in the
market is below this, you should buy the stock.

12. *Consider again the stock described in question 11. What might account for the
difference in the market price of the stock and the price you are willing to pay for
the stock?

Answer: The difference could reflect the fact that you require a lower risk
premium than the market in general or that you think that dividends for this
company are going to grow faster than the market in general. It could also reflect
market pessimism, pushing the price below the fundamental value.

13. You are trying to decide whether to buy stock in Company X or Company Y.
Both companies need $1000 capital investment and will earn $200 in good years
(with probability 0.5) and $60 in bad years. The only difference between the
companies is that Company X is planning to raise all of the $1000 needed by
issuing equity while Company Y plans to finance $500 through equity and $500
through bonds on which 10% interest must be paid.

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Construct a table showing the expected value and standard deviation of the equity
return for each of the companies. (You could use Table 8.3 as a guide.) Based on
this table, in which company would you buy stock? Explain your choice.

Answer:

% equity % bonds Pay on Pay to Equity Expected Standard


bonds equity return Value Deviation
holders
100 0 0 60-200 6-20% 13% 7%
50 50 50 10-150 2-30% 16% 14%
(Remember, the expected value of the equity return is calculated as a % of 500
the amount put into equity.)
Which company you choose depends on your attitude toward risk. If you are
willing to take on extra risk by buying stock in Company Y, you get a higher
expected return. If you are more risk averse, you may want to opt for the lower
but safer return of company X.

14. Your brother has a $1000 and a one-year investment horizon and asks your advice
about whether he should invest in a particular companys stock. What
information would you suggest he analyze when making his decision? Is there an
alternative investment strategy to gain exposure to the stock market you might
suggest he consider?

Answer: You should explain that the return on his investment will depend on the
dividend he may be paid and the movement in the stock price over the year. You
could show him how to use the dividend discount model to assess whether the
stock is he considering is over- or under-valued relative to fundamentals to help
predict his chances of making a capital gain. You should mention that stocks are a
relatively risky investment over a short-run investment horizon.
You could suggest that he invest his $1000 in a mutual fund, thus spreading the
risk over a portfolio of stocks.

15. Given that many stock market indices across the world fell and rose together
during the financial crisis of 2007-2009, do you think investing in global stock
markets is an effective way to reduce risk? Why or why not?

Answer: While it is true that movements in stock market indices across the world
have become more highly correlated over time, as long as they are not perfectly
correlated, there are benefits from spreading your investments. (Recall how
spreading reduces risk from chapter 5.)

16. Do you think a proposal to abolish limited liability for stockholders would be
supported by companies issuing stock?
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Chapter 08 - Stocks, Stock Markets, and Market Efficiency

Answer: No. The obvious downside would be that stocks would become much
less attractive as an investment, making it much costlier for firms to raise funds
by issuing stock. The potential benefit would be that bondholders and creditors
might find the company more attractive, as in the event of bankruptcy they could
pursue stockholders for what they are owed. Practically speaking, however, this
is unlikely to be a feasible option.

17. You peruse the available records of some public figures in your area and notice
that they persistently gain higher returns on their stock portfolios than the market
average. As a believer in efficient markets, what explanation for these rates of
returns seems most likely to you?

Answer: Your first instinct is that the public officials have access to inside
information, which they use to guide their investment decisions. Other
possibilities are that these public figures have simply been lucky or that they have
a higher than average appetite for riskier investments that have being doing well.

18. Do you think that widespread belief in the efficient markets theory was a
significant contributor to the 2007-2009 financial crisis? Why or why not?

Answer: The efficient market hypothesis does not postulate that market prices of
securities are always correct, but that they reflect all known information that
impact their value. The crisis emerged as it became evident that relevant
information was incomplete or incorrect, leading to large price movements as
investors reassessed the risks associated with certain securities.

19. Based on the dividend-discount model, what do you think would happen to stock
prices if there were an increase in the perceived riskiness of bonds?

Answer: If investors perceive bonds are more risky, then the relative riskiness of
stocks will fall. Stocks would become relatively more attractive, requiring a
smaller risk premium than before. From the dividend discount model, we can see
that a fall in the risk premium (which is in the denominator) would lead to a rise
in stock prices.

20. *Use the dividend-discount model to explain why an increase in stock prices is
often a good indication that the economy is expected to do well.

Answer: How well investors expect the economy to do is reflected in the expected
growth rate of dividends, g. When investors are optimistic about the future, they
will expect dividends to grow at a faster rate, which increases the price they are
willing to pay for stocks. From the dividend discount formula for the stock price,
we can see that g enters the numerator positively and the denominator negatively,
so if g increases, the stock price increases.

* indicates more difficult problems

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