BFN 110 Lecture Notes - Lecture 15: Risk-Free Interest Rate, Risk Premium, Efficient-Market Hypothesis

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coralimpala133

6 Jan 2021

School

Tunxis Community College

Department

Business – Finance

Course

BFN 110

Professor

garside

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Document Summary

Calculate variance and standard deviation for an asset. Where r line is the average return. And ri is the actual return for observation i. If historical returns from an asset are 60%, -25% and 50% and avg return is 28. 33% S = square root [ (60-28. 33)2 + (-25-28. 33)2 + (50-28. 33)2. Prices of securities change due to new info arriving. If it"s very fast, then the market is said to be efficient. In an inefficient market, prices reflect all available info. All info is reflected in the share price. Investors cannot use public info to outperform the market. All public info reflected in share price. Trend or technical analysis cannot be used to find undervalued or. Assigning probabilities to different outcomes allows a measure of the return that can be expected in the long run. = sum of probability of return x return. An investor believes that the returns for an investment depends on the state of the economy.

Related Questions

Please write a 250 word response to the below discussion. Please provide 2 scholarly sources.

The efficient market hypothesis states that share prices reflect all relevant information, and that it is impossible to beat the market or achieve above-average returns on a sustainable basis. There are many critics of this theory, such as behavioral economists, who believe in inherent market inefficiencies. The Efficient Market Hypothesis (EMH) states that securities are very efficient in reflecting the truth about a stock. In other words, when new information is available about a stock, it is incorporated into the price adjustments of the stock quickly enough to reflect the actual state of the market (Malkiel, 2003). EHM debunks the idea that financial analysis and forecasting are useful tools to shop for stocks. In other words, because securities accurately reflect the status of that stock, it is not possible to use financial analysis to find an undervalued stock or predict trends in the market in order to buy low with the future insight to sell high. There are three levels, or degrees, of the efficient market hypothesis: weak, semi-strong, and strong. The weak form assumes that current stock prices reflect all available information, and that past price performance has no relationship with the future. In other words, this form of the hypothesis says that using technical analysis to achieve exceptional returns is impossible. The semi-strong form says that stock prices have factored in all available public information. Because of this, it's impossible to use fundamental analysis to choose stocks that will beat the market's returns. Finally, the strong form of the efficient market hypothesis says that all information, public as well as private, is incorporated into current stock prices. This form of the efficient market hypothesis essentially assumes a perfect market, and isn't plausible when there are insider trading restrictions (VanBergen, 2011). Yes, I believe that financial statement analysis can provide a significant advantage to an investor. The key is that empirical analysis, specifically statistical models aimed at forecasting future trends based on historical data, are simply another tool to be taken in to account. They are not a single source of the definitive answer. But, through the use of high power computing and mathematically rigorous modeling tools, forecasting is a powerful tool to provide additional insight to decision makers to include the financial industry. In support of my position, (Malkiel 2003) reports the findings of several empirical studies which demonstrate positive statistical correlations in short-run return analysis and the successful prediction of up to 40% of variation in long-term return analysis through time-series statistical models, which are able to take into account seasonal fluctuations (Malkiel 2003). One experimental study demonstrated with statistical significance that the Ohlson model provides predictive ability for future stock price movements (Lee, Chen and Tsai, 2014).

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Multiple Choice Quiz
PLS EXPLAIN ALL YOUR ANSWERS AND SHOW THE CALCULATIONS
1
A share of common stock represents:
A) A claim from a lender against a borrower.
B) A share in the company's debts.
C) A share of ownership of the company.
D) An unlimited liability to the owner of the stock.

2
The fact that common stockholders are residual claimant'smeans:
A) The stockholders have a claim against the revenue that remainsafter everyone else is paid.
B) The stockholders receive their dividends before any otherresiduals are paid.
C) The stockholders are paid any past due dividends before otherclaims are paid.
D) The stockholders are paid before the bondholders but after anytaxes are paid.

3
The concept of limited liability says a stockholder of acorporation:
A) Is liable for the corporation's liabilities, but nothingmore.
B) Cannot receive dividends that exceed his/her investment.
C) Cannot lose more than his/her investment.
D) Is only responsible for any taxes that the corporation may owebut not its other debts.

4
You have a portfolio valued at $1000. Over the next twelve monthsit loses 80% of its valuWhat return does the portfolio need to earnover the following twelve months to restore the portfolio to itsoriginal value?
A) 75%.
B) 200%.
C) 400%.
D) 25%.

5
The theory of efficient markets assumes that:
A) Prices of bonds, but not stocks, reflect all availableinformation.
B) The prices of all financial instruments reflect all availableinformation.
C) Stock prices are relatively rigid because it takes a while forinformation to efficiently move through the market.
D) The best approach to determining stock prices is to follow thechartists.

6
The notion that stock prices reflect all current availableinformation:
A) Makes the risk of holding stocks greater.
B) Indicates that mutual fund managers will not, on average,outperform market averages.
C) Says stock prices should be more rigid than they are.
D) Makes it easier to predict the movements in the price of astock.

7
Why are stock market bubbles costly for the economy?
A) They imply that the actual stock price is equal to thefundamental value of the stock.
B) They hurt consumers more than corporations.
C) They lead to a reduction in real investment in both theshort-term and long-term.
D) They lead to a misallocation of resources in both the short-termand long-term.

8
Stock market bubbles impact consumers by:
A) Encouraging greater consumption of luxury goods and greatersaving.
B) Encouraging greater consumption of luxury goods and lesssaving.
C) Encouraging more work and delaying retirement.
D) Resulting in less investment in home ownership and more intostocks.

9
If a public corporation goes bankrupt and does not have enoughassets to pay off all creditors:
A) The stockholders are personally liable for the balance.
B) The fact that stockholders are residual claimants means they mayhave to pay in additional capital to cover the obligations.
C) The stockholders receive any dividends due before the othercreditors are paid.
D) The stockholders cannot lose more than their investment.

10
The Dow Jones Industrial Average:
A) Gives equal weight to a change in the price of the stock of anycompany in the index.
B) Reflects that a 10% increase in a share of stock selling for $30will have the same affect on the index as a 10% increase in theprice of a stock selling for $60.
C) Is a value-weighted index.
D) Gives greater weight to shares with higher prices.

11
The Standard & Poor's 500 Index differs from the Dow JonesIndustrial Index because:
A) It takes into account the stock prices of 500 of the largestfirms, which is less than the DJIA.
B) It is a price-weighted index, where the DJIA is a value-weightedindex.
C) Larger firms are less important in the S&P 500 than in theDJIA.
D) It takes into account the prices of more stocks and it uses adifferent weighting scheme.

12
The theory of efficient markets implies:
A) Stock prices should be highly unpredictable.
B) The price at which stocks currently trade only reflects pastinformation.
C) Expectations do not play a role in stock prices because thisisn't real information.
D) The chartists are in fact correct that there are patterns instock prices.

13
The theory of efficient markets me
A) Professional fund managers should be able to consistently beatthe market average.
B) A professional fund manager should really not expect to beat themarket average consistently.
C) A professional fund manager who beats the market average oneyear should expected to beat the market average the nextyear.
D) A professional fund manager who beats the market average oneyear should be expected to not beat the market average the nextyear.

14
Stocks appear to present risk, yet many people have substantialparts of their wealth invested in them. This behavior could beexplained by the fact that:
A) People are irrational in their investment behavior, onlyfocusing on positive outcomes.
B) People are not very risk-averse and do not require a riskpremium for stocks.
C) Investing in stocks over the long run is not as risky asshort-term holdings.
D) People are not efficient users of information.

15
The price of a stock is currently $750 and the stock will pay a $43dividend. The interest rate is 7.5%. Based on the dividend-discountmodel, what is the expected price of this stock for nextyear?
A) $651.17.
B) $657.67.
C) $691.17.
D) $763.25.

[1] The explicit costs, such as the legal expenses, associated with corporate default are classified as _____ costs.
[A] beta conversion
[B] direct bankruptcy
[C] indirect bankruptcy

[2] An indirect cost of bankruptcy is the loss of key employees.
[A] True
[B] False

[3] A legal attempt to financially restructure a failing firm so that it can continue operating as a going concern is called a reorganization.
[A] True
[B] False

[4] The optimal capital structure has been achieved when the:
[A] weight of equity is equal to the weight of debt.
[B] debt-to-equity ratio selected results in the lowest possible weighted average cost of capital.
[C] cost of equity is maximized.

[5] The optimal capital structure will tend to include more debt for firms with:
[A] less taxable income.
[B] lower probability of financial distress.
[C] substantial tax shields from other sources.

[6] The optimal capital structure of a firm:
[A] will remain constant over time unless the firm makes an acquisition.
[B] will be the same for all firms in the same industry.
[C] will vary over time as taxes and market conditions change.

[7] In a world with corporate taxes, MM theory implies that that all firms should choose an all-debt capital structure.
[A] True
[B] False

[8] A firm is technically insolvent when:
[A] the value of its stock declines by more than 50 percent in any given 12-month period.
[B] the value of the firm's assets is less than the value of the firm's liabilities.
[C] it is unable to meet its financial obligations.

[9] Which one of the following statements is correct concerning a Chapter 7 bankruptcy?
[A] A firm reorganizes its operations in an effort to return to being a viable concern.
[B] A trustee will assume control of the firm's assets until those assets can be liquidated.

[10] If the net present value of a project is positive (non-zero), then the project's internal rate of return will exceed its required rate of return.
[A] True
[B] False

[11] Which one of these methods uses accounting values rather than financial values?
[A] AAR
[B] IRR
[C] NPV

[12] An investment should be accepted if the NPV is positive and rejected if it is negative.
[A] True
[B] False

[13] The length of time required for an investment to generate cash flows sufficient to recover the initial cost of the investment is called the:
[A] net present value.
[B] payback period.
[C] internal rate of return.

[14] An investment is acceptable if its average accounting return (AAR):
[A] exceeds the target AAR.
[B] is less than the target AAR.

[15] The discount rate that makes the net present value of an investment exactly equal to zero is called the internal rate of return.
[A] True
[B] False

[16] The most valuable investment given up if an alternative investment is chosen is referred to as a(n):
[A] sunk cost.
[B] opportunity cost.
[C] erosion cost.

[17] The cost of test marketing a product prior to deciding whether or not to produce the product is a sunk cost.
[A] True
[B] False

[18] An asset will be depreciated faster using MACRS rather than the straight-line method.
[A] True
[B] False

[19] The financial break-even point determines which one of these values?
[A] Fixed costs
[B] Variable cost per unit
[C] Sales quantity

[20] The return earned in an average year over a multi-year period is called the _____ average return.
[A] arithmetic
[B] standard
[C] geometric

[21] The capital gains yield plus the dividend yield on a security is called the:
[A] geometric return.
[B] total return.
[C] variance of returns.

[22] Which one of the following is an example of a nondiversifiable risk?
[A] A poorly managed firm suddenly goes out of business due to lack of sales
[B] A key employee of a firm suddenly resigns and accepts employment with a key competitor
[C] A well respected chairman of the Federal Reserve suddenly resigns

[23] Beta values are highly dependent on the covariance of a security with the market.
[A] True
[B] False

[24] Insider trading does not offer any advantages if the financial markets are:
[A] inefficient.
[B] semiweak form efficient.
[C] strong form efficient.

[25] MM Propositions ignore bankruptcy costs.
[A] True
[B] False

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BFN 110 Lecture Notes - Lecture 15: Risk-Free Interest Rate, Risk Premium, Efficient-Market Hypothesis

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