Chapter 7: Rational Expectations, Efficient Markets, and the Valuation of Corporate

Equities
4) Forecasts satisfying rational expectations are unbiased.
7) Expectations are rational if they are formed using all relevant information.
8) If investors do not have rational expectations, asset markets are not strongly
efficient.
9) If investors do have rational expectations, asset markets are strongly efficient.
11) Earnings for a corporation are an example of a fundamental quantity
determining the price of that corporations stock.
12) All public corporations must pay a fraction of their profits as dividends.
13) The relevant interest rate when pricing a stock is called the required rate of
return.
14) The relevant interest rate when pricing a stock is called the yield to maturity.
15) Markets for financial assets are more efficient than the market for labor.
16) The price of a stock is directly related to earnings and the required rate of return.
17) The price of a stock is directly related to the expected future price and earnings.
18) According to the Gordon Growth Model, the price of a stock is directly related
to the expected growth rate of earnings.
21) If a market is strongly efficient, insider information does not help investors
make profits.
22) If a market is weakly efficient, insider information does not help investors make
profits.
23) Allocational efficiency means that past data on prices and fundamentals are fully
reflected in the price.
24) If a market is semi-strongly efficient, investors cannot use fundamental analysis
to make profits.
25) According to the Gordon Growth Model, an increase in the growth rate of
earnings would lead to an increase in the current value of a stock.

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27) Behavioral finance explains how investors form rational expectations.

28) Bubbles in financial markets are evidence that they are not strongly efficient.
29) The small firm effect might be due to high liquidity of those stocks.
30) Weakly efficient markets could have bubbles.
31) Mutual funds are inherently more risky than owning shares of a single stock.
34) When an asset can be purchased with cheap, borrowed money, that asset is a
good candidate for the development of a bubble).
Multiple Choice
1) If technical analysis cannot prove profitable information to investors, markets
satisfy
a) weak efficiency.
b) semi-strong efficiency.
c) strong efficiency.
d) all of the above.
2) If fundamental analysis does not help stock market investors make profits, then
the stock market is
a) allocationally efficient.
b) weakly efficient.
c) semi-strongly efficient.
d) all of the above.
3) An analyst says that inside information would not have helped investors forecast
the collapse of the stock market in 2008. This is true if markets satisfy
a) allocational efficiency.
b) weak efficiency.
c) semi-strong efficiency.
d) strong efficiency.
5) If insider information does help investors, the market cannot be
a) allocationally efficient.
b) weakly efficient.
c) strongly efficient.
d) The market can satisfy all these forms of efficiency.

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6) If an asset market is not weakly efficient, then it cannot be

a) semi-strongly efficient.
b) strongly efficient.
c) both of the above.
d) neither of the above.
12) The earnings for a company are $10 and they are expected to grow at 5%
annually. According to the Gordon Growth Model, if the required rate of return is
9%, then the price of the companys stock should be
a) $11.40.
b) $218.00.
c) $262.50.
d) $272.50.
13) The earnings for a company are $10 and they are expected to grow at 3%
annually. According to the Gordon Growth Model, if the required rate of return is
4%, then the price of the companys stock should be
a) $10.10.
b) $257.50.
c) $1030.00.
d) none of the above.
14) The earnings for a company are $10 and they are expected to grow at 2%
annually. According to the Gordon Growth Model, if the required rate of return is
5%, then the price of the companys stock should be
a) $210.
b) $510.
c) $525.50.
d) none of the above.
18) Laws that require companies to fully inform investors about debts and loans on
their balance sheets are intended to increase
a) transparency.
b) efficiency.
c) volatility.
d) all of the above.
19) Transparency laws are intended to reduce
a) efficiency.
b) earnings.
c) asymmetric information.
d) all of the above.
20) Increased transparency should lead to increased
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a)
b)
c)
d)

efficiency.
volatility.
asymmetric information.
all of the above.

21) If the _____ for a stock fall(s), the current price of the stock rises.
a) earnings
b) expected price
c) required rate of return
d) none of the above
22) If the _____ for a stock rise(s), the current price of the stock rises.
a) earnings
b) volatility
c) required rate of return
d) none of the above
24) Forecasting stock prices using trends of past data should not be an effective
method for making trading decisions if asset markets are
a) weakly efficient.
b) semi-strongly efficient.
c) strongly efficient.
d) all of the above.
25) Which of the following would be evidence that the stock market is not even
weakly efficient?
a) Stock prices move in a random walk.
b) Technical trading strategies are not profitable.
c) Stock prices tend to rise on Wednesdays.
d) All of the above.
26) Which of the following could be examples of inefficiencies in financial markets
data?
a) January effect
b) small firms effect
c) bubbles
d) all of the above
27) Which of the following could be examples of inefficiencies in financial markets
data?
a) random walk
b) high volatility
c) bubbles
d) all of the above

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Short Answer
1) What is an allocationally efficient market?
Allocational efficiency implies that resources are put to their most productive
use.
2) Why would transparency contribute to asset market efficiency?
Transparency makes information available to all market participants,
reducing asymmetric information that might allow some to make excess returns.
3) Does technical analysis produce forecasts that satisfy rational expectations?
Explain.
No. Technical analysis uses selected portions of past data, while rational
expectations uses all relevant information.
4) If insider information helps investors to make profits, what does that say about
the efficiency of the market?
5) If fundamental analysis helps investors to make profits, what does that say about
the efficiency of the market?
The market could be weakly efficient but not strongly or semi-strongly
efficient.
6) What is the most compelling evidence for a lack of efficiency in financial
markets? Can any type of efficiency be justified?
Bubbles show that fundamentals do not fully explain asset prices, so those
markets could be weakly efficient but not strongly or semi-strongly efficient.
7) What is short selling?
Short selling means selling an asset one does not own, promising to buy it
back at a future date.
14) The earnings for a company are $20, and they are expected to grow at 4%
annually. According to the Gordon Growth Model, if the required rate of return is
9%, what is the price of the companys stock?

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15) The earnings for a company are $12, and they are expected to grow at 5%
annually. According to the Gordon Growth Model, if the required rate of return is
15%, then the price of the companys stock should be
$126
18) What is a portfolio diversification investment strategy?
Portfolio diversification is an investment strategy often described as not
putting all of your eggs (money) in one basket (asset).
19) What is a sectoral asset allocation investment strategy?
Sectoral asset allocation strategy is a strategy is to invest heavily in stocks
and other risky assets when young but to shift into less volatile assets, like short
term bonds, as one nears retirement or other cash out event.

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