Stock Markets Overview

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Questions and Answers

What is the main premise of the capital asset pricing model (CAPM)?

The model only considers unsystematic risk, which is specific to individual firms.

Only systematic risk, which is related to overall market movements, is relevant. (correct)

The model focuses on total risk, including both systematic and unsystematic risk.

All risks, both systematic and unsystematic, must be considered.

Which factor is NOT explicitly included in the Arbitrage Pricing Model (APM)?

Inflation

Economic growth

Company-specific risk (correct)

Market risk

What does the beta coefficient (Bj) represent in the CAPM formula?

The standard deviation of the asset's returns

The expected return of the asset

The sensitivity of an asset's return to changes in the market return (correct)

The risk-free rate of return

Which of these is NOT a method for measuring a stock's risk?

Sharpe Ratio (C) Signup and view all the answers

How is a stock's volatility generally measured?

By calculating the variance of its returns (B) Signup and view all the answers

What is the relationship between the beta of a stock and its risk?

A higher beta indicates higher risk, and a lower beta indicates lower risk. (B) Signup and view all the answers

How is the beta of a stock commonly estimated?

By using time-series analysis to study historical data (B) Signup and view all the answers

Value-at-Risk (VaR) is most closely associated with which type of risk?

Financial risk (A) Signup and view all the answers

What is the primary reason companies issue stocks?

To raise capital for company growth (D) Signup and view all the answers

Which of the following is NOT a category of stocks?

High-yield stocks (A) Signup and view all the answers

What is the primary advantage of investing in common stock?

Potential for capital appreciation (B) Signup and view all the answers

Which of the following is a method of valuing stocks based on discounted cash flows?

Dividend Discount Model (DDM) (D) Signup and view all the answers

What is the purpose of the required rate of return?

To determine the value of a share (D) Signup and view all the answers

What is a distinguishing characteristic of blue-chip stocks?

They are shares in large, well-established companies. (A) Signup and view all the answers

Which of the following is NOT a factor that influences the required rate of return on a stock?

Company's sales revenue (D) Signup and view all the answers

Which statement regarding institutional investors' participation in the stock market is TRUE?

Institutional investors are the main drivers of stock price fluctuations. (D) Signup and view all the answers

Which of these situations would provide the best measure of a stock's performance using the Treynor Index?

When a stock's performance is being evaluated by its beta value. (B) Signup and view all the answers

If a stock market is said to be semistrong-form efficient, what does it imply?

The stock prices fully reflect all publicly available information, including announcements by firms, economic news, and political news. (C) Signup and view all the answers

What does a high Sharpe Index indicate about a stock's performance?

A higher return for a given level of risk compared to other stocks. (C) Signup and view all the answers

Which of these is NOT a characteristic of a stock market that is considered to be strong-form efficient?

The market is weak-form efficient and semistrong-form efficient. (C) Signup and view all the answers

Which of these would be considered a type of public information relevant to a stock's performance?

A company's recent announcement about a new product launch. (B) Signup and view all the answers

What is one implication of a stock market being weak-form efficient?

It's impossible to predict future price movements based on past price data. (A) Signup and view all the answers

Which of the following statements best describes the relationship between the Sharpe Index and the Treynor Index?

The two indices measure different aspects of a stock's performance; the Sharpe Index emphasizes overall risk, while the Treynor Index focuses on systematic risk. (D) Signup and view all the answers

If you are 95% confident that your worst daily loss on a $100 investment will not exceed $4, how much is the maximum possible loss expressed as a percentage?

-4% (D) Signup and view all the answers

Study Notes

Stock Markets: Learning Objectives

Describe the purpose of stock markets.
Explain methods of valuing stocks and determining the required rate of return.

What are Stocks?

Stocks are securities that represent a share of ownership in a company.
Stocks are also called equities.

Who are the Market Participants?

Individuals: Investments by individuals in large corporations often exceed 50% of the total equity. Individual investments are usually small, resulting in ownership being spread among many shareholders.
Institutions: Financial institutions like commercial banks, stock-owned savings institutions, savings banks, finance companies, stock mutual funds, securities firms, insurance companies, and pension funds participate in stock markets. Their participation takes various forms, including issuing stock, managing trust funds containing stocks, investing in stocks for portfolios, and using proceeds to invest in stocks. Pension funds often invest a significant portion of their contributions in the stock market.

Role & Function of Stock Markets

Stock markets facilitate the flow of funds from households, mutual funds, and other institutional investors to corporations to support expansion, operations, and investments.

Why People Buy Stocks?

Capital appreciation: Increased stock prices.
Dividend payments: Distributions of company earnings to stockholders.
Voting rights: Ability to vote and influence company decisions.

Why Companies Issue Stocks?

Funding: Raise capital for various purposes including paying off debt, launching new products, expanding into new markets, and enlarging facilities.

What Kinds of Stocks are There?

Common stock: Standard stock
Preferred stock: A separate class of stock

What Categories of Stocks are There?

Growth stocks: Earnings grow faster than market average.
Income stocks: Pay consistent dividends.
Value stocks: Low price-to-earnings ratio (PE ratio).
Blue-chip stocks: Shares in large, established companies with a proven history of growth.

Stock Valuation

The present value of a stock is the sum of the present values of all future dividend payments.

Required Rate of Return on Stocks

Present Value of a stock: A formula calculating the present value of a stock based on future dividend payments.
Required rate of return estimation methods:
- Capital asset pricing model (CAPM): Assumes the only relevant risk of a firm is the systematic risk of exposure to general stock market movements. Unsystematic risk is irrelevant.
  - The formula is Rᵢ = Rf + Bi(Rm - Rf) where: Rᵢ = return of an asset; Rf = prevailing risk-free rate; Rm = market return; Bi = beta of the asset.
- Arbitrage pricing model (APM): A model suggests that a stock's price can be influenced by a set of factors, in addition to the market, such as economic growth and inflation. The formula is E(R) = Bo + ∑ BiFi. Where: E(R) = expected return of the asset; Bo = a constant; Bi = Sensitivity of the asset return to a particular force; Fi...Fm = values of factors 1 to m

Factors That Affect Stock Prices

International economic conditions
U.S. fiscal policy
U.S. monetary policy
U.S. economic conditions
Industry conditions
Firm-specific conditions
Stock market conditions
Market risk premium
Firm's systematic risk (Beta)
Risk-free Interest Rate
Firm risk premium
Expected Cash Flows

Stock's Risk Measurement

Volatility: Indicates uncertainty about future returns; measured using standard deviation.
Beta: Estimated by obtaining past returns of the firm and the market; using regression analyses.
Value-at-risk (VaR): Measures potential loss in value of an asset or portfolio.

Measuring Stock Performance

Sharpe index: Measures excess return above the risk-free rate per unit of risk. A higher index implies better performance.
- The formula is (R - Rf) / σ.
Treynor index: Measures excess return above the risk-free rate per unit of beta. A higher index implies better performance.
- The formula is (R - Rf) / β.

Can Investors Earn Abnormal Returns?

Stock Market Efficiency

Weak-form efficiency: Security prices reflect all past trade-related information, such as historical prices and trading volume.
Semistrong-form efficiency: Security prices reflect all publicly available information, such as announcements by firms, economic news, and political events.
Strong-form efficiency: Security prices reflect all information, including private or insider information.

Key Takeaways

When valuing a stock using the free cash flow model, an accurate estimate of the required rate of return is essential.
Stock prices are influenced by factors affecting future cash flows and the investors' required return.
Stock risk is measured by volatility, beta, and value-at-risk.
Stock market efficiency implies stock prices reflect available information.

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Description

This quiz focuses on the fundamental aspects of stock markets, including their purpose and the methods used for valuing stocks. Participants will explore the roles of different market participants, from individuals to institutions. Test your knowledge on how stock ownership and investment strategies are structured within the market.