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Chapter 8 Stocks, Stock Markets, and Market Efficiency Conceptual and Analytical Problems Explain why being a residual claimant makes stock ownership risky. Answer: Stockholders do not receive dividends unless all of the firm’s 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. Do individual shareholders have an effective say in corporate governance matters? Answer: In principle, shareholders have a say on corporate affairs. They elect members of the company’s board of directors and can vote on important issues raised at the company’s annual meeting. Furthermore, they can offer resolutions to be voted on at the annual meeting. However, individual shareholders usually have one vote for each share owned. With large companies having millions of shares outstanding, the impact of a small shareholder is limited. In addition, while shareholders vote to elect directors, managers, rather than owners, often control the overall board. Consider the following information on the stock market in a small economy.
Company Shares Outstanding Price, beginning of year Price, end of year
1 100 $100 $94
2 1,000 $20 $25
3 10,000 $3 $6
Compute a price-weighted stock price index for the beginning of the year and the end of the year. What is the percentage change? Compute a value-weighted stock price index for the beginning of the year and the end of the year. What is the percentage change? Answer: For a price-weighted index, we find the cost of buying one share of each company at the beginning of the year is $123 = $100 + $20 + $3. The cost of buying one share of each at the end of the year is $125 = $94 + $25 + $6. So the percentage change is 1.6%. The percentage change in a value-weighted index is given by percentage change in the sum of the values of the companies. At the beginning of the year, the value of the companies is given by $60,000 = $100(100) + $20(1,000) + $3(10,000). At the end of the year, the value is $94,400 = $94(100) + $25(1,000) + $6(10,000) So, the percentage change is 57.3%. To raise wealth and stimulate private spending, suppose the central bank lowers interest rates, making stock market investment relatively attractive. Which stock market index would you monitor to judge the effectiveness of the policy: the Dow Jones Industrial Average or the S&P 500? Why? Answer: Since the S&P 500 is a value-weighted index, it tracks the value of owning each of the companies in the index. Thus, it is a measure of stock market wealth. The DJIA, in contrast, is a price-weighted index that sums the cost of a single share of each of the stocks in the index. As such, it does not measure wealth. Suppose you see evidence that the stock market is efficient. Would that make you more or less likely to invest in stocks for your 401(k) retirement plan when you get your first job? Answer: Efficient markets suggest that all relevant information is incorporated into stock prices, and that changes in prices on a particular day reflect that day’s “news.” In this view, prediction of stock prices into the future is equivalent to trying to forecast generally unknowable events. Your decision to invest in equities for retirement likely is based on other information, like your attitude toward risk and knowledge of the historical long-run performance of a diversified portfolio of stocks. Professor Siegel argues that investing in stocks for retirement may be less risky than investing in bonds. Would you recommend this approach to an individual in his or her early 60s? Answer: The closer an individual is to retirement, the less time for a portfolio to overcome downward shocks to its value. Consequently. allocating retirement funds to a stock portfolio is riskier for a 60-year old than for a 25-year old. Investment advisors often suggest that those close to retirement lower the fraction of their savings exposed to equities. How do venture capital firms, which specialize in identifying and financing promising but high-risk businesses, help the economy grow? Answer: New companies often have difficulty finding financing to put their plans into action. Venture capital firms specialize (say, in one particular industry) in identifying promising firms and providing early-stage funding. As a result, companies with productive uses of funds that could not get start-up loans from traditional intermediaries may succeed in bringing their good or service to the economic marketplace. The resulting shift of resources to more productive activities boosts incomes and economic growth. 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. 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 2½ percent, the growth rate of dividends is 1 percent and the current level of dividends is $70, 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: If the current dividend is $70, the risk-free rate is 2.5 percent and the growth rate of dividends is 1 percent the value of the S&P 500 index warranted by fundamentals is: P = $70(1.01) / (0.025 – 0.01) = $4,713.33 On January 3, 2017, the S&P 500 was at $2,257.83. This suggests either that the stocks in the index are undervalued, or that that the equity risk premium is positive. Investors may have viewed the competing risk-free yield as unsustainably low. Why is a booming stock market not always a good thing for the economy? 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. 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 day’s 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 performance as percentage changes is the best solution. You are thinking about investing in stock in a company which paid a dividend of $10 this year and whose dividends you expect to grow at 4 percent a year. The risk free rate is 3 percent and you require a risk premium of 5 percent. 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. Consider again the stock described in Problem 12. 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. 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.
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 bonds Pay to equity holders Equity return Expected Value Standard Deviation
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. Your brother has a $1,000 and a one-year investment horizon and asks your advice about whether he should invest in a particular company’s 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. 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.) Do you think a proposal to abolish limited liability for stockholders would be supported by companies issuing stock? 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. 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. 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. 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. 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. Memories of the 2007-2009 financial crisis have made you more risk averse, doubling the risk premium you require to purchase a stock. Suppose that your risk premium before the crisis was 4 percent and that you had been willing to pay $412 for a stock with a dividend payment of $10 and expected dividend growth of 3 percent. Using the dividend discount model, with unchanged risk-free rate, dividend payment and expected dividend growth, what price (rounded to the nearest dollar) would you now be willing to pay for this stock? Answer: First, use the dividend discount model formula to calculate the risk-free interest rate. Ptoday = Dtoday (1 + g)/(rf + rp - g) $412 = 10(1.03)/(rf + 0.04 - 0.03) This gives rf = 0.015 or 1.5% Using this information, calculate the price you would be willing to pay with rp = 0.08. Ptoday = 10(1.03)/0.015 + 0.08 - 0.03 = $158.4615 = $158 Suppose a shock to the financial system were to disproportionately hit corporate bond markets making it much harder for companies to raise new funds via bond issuance. As a result, the proportion of equity financing rises significantly. What impact would you anticipate this would have on i) the expected return on holding stocks and ii) the volatility of equity returns? Answer: As the proportion of a company’s financing via equity versus debt rises, the company’s leverage falls. While this shift reduces the expected return to equity holders, it also reduces the standard deviation of equity returns. ii) The decline in volatility of equity returns reflects the residual claimant status of stockholders. With a smaller proportion of bondholders to be paid ahead of equity holders, the standard deviation of equity returns is lower. Data Exploration: How well does the stock market anticipate the behavior of the economy? Plot on a monthly basis since 1972 the percentage change from a year ago of the Wilshire 5000 index (FRED code: WILL5000PR). Is the index a reliable predictor of business cycle downturns (depicted in the graph by vertical, shaded bars)?
Answer: The data plot is:
Wilshire Associates, Wilshire 5000 Price Index© [WILL5000PR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WILL5000PR, August 15, 2016.
Among various measures of financial conditions, a broad index of the stock market is one of the best predictors of economic downturns and upturns because investors are forward-looking and know that future profits and dividends depend on prospective economic activity. In the case of the Wilshire 5000, the index fell below the year-ago level before the recessions of 1973 and 2001 (recessions appear as vertical gray bars in the graph). And, it fell below the year-ago level in the first or second month of the recessions of 1981, 1990, and 2008. However, the index also fell below the year-ago level in the absence of a subsequent economic downturn once in the 1970s, twice in the 1980s, and once in the 2000s. Accordingly, a famous economist once quipped decades ago: “The stock market forecast nine of the past five recessions.” Why might the stocks of small firms outperform large firms over long periods of time? Will this hold over short periods of time, too? Plot since 1979 the stock indexes for small firms (FRED code: WILLSMLCAP) and large firms (FRED code: WILLLRGCAP) using annual data scaled to a common base year of 1979 = 100. Answer: The data plot is: Wilshire Associates, Wilshire US Small-Cap Total Market Index© [WILLSMLCAP] and Wilshire US Large-Cap Total Market Index© [WILLLRGCAP], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WILL5000PR, August 15, 2016. Because risk requires compensation, we expect the stocks of small firms (that have a higher probability of failure) to offer higher returns than the stocks of large firms. However, this pattern need not hold over any short-term period. For example, the out-performance of large-cap stocks in the late 1990s probably reflects the “dot.com” equity bubble. In that period, technology companies that initially were classified as “small cap” were reclassified as “large cap” as the boom proceeded, and then saw their values plunge when the boom went bust. The NASDAQ stock market index (FRED code: NASDAQCOM) is comprised of stocks that tend to be relatively new and focused on technology, while the Wilshire 5000 (FRED code: WILL5000PR) includes all actively traded stocks in the United States. Which do you think is more volatile? Plot on a monthly basis from 1980 the percent change from a year ago of these two indexes and discuss whether your intuition was correct. Answer: The data plot is: NASDAQ OMX Group, NASDAQ Composite Index© [NASDAQCOM], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/NASDAQCOM. Wilshire Associates, Wilshire 5000 Price Index© [WILL5000PR], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WILL5000PR. Answer: The components of the NASDAQ hint that this index would be more volatile than the broader Wilshire 5000. This was clearly true in the “dot.com” boom of the 1990s that culminated in the bust at the turn of the century. Since then, the volatility of the two has been similar. In part, this similarity reflects the large number of stocks in each index (NASDAQ has about 3,000 stocks and the Wilshire 5000 less than 4,000). Moreover, the largest proportion of equities in the Wilshire 5000 are NASDAQ stocks, suggesting that their statistical properties should be broadly similar. To see the impact of the bubble in internet stocks on household wealth, plot on a monthly basis since 1980 the NASDAQ stock index (FRED code: NASDAQCOM) on the left axis and the market value of nonfarm nonfinancial corporations (FRED code: MVEONWMVBSNNCB) on the right axis. Comment on the impact of the bursting of the bubble on this measure of equity wealth. Aside from the NASDAQ decline, what else might have caused it to drop? Answer: The plot is: NASDAQ OMX Group, NASDAQ Composite Index© [NASDAQCOM], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/NASDAQCOM, August 15, 2016. Wealth as measured by the value of corporations fell along with the NASDAQ index, but by a smaller percentage. On a monthly basis, the NASDAQ peaked at a value of 4802 in March 2002, when the value of corporations was $15,172 billion. By September 2002, the NASDAQ had fallen to 1251, a plunge of about 74%. The value of corporations had fallen to $7,526 billion, a decline of 50%. The NASDAQ was dominated by new internet companies. When their stock prices collapsed, their values fell by more than those of established, stable firms that are included in the broad wealth measure. Nonetheless, the impact on wealth of the bursting of the bubble was sizable. Wealth may also have declined due to falling income in the recession of 2001 that also diminished the value of firms not included in the NASDAQ. Have stock dividends become a more important source of income to U.S. households? Plot on a quarterly basis since 1959 the share of dividend income (FRED code: B703RC1Q027SBEA) in personal disposable income (FRED code: DSPI). Can you explain the 50-year trend? Answer: The data plot is: Several factors may explain the rise in dividend income as a proportion of disposable income. Ownership of equity has become much more widespread over this period. Part of that shift may reflect demographics, as a larger share of the population saves for retirement. Another part may reflect the gradual migration of firms’ pension programs from traditional defined-benefit schemes toward defined-contribution plans (including so-called 401(k) plans). Advisers of these pension plans often encourage workers to hold their retirement accounts partly in stocks. The improved liquidity of stocks likely also has encouraged the trend. Finally, the decline in top marginal tax rates probably made dividends relatively more attractive to investors over time indicates more difficult problems. Solution Manual for Money, Banking and Financial Markets Stephen G. Cecchetti, Kermit L. Schoenholtz 9781259746741, 9780078021749, 9780077473075
