Chapter 7: Stock Price Behavior and Market Efficiency

Areas of focus for the FINA 405 Mid Term

Test is administered online, there are 40 questions. You’ll have 2 hours to take the exam. You can use a sheet of notes, both front and back can be filled with notes and formulas and anything else.

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Where you should focus your prep

Know how to calculate the dollar and percentage return on an investment. (Reference Chapter 1)

Know how to calculate an annualized rate of return.

Know how to calculate a geometric average return

You need to be able to calculate a percentage return on an investment if you’re given information that you can use to calculate the change in value and income received. (Reference Chapter 1)

You need to know what we mean by the risk free rate. (Reference Chapter 1)

You should understand what we mean when we say plus or minus one standard deviation; plus or minus two standard deviations; plus or minus three standard deviations.

You should know what short selling is. (Reference Chapter 2)

Know about margin trading concepts: be able to calculate the price at which an investor would receive a margin call if they purchased shares on margin. Determine what the price needs to fall to that would trigger a margin call. (Chapter reference 2)

You should be able to identify the impacts of margin trading. (Reference Chapter 2)

You should understand what we mean by asset allocation. (Reference several Chapters)

You should understand what initial margin is and what maintenance margin is. (Reference Chapter 2)

Know the difference between options and futures contracts and when you’re obligated to transact: for example, options buyers have the right to transact, futures buyers have an obligation to deliver the terms of the futures contract unless the contract is closed prior to expiration. (Reference Chapter 3)

Understand what needs to happen to the value of an underlying asset for options buyers, and futures buyers to make money, i.e., understand the profit profile of derivatives buyers. Also understand the profit profile for options and futures sellers, i.e, how sellers of derivatives make money. (Reference Chapter 3)

You need to be able to calculate the cost, proceeds and profit if you were to buy a put option. You need to remember that there’s a multiplier involved–there are 100 options per contract, so when you’re calculating your numbers, whether it be cost, proceeds, or profits, make sure to consider this: if for example you were working with 5 contracts, you need to make sure to multiply those contracts by 100 options. If the option cost was $1.50 per option and you bought 5 contracts, you’re spending 5 x 100 x 1.50. (reference Chapter 3)

If given a PE ratio, a stock price and shares outstanding, you need to be able to calculate net income. (Reference Chapter 3)

If given income, equity, shares outstanding and price per share, you should be able to calculate a firm’s PE ratio.

You should be able to distinguish between several types of investments, i.e., you should understand the characteristics of different types of investments, such as the return profile, and the risk profile of treasury bills, government bonds, small company stocks, large company stocks and corporate bonds. You should also be able to describe money market instruments. (Reference Chapter 1 and Chapter 3)

You should understand what needs to happen in order for the seller of a call option to make money; what needs to happen in order for the buyer of a call option to make money; what needs to happen in order for the seller of a put option to make money; and what needs to happen in order for the buyer of a put option to make money. (Reference Chapter 3)

You should understand the characteristics of money market instruments (Reference Chapter 3)

Understand basic bond terminology an definitions. Know what Par Value (sometimes called face value) is, and what it’s used for; know what a bond’s coupon rate is for, and how to use it to calculate the interest payment on a bond. Know what a bond’s current yield is, and know how to calculate it. It won’t hurt to include the current yield formula on your notes sheet. (reference Chapter 3)

Understand different categories of mutual fund investing: for example, what are growth funds, sector funds, global funds, index funds, equity income funds. (Reference Chapter 4)

Be able to calculate the Net Asset Value (NAV) of a mutual fund if given market value, liabilities, and shares outstanding (Reference Chapter 4)

Know what a hedge fund is (Reference Chapter 4)

You should understand the characteristics and advantages of mutual funds (Reference Chapter 4).

You need to be able to calculate the return on a price weighted index. (Reference Chapter 5)

You need to understand the difference between an initial public offering and a seasoned equity offering. (Reference Chapter 5)

Know what a rights offer is. (Reference Chapter 5).

Know the difference between a value weighted index and a price weighted index. Be able to determine the return on an index. The return on an index is done the same way as the return for any other asset, you just won’t have any income: (Ending Value – Beginning value) / (Beginning value). For value weighted indexes, be able to create the index’s beginning value and ending value in order to calculate the index return. (Reference Chapter 5)

Understand the IPO process. Know about the different underwriting methods that companies and bankers have to choose from in order to bring their issues to market: for example, know what best efforts underwriting is, know what a Dutch auction process means, know what guaranteed sale underwriting is, and know what firm commitment underwriting is. (Reference Chapter 5)

Know what venture capital and private equity are. (Reference Chapter 5)

You should be able to use the constant dividend growth model in order to calculate a required rate of return, i.e., the variable (k) in those formulas. (Reference Chapter 6)

You need to be able to calculate a stock price based on the two stage dividend growth model, where there’s a dividend growth rate for a certain period of time, and then another dividend growth rate that would begin at some point in the future. (Reference Chapter 6)

Know how to calculate risk premium. In the CAPM model it’s the market rate of return minus the risk free rate. For an individual stock it’s the stock’s return minus the risk free rate. (Reference Chapter 1 and Chapter 6)

You should be able to use the residual income model for stock valuation in order to calculate a firms’ PE ratio. (Reference Chapter 6)

You need to be able to calculate a firm’s stock price using the constant dividend growth model. (Reference Chapter 6)

Understand what Beta is, what it measures and how it influences the expected return / discount rate that is calculated from the CAPM formula. You should be familiar with the CAPM formula, it’s inputs and variables. It won’t hurt to include the CAPM formula on your notes sheet. (Reference, Chapter 6)

Know how to calculate abnormal returns, i.e., the actual observed return minus the expected return. (Reference Chapter 7).

You need to be able to calculate a cumulative abnormal return. (Reference Chapter 7)

You should have a sense for how index funds do compared to actively managed funds. (Reference Chapter 7).

Understand different investment strategies that have the potential to expose market inefficiencies: understand which strategies are backed by solid research. Focus on the following strategies: Selling stocks on Mondays, Selling Small Company stocks in December and repurchasing them in February, selling stocks on the 25th of the month and repurchasing them on the 5th of the following month, selling stocks as soon as positive earnings surprises are announced, buying stocks with relatively low P/E ratios. (Reference Chapter 7)

(Reference Chapter 8)

You need to be able to distinguish between technical analysis and fundamental analysis. (Reference chapter 8)

You should understand what a bull market is, what a bear market is, what a stock market bubble is. (Reference Chapter 8)

Know the roles and tendencies of different types of market participants are, including: specialists, noise traders, sentiment traders, arbitrageurs, and market makers. (Reference multiple chapters mostly Chapter 5, some Chapter 8)

Be able to calculate a moving average (Reference Chapter 8)

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