Question

True or False. Briefly explain your answers.

a. Very risk-averse investors will tend to short the riskless asset to nance a levered position in the stock market.

b. According to the random walk hypothesis, stock returns are not predictable.

c. The Gordon growth model assumes that the growth rate of expected dividends moves around from one period to the next.

Answer 1

a.False

Reason:Very risk averse investor will generally prefer to purchase the securities having lower risk even if they are giving him lesser returns.He will purchase larger volume of risk free asset and lower volume of risky asset in his portfolio.If he short the riskless asset now it means that he will sale the riskless asset now and will purchase it in future date to complete the contract.But if he does that then at present he will have more risky securities than riskless securities in his hand to trade with due to which overall portfolio risk at present would be higher.Hence he should purchase more risk free securities at present.

b.True.

Reason:Random Walk hypothesis states that stock market prices are evolve randomly .According to random walk theory the stock exchange prices can never be predicted since they are merely"statistical ups and down"and are not the result of any basic factors.Accordingly the behaviour of stock exchange prices is almost unpredictable and there can be no relationship between the present stock exchange prices of the securities and their future prices.Because of these reasons stock returns are not predictable.

C.False

Reason:Gordon growth rate model find outs intrinsic value of stock based on expected dividend that grows at a constant rate.This model assumes constant growth rate of expected for dividend in perpetuity.As one of the assumptions in this model is retention ratio remains constant and hence growth rate is also constant(g=br).Hence growth rate of dividend does not move around from one period to the next.