Question

True or False. Briefly explain your answers.

a) If the dividend-price ratio is stable in the long run, then a low dividend-price ratio today predicts either high returns or low dividend growth in the future.

b) Since 250 stocks have estimates of Jensen's alpha that are statistically different from zero at the 5% level of significance, the CAPM does not provide a valid description of the relationship between risk and expected return for the stock market.

c) If the nominal interest rate is positive, then the real interest rate is also positive.

d) The random walk hypothesis states that a stock's price moves randomly and is not determined by fundamentals such as expected future dividends or earning

Answer 1

a) True. As the dividend to price ratio drops means either the numerator has decreased i.e. dividend growth is low in the future or the denominator has increased i.e. capital appreciation or market price appreciation due to expected high returns from the stock.

b) True. Jensen's alpha is the risk-adjusted measure i.e. return above or below that is predicted by CAPM. So if Jensen's alpha is statistically not zero with a confidence interval of 95%, then the CAPM does not provide a valid description of the relationship between risk and expected return for the stock market.

c) False. As the nominal rate is the sum of the real rate and inflation rate. so it is a possibility where real rates are negative but the inflation is greater than the absolute value of real rate and hence the sum becomes positive. (e.g. real rate = -2% and inflation = 4%)

d) True as random walk hypothesis says stock price changes randomly and hence cannot be predicted.