Chapter 1Why Study Financial Markets and Institutions?

Multiple Choice Questions

1. Financial markets and institutions

(a) involve the movement of huge quantities of money.(b) affect the profits of businesses.(c) affect the types of goods and services produced in an economy.(d) do all of the above.(e) do only (a) and (b) of the above.

Answer: D

2. Financial market activities affect

(a) personal wealth.(b) spending decisions by individuals and business firms.(c) the economy’s location in the business cycle.(d) all of the above.

Answer: D

3. Markets in which funds are transferred from those who have excess funds available to those who have a shortage of available funds are called

(a) commodity markets.(b) funds markets.(c) derivative exchange markets.(d) financial markets.

Answer: D

4. The price paid for the rental of borrowed funds (usually expressed as a percentage of the rental of $100 per year) is commonly referred to as the

(a) inflation rate.(b) exchange rate.(c) interest rate.(d) aggregate price level.

Answer: C

5. The bond markets are important because

(a) they are easily the most widely followed financial markets in the United States.(b) they are the markets where interest rates are determined.(c) they are the markets where foreign exchange rates are determined.(d) all of the above.

Answer: B

6. Interest rates are important to financial institutions since an interest rate increase _________ the cost of acquiring funds and _________ the income from assets.

(a) decreases; decreases(b) increases; increases(c) decreases; increases(d) increases; decreases

Answer: B

7. Typically, increasing interest rates

(a) discourage individuals from saving.(b) discourage corporate investments.(c) encourage corporate expansion.(d) encourage corporate borrowing.(e) none of the above.

Answer: B

8. Compared to interest rates on long-term U.S. government bonds, interest rates on _________ fluctuate more and are lower on average.

(a) medium-quality corporate bonds(b) low-quality corporate bonds(c) high-quality corporate bonds(d) three-month Treasury bills(e) none of the above

Answer: D

9. Compared to interest rates on long-term U.S. government bonds, interest rates on three-month Treasury bills fluctuate _________ and are _________ on average.

(a) more; lower(b) less; lower(c) more; higher(d) less; higher

Answer: A

10. The stock market is important because

(a) it is where interest rates are determined.(b) it is the most widely followed financial market in the United States.(c) it is where foreign exchange rates are determined.(d) all of the above.

Answer: B

Chapter 2Overview of the Financial System


1. Every financial market performs the following function:

(a) It determines the level of interest rates.(b) It allows common stock to be traded.(c) It allows loans to be made.(d) It channels funds from lenders-savers to borrowers-spenders.

Answer: D

2. Financial markets have the basic function of

(a) bringing together people with funds to lend and people who want to borrow funds.(b) assuring that the swings in the business cycle are less pronounced.(c) assuring that governments need never resort to printing money.(d) both (a) and (b) of the above.(e) both (b) and (c) of the above.

Answer: A

3. Which of the following can be described as involving direct finance?

(a) A corporation’s stock is traded in an over-the-counter market.(b) People buy shares in a mutual fund.(c) A pension fund manager buys commercial paper in the secondary market.

(d) An insurance company buys shares of common stock in the over-the-counter markets.(e) None of the above.

Answer: E

4. Which of the following can be described as involving direct finance?

(a) A corporation’s stock is traded in an over-the-counter market.(b) A corporation buys commercial paper issued by another corporation.(c) A pension fund manager buys commercial paper from the issuing corporation.(d) Both (a) and (b) of the above.(e) Both (b) and (c) of the above.

Answer: B

5. Which of the following can be described as involving indirect finance?

(a) A corporation takes out loans from a bank.(b) People buy shares in a mutual fund.(c) A corporation buys commercial paper in a secondary market.(d) All of the above.(e) Only (a) and (b) of the above.

Answer: E

6. Which of the following can be described as involving indirect finance?

(a) A bank buys a U.S. Treasury bill from one of its depositors.(b) A corporation buys commercial paper issued by another corporation.(c) A pension fund manager buys commercial paper in the primary market.(d) Both (a) and (c) of the above.

Answer: D

7. Financial markets improve economic welfare because

(a) they allow funds to move from those without productive investment opportunities to those who have such opportunities.(b) they allow consumers to time their purchases better.(c) they weed out inefficient firms.(d) they do all of the above.(e) they do (a) and (b) of the above.

Answer: E

8. A country whose financial markets function poorly is likely to

(a) efficiently allocate its capital resources.(b) enjoy high productivity.

(c) experience economic hardship and financial crises.(d) increase its standard of living.

Answer: C

9. Which of the following are securities?

(a) A certificate of deposit(b) A share of Texaco common stock(c) A Treasury bill(d) All of the above(e) Only (a) and (b) of the above

Answer: D

10. Which of the following statements about the characteristics of debt and equity are true?

(a) They both can be long-term financial instruments.(b) They both involve a claim on the issuer’s income.(c) They both enable a corporation to raise funds.(d) All of the above.(e) Only (a) and (b) of the above.

Answer: D

11. The money market is the market in which _________ are traded.

(a) new issues of securities(b) previously issued securities(c) short-term debt instruments(d) long-term debt and equity instruments

Answer: C

12. Long-term debt and equity instruments are traded in the _________ market.

(a) primary(b) secondary(c) capital(d) money

Answer: C

13. Which of the following are primary markets?

(a) The New York Stock Exchange(b) The U.S. government bond market(c) The over-the-counter stock market(d) The options markets(e) None of the above

Answer: E

14. Which of the following are secondary markets?

(a) The New York Stock Exchange(b) The U.S. government bond market(c) The over-the-counter stock market(d) The options markets(e) All of the above

Answer: E

15. A corporation acquires new funds only when its securities are sold in the

(a) secondary market by an investment bank.(b) primary market by an investment bank.(c) secondary market by a stock exchange broker.(d) secondary market by a commercial bank.

Answer: B

16. Intermediaries who are agents of investors and match buyers with sellers of securities are called

(a) investment bankers.(b) traders.(c) brokers.(d) dealers.(e) none of the above.

Answer: C

17. Intermediaries who link buyers and sellers by buying and selling securities at stated prices are called

(a) investment bankers.(b) traders.(c) brokers.(d) dealers.(e) none of the above.

Answer: D

18. An important financial institution that assists in the initial sale of securities in the primary market is the

(a) investment bank.(b) commercial bank.(c) stock exchange.

(d) brokerage house.

Answer: A

19. Which of the following statements about financial markets and securities are true?

(a) Most common stocks are traded over-the-counter, although the largest corporations have their shares traded at organized stock exchanges such as the New York Stock Exchange.(b) A corporation acquires new funds only when its securities are sold in the primary market.(c) Money market securities are usually more widely traded than longer-term securities and so tend to be more liquid.(d) All of the above are true.(e) Only (a) and (b) of the above are true.

Answer: D


(a) A bond is a long-term security that promises to make periodic payments called dividends to the firm’s residual claimants.(b) A debt instrument is intermediate term if its maturity is less than one year.(c) A debt instrument is long term if its maturity is ten years or longer.(d) The maturity of a debt instrument is the time (term) that has elapsed since it was issued.

Answer: C


(a) Few common stocks are traded over-the-counter, although the over-the-counter markets have grown in recent years.(b) A corporation acquires new funds only when its securities are sold in the primary market.(c) Capital market securities are usually more widely traded than longer term securities and so tend to be more liquid.(d) All of the above are true.(e) Only (a) and (b) of the above are true.

Answer: B

22. Which of the following markets is sometimes organized as an over-the-counter market?

(a) The stock market(b) The bond market(c) The foreign exchange market(d) The federal funds market(e) all of the above

Answer: E

23. Bonds that are sold in a foreign country and are denominated in that country’s currency are known as

(a) foreign bonds.(b) Eurobonds.(c) Eurocurrencies.(d) Eurodollars.

Answer: A

24. Bonds that are sold in a foreign country and are denominated in a currency other than that of the country in which they are sold are known as

(a) foreign bonds.(b) Eurobonds.(c) Eurocurrencies.(d) Eurodollars.

Answer: B

25. Financial intermediaries

(a) exist because there are substantial information and transaction costs in the economy.(b) improve the lot of the small saver.(c) are involved in the process of indirect finance.(d) do all of the above.(e) do only (a) and (b) of the above.

Answer: D

26. The main sources of financing for businesses, in order of importance, are

(a) financial intermediaries, issuing bonds, issuing stocks.(b) issuing bonds, issuing stocks, financial intermediaries.(c) issuing stocks, issuing bonds, financial intermediaries.(d) issuing stocks, financial intermediaries, issuing bonds.

Answer: A

27. The presence of transaction costs in financial markets explains, in part, why

(a) financial intermediaries and indirect finance play such an important role in financial markets.(b) equity and bond financing play such an important role in financial markets.(c) corporations get more funds through equity financing than they get from financial intermediaries.(d) direct financing is more important than indirect financing as a source of funds.

Answer: A

28. Financial intermediaries can substantially reduce transaction costs per dollar of transactions because their large size allows them to take advantage of

(a) poorly informed consumers.(b) standardization.(c) economies of scale.(d) their market power.

Answer: C

29. The purpose of diversification is to

(a) reduce the volatility of a portfolio’s return.(b) raise the volatility of a portfolio’s return.(c) reduce the average return on a portfolio.(d) raise the average return on a portfolio.

Answer: A

30. An investor who puts all her funds into one asset _________ her portfolio’s _________.

(a) increases; diversification(b) decreases; diversification(c) increases; average return(d) decreases; average return

Answer: B

31. Through risk-sharing activities, a financial intermediary _________ its own risk and _________ the risks of its customers.

(a) reduces; increases(b) increases; reduces(c) reduces; reduces(d) increases; increases

Answer: B

32. The presence of _________ in financial markets leads to adverse selection and moral hazard problems that interfere with the efficient functioning of financial markets.

(a) noncollateralized risk(b) free-riding(c) asymmetric information(d) costly state verification

Answer: C

33. When the lender and the borrower have different amounts of information regarding a transaction, _________ is said to exist.

(a) asymmetric information

(b) adverse selection(c) moral hazard(d) fraud

Answer: A

34. When the potential borrowers who are the most likely to default are the ones most actively seeking a loan, _________ is said to exist.

(a) asymmetric information(b) adverse selection(c) moral hazard(d) fraud

Answer: B

35. When the borrower engages in activities that make it less likely that the loan will be repaid, _________ is said to exist.

(a) asymmetric information(b) adverse selection(c) moral hazard(d) fraud

Answer: C

36. The concept of adverse selection helps to explain

(a) which firms are more likely to obtain funds from banks and other financial intermediaries, rather than from the securities markets.(b) why indirect finance is more important than direct finance as a source of business finance.(c) why direct finance is more important than indirect finance as a source of business finance.(d) only (a) and (b) of the above.(e) only (a) and (c) of the above.

Answer: D

37. Adverse selection is a problem associated with equity and debt contracts arising from

(a) the lender’s relative lack of information about the borrower’s potential returns and risks of his investment activities.(b) the lender’s inability to legally require sufficient collateral to cover a 100 percent loss if the borrower defaults.(c) the borrower’s lack of incentive to seek a loan for highly risky investments.(d) none of the above.

Answer: A

38. When the least desirable credit risks are the ones most likely to seek loans, lenders are subject to the

(a) moral hazard problem.(b) adverse selection problem.(c) shirking problem.(d) free-rider problem.(e) principal-agent problem.

Answer: B

39. Financial institutions expect that

(a) moral hazard will occur, as the least desirable credit risks will be the ones most likely to seek out loans.(b) opportunistic behavior will occur, as the least desirable credit risks will be the ones most likely to seek out loans.(c) borrowers will commit moral hazard by taking on too much risk, and this is what drives financial institutions to take steps to limit moral hazard.(d) none of the above will occur.

Answer: C

40. Successful financial intermediaries have higher earnings on their investments because they are better equipped than individuals to screen out good from bad risks, thereby reducing losses due to

(a) moral hazard.(b) adverse selection.(c) bad luck.(d) financial panics.

Answer: B

41. In financial markets, lenders typically have inferior information about potential returns and risks associated with any investment project. This difference in information is called

(a) comparative informational disadvantage.(b) asymmetric information.(c) variant information.(d) caveat venditor.

Answer: B

42. The largest depository institution at the end of 2004 was

(a) life insurance companies.(b) pension funds.(c) state retirement funds.

(d) none of the above.

Answer: D

43. Which of the following financial intermediaries are depository institutions?

(a) A savings and loan association(b) A commercial bank(c) A credit union(d) All of the above(e) Only (a) and (c) of the above

Answer: D

44. Which of the following is a contractual savings institution?

(a) A life insurance company(b) A credit union(c) A savings and loan association(d) A mutual fund

Answer: A

Chapter 3What Do Interest Rates Mean and What Is Their

Role in Valuation?


1. A loan that requires the borrower to make the same payment every period until the maturity date is called a

(a) simple loan.(b) fixed-payment loan.(c) discount loan.(d) same-payment loan.(e) none of the above.

Answer: B

2. A coupon bond pays the owner of the bond

(a) the same amount every month until maturity date.(b) a fixed interest payment every period and repays the face value at the maturity date.(c) the face value of the bond plus an interest payment once the maturity date has been

reached.(d) the face value at the maturity date.(e) none of the above.

Answer: B

3. A bond’s future payments are called its

(a) cash flows.(b) maturity values.(c) discounted present values.(d) yields to maturity.

Answer: A

4. A credit market instrument that pays the owner the face value of the security at the maturity dateand nothing prior to then is called a

(a) simple loan.(b) fixed-payment loan.(c) coupon bond.(d) discount bond.

Answer: D

5. (I) A simple loan requires the borrower to repay the principal at the maturity date along with an interest payment. (II) A discount bond is bought at a price below its face value, and the face value is repaid at the maturity date.

(a) (I) is true, (II) false.(b) (I) is false, (II) true.(c) Both are true.(d) Both are false.

Answer: C

6. Which of the following are true of coupon bonds?

(a) The owner of a coupon bond receives a fixed interest payment every year until the maturity date, when the face or par value is repaid.

(b) U.S. Treasury bonds and notes are examples of coupon bonds.(c) Corporate bonds are examples of coupon bonds.(d) All of the above.(e) Only (a) and (b) of the above.

Answer: D

7. Which of the following are generally true of all bonds?

(a) The longer a bond’s maturity, the lower is the rate of return that occurs as a result of the increase in an interest rate.

(b) Even though a bond has a substantial initial interest rate, its return can turn out to be negative if interest rates rise.

(c) Prices and returns for long-term bonds are more volatile than those for shorter-term bonds.

(d) All of the above are true.(e) Only (a) and (b) of the above are true.

Answer: D

8. (I) A discount bond requires the borrower to repay the principal at the maturity date plus an interest payment. (II) A coupon bond pays the lender a fixed interest payment every year until the maturity date, when a specified final amount (face or par value) is repaid.


Answer: B

9. If a $5,000 coupon bond has a coupon rate of 13 percent, then the coupon payment every year is

(a) $650.(b) $1,300.(c) $130.(d) $13.(e) None of the above.

Answer: A

10. An $8,000 coupon bond with a $400 annual coupon payment has a coupon rate of

(a) 5 percent.(b) 8 percent.(c) 10 percent.(d) 40 percent.

Answer: A

11. The concept of _________ is based on the common-sense notion that a dollar paid to you in the future is less valuable to you than a dollar today.

(a) present value(b) future value(c) interest(d) deflation

Answer: A

12. Dollars received in the future are worth _________ than dollars received today. The process of calculating what dollars received in the future are worth today is called _________

(a) more; discounting.(b) less; discounting.(c) more; inflating.(d) less; inflating.

Answer: B

13. The process of calculating what dollars received in the future are worth today is called

(a) calculating the yield to maturity.(b) discounting the future.(c) compounding the future.(d) compounding the present.

Answer: B

14. With an interest rate of 5 percent, the present value of $100 received one year from now is approximately

(a) $100.(b) $105.(c) $95.(d) $90.

Answer: C

15. With an interest rate of 10 percent, the present value of a security that pays $1,100 next year and $1,460 four years from now is approximately

(a) $1,000.(b) $2,000(c) $2,560.(d) $3,000.

Answer: B


(a) $93.

(b) $96.(c) $100.(d) $108.

Answer: A


(a) $106.(b) $100.(c) $94.(d) $92.

Answer: C

18. The interest rate that equates the present value of the cash flow received from a debt instrument with its market price today is the

(a) simple interest rate.(b) discount rate.(c) yield to maturity.(d) real interest rate.

Answer: C

19. The interest rate that financial economists consider to be the most accurate measure is the

(a) current yield.(b) yield to maturity.(c) yield on a discount basis.(d) coupon rate.

Answer: B

20. Financial economists consider the _________ to be the most accurate measure of interest rates.

(a) simple interest rate(b) discount rate(c) yield to maturity(d) real interest rate

Answer: C

21. For a simple loan, the simple interest rate equals the

(a) real interest rate.(b) nominal interest rate.(c) current yield.

(d) yield to maturity.

Answer: D

22. For simple loans, the simple interest rate is _________ the yield to maturity.

(a) greater than(b) less than(c) equal to(d) not comparable to

Answer: C

23. The yield to maturity of a one-year, simple loan of $500 that requires an interest payment of $40 is

(a) 5 percent.(b) 8 percent.(c) 12 percent.(d) 12.5 percent.

Answer: B

24. The yield to maturity of a one-year, simple loan of $400 that requires an interest payment of $50 is

(a) 5 percent.(b) 8 percent.(c) 12 percent.(d) 12.5 percent.

Answer: D

25. A $10,000, 8 percent coupon bond that sells for $10,000 has a yield to maturity of


Answer: A

26. Which of the following $1,000 face value securities has the highest yield to maturity?

(a) A 5 percent coupon bond selling for $1,000(b) A 10 percent coupon bond selling for $1,000(c) A 12 percent coupon bond selling for $1,000(d) A 12 percent coupon bond selling for $1,100

Answer: C

27. Which of the following $1,000 face value securities has the highest yield to maturity?

(a) A 5 percent coupon bond selling for $1,000(b) A 10 percent coupon bond selling for $1,000(c) A 15 percent coupon bond selling for $1,000(d) A 15 percent coupon bond selling for $900

Answer: D

28. Which of the following are true for a coupon bond?

(a) When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate.

(b) The price of a coupon bond and the yield to maturity are negatively related.(c) The yield to maturity is greater than the coupon rate when the bond price is below

the par value.(d) All of the above are true.(e) Only (a) and (b) of the above are true.

Answer: D



(b) The price of a coupon bond and the yield to maturity are negatively related.(c) The yield to maturity is greater than the coupon rate when the bond price is above


Answer: E



(b) The price of a coupon bond and the yield to maturity are positively related.(c) The yield to maturity is greater than the coupon rate when the bond price is above


Answer: A

31. A consol bond is a bond that

(a) pays interest annually and its face value at maturity.(b) pays interest in perpetuity and never matures.(c) pays no interest but pays face value at maturity.

(d) rises in value as its yield to maturity rises.

Answer: B

32. The yield to maturity on a consol bond that pays $100 yearly and sells for $500 is

(a) 5 percent.(b) 10 percent.(c) 12.5 percent.(d) 20 percent.(e) 25 percent.

Answer: D

33. The yield to maturity on a consol bond that pays $200 yearly and sells for $1000 is


Answer: C

34. A frequently used approximation for the yield to maturity on a long-term bond is the

(a) coupon rate.(b) current yield.(c) cash flow interest rate.(d) real interest rate.

Answer: B

35. The current yield on a coupon bond is the bond’s _________ divided by its _________.

(a) annual coupon payment; price(b) annual coupon payment; face value(c) annual return; price(d) annual return; face value

Answer: A

36. When a bond’s price falls, its yield to maturity _________ and its current yield _________.

(a) falls; falls(b) rises; rises(c) falls; rises(d) rises; falls

Answer: B

37. The yield to maturity for a one-year discount bond equals

(a) the increase in price over the year, divided by the initial price.(b) the increase in price over the year, divided by the face value.(c) the increase in price over the year, divided by the interest rate.(d) none of the above.

Answer: A

38. If a $10,000 face value discount bond maturing in one year is selling for $8,000, then its yield to maturity is


Answer: C



Answer: C



Answer: D



Answer: A

42. The Fisher equation states that

(a) the nominal interest rate equals the real interest rate plus the expected rate of inflation.

(b) the real interest rate equals the nominal interest rate less the expected rate of inflation.

(c) the nominal interest rate equals the real interest rate less the expected rate of inflation.

(d) both (a) and (b) of the above are true.(e) both (a) and (c) of the above are true.

Answer: D

43. If you expect the inflation rate to be 15 percent next year and a one-year bond has a yield to maturity of 7 percent, then the real interest rate on this bond is

(a) 7 percent.(b) 22 percent.(c) –15 percent.(d) –8 percent.(e) none of the above.

Answer: D

44. If you expect the inflation rate to be 5 percent next year and a one-year bond has a yield to maturity of 7 percent, then the real interest rate on this bond is

(a) –12 percent.(b) –2 percent.(c) 2 percent.(d) 12 percent.

Answer: C

45. The nominal interest rate minus the expected rate of inflation

(a) defines the real interest rate.(b) is a better measure of the incentives to borrow and lend than is the nominal interest

rate.(c) is a more accurate indicator of the tightness of credit market conditions than is the

nominal interest rate.(d) all of the above.(e) only (a) and (b) of the above.

Answer: D

46. The nominal interest rate minus the expected rate of inflation

(a) defines the real interest rate.(b) is a less accurate measure of the incentives to borrow and lend than is the nominal

interest rate.(c) is a less accurate indicator of the tightness of credit market conditions than is the

nominal interest rate.

(d) defines the discount rate.

Answer: A

47. In which of the following situations would you prefer to be making a loan?

(a) The interest rate is 9 percent and the expected inflation rate is 7 percent.(b) The interest rate is 4 percent and the expected inflation rate is 1 percent.(c) The interest rate is 13 percent and the expected inflation rate is 15 percent.(d) The interest rate is 25 percent and the expected inflation rate is 50 percent.

Answer: B

48. In which of the following situations would you prefer to be borrowing?

(a) The interest rate is 9 percent and the expected inflation rate is 7 percent.(b) The interest rate is 4 percent and the expected inflation rate is 1 percent.(c) The interest rate is 13 percent and the expected inflation rate is 15 percent.(d) The interest rate is 25 percent and the expected inflation rate is 50 percent.

Answer: D

49. What is the return on a 5 percent coupon bond that initially sells for $1,000 and sells for $1,200 one year later?

(a) 5 percent(b) 10 percent(c) –5 percent(d) 25 percent(e) None of the above

Answer: D

50. What is the return on a 5 percent coupon bond that initially sells for $1,000 and sells for $900 one year later?

(a) 5 percent(b) 10 percent(c) –5 percent(d) –10 percent(e) None of the above

Answer: C

51. The return on a 5 percent coupon bond that initially sells for $1,000 and sells for $1,100 one year later is

(a) 5 percent.(b) 10 percent.(c) 14 percent.

(d) 15 percent.

Answer: D

52. The return on a 10 percent coupon bond that initially sells for $1,000 and sells for $900 one year later is

(a) –10 percent.(b) –5 percent.(c) 0 percent.(d) 5 percent.

Answer: C

53. Which of the following are generally true of all bonds?

(a) The only bond whose return equals the initial yield to maturity is one whose time to maturity is the same as the holding period.

(b) A rise in interest rates is associated with a fall in bond prices, resulting in capital losses on bonds whose term to maturities are longer than the holding period.

(c) The longer a bond’s maturity, the greater is the price change associated with a given interest rate change.


Answer: D

54. Which of the following are true concerning the distinction between interest rates and return?

(a) The rate of return on a bond will not necessarily equal the interest rate on that bond.

(b) The return can be expressed as the sum of the current yield and the rate of capital gains.

(c) The rate of return will be greater than the interest rate when the price of the bond falls between time t and time t + 1.


Answer: E

55. If the interest rates on all bonds rise from 5 to 6 percent over the course of the year, which bond would you prefer to have been holding?

(a) A bond with one year to maturity(b) A bond with five years to maturity(c) A bond with ten years to maturity(d) A bond with twenty years to maturity

Answer: A

56. Suppose you are holding a 5 percent coupon bond maturing in one year with a yield to maturity of 15 percent. If the interest rate on one-year bonds rises from 15 percent to 20 percent over the course of the year, what is the yearly return on the bond you are holding?

(a) 5 percent(b) 10 percent(c) 15 percent(d) 20 percent

Answer: C

57. (I) Prices of longer-maturity bonds respond more dramatically to changes in interest rates. (II) Prices and returns for long-term bonds are less volatile than those for short-term bonds.


Answer: A

58. (I) Prices of longer-maturity bonds respond less dramatically to changes in interest rates. (II) Prices and returns for long-term bonds are less volatile than those for shorter-term bonds.


Answer: D

59. The riskiness of an asset’s return that results from interest rate changes is called

(a) interest-rate risk.(b) coupon-rate risk.(c) reinvestment risk.(d) yield-to-maturity risk.

Answer: A

60. If an investor’s holding period is longer than the term to maturity of a bond, he or she is exposed to

(a) interest-rate risk.(b) reinvestment risk.(c) bond-market risk.(d) yield-to-maturity risk.

Answer: B

61. Reinvestment risk is the risk that

(a) a bond’s value may fall in the future.(b) a bond’s future coupon payments may have to be invested at a rate lower than the

bond’s yield to maturity.(c) an investor’s holding period will be short and equal in length to the maturity of the

bonds he or she holds.(d) a bond’s issuer may fail to make the future coupon payments and an investor will

have no cash to reinvest.Answer: B

62. (I) The average lifetime of a debt security’s stream of payments is called duration. (II) The duration of a portfolio is the weighted average of the durations of the individual securities, with the weights reflecting the proportion of the portfolio invested in each.


Answer: C

63. The duration of a ten-year, 10 percent coupon bond when the interest rate is 10 percent is 6.76 years. What happens to the price of the bond if the interest rate falls to 8 percent?

(a) it rises 20 percent(b) it rises 12.3 percent(c) it falls 20 percent(d) it falls 12.3 percent

Answer: B

True/False

1. A bond’s current market value is equal to the present value of the coupon payments plus the present value of the face amount.

Answer: TRUE

2. Discounting the future is the procedure used to find the future value of a dollar received today.

Answer: FALSE

3. The current yield is the best measure of an investor’s return from holding a bond.

Answer: FALSE

4. Unless a bond defaults, an investor cannot lose money investing in bonds.

Answer: FALSE

5. The current yield is the yearly coupon payment divided by the current market price.

Answer: TRUE

6. Prices for long-term bonds are more volatile than for shorter-term bonds.

Answer: TRUE

7. A long-term bond’s price is less affected by interest rate movements than is a short-term bond’s price.

Answer: FALSE

8. Increasing duration implies that interest-rate risk has increased.

Answer: TRUE

9. All else being equal, the greater the interest rate the greater is the duration.

Answer: FALSE

10. Interest-rate risk is the uncertainty that an investor faces because the interest rate at which a bond’s future coupon payments can be invested is unknown.

Answer: FALSE

11. The real interest rate is equal to the nominal rate minus inflation.

Answer: TRUE

12. The current yield goes up as the price of a bond falls.

Answer: TRUE

Essay

1. Distinguish between coupon rate, yield to maturity, and current yield.

2. Describe the cash flows received from owning a coupon bond.

3. What concept is used to value a bond?

4. How is a bond’s current yield calculated? Why is current yield a more accurate approximation of yield to maturity for a long-term bond than for a short-term bond?

5. Why are long-term bonds more risky than short-term bonds?

6. What is interest-rate risk and how is it measured?

7. Why may a bond’s rate of return differ from its yield to maturity?

8. How does reinvestment risk differ from interest-rate risk?

9. What is the distinction between the nominal interest rate and the real interest rate? Which is a better indicator of incentives to borrow and lend? Why?

10. Describe how Treasury Inflation Protection Securities (TIPS) work and how they help policymakers estimate expected inflation.

Chapter 4Why Do Interest Rates Change?


1. As the price of a bond _________ and the expected return _________, bonds become more attractive to investors and the quantity demanded rises.

(a) falls; rises(b) falls; falls(c) rises; rises(d) rises; falls

Answer: A

2. The supply curve for bonds has the usual upward slope, indicating that as the price _________, ceteris paribus, the _________ increases.

(a) falls; supply(b) falls; quantity supplied(c) rises; supply(d) rises; quantity supplied

Answer: D

3. When the price of a bond is above the equilibrium price, there is excess _________ in the bond market and the price will _________.

(a) demand; rise(b) demand; fall(c) supply; fall(d) supply; rise

Answer: C

4. When the price of a bond is below the equilibrium price, there is excess _________ in the bond market and the price will _________.

(a) demand; rise(b) demand; fall(c) supply; fall

(d) supply; rise

Answer: A

5. When the price of a bond is _________ the equilibrium price, there is an excess supply of bonds and the price will _________.

(a) above; rise(b) above; fall(c) below; fall(d) below; rise

Answer: B

6. When the price of a bond is _________ the equilibrium price, there is an excess demand for bonds and the price will _________.

(a) above; rise(b) above; fall(c) below; fall(d) below; rise

Answer: D

7. When the interest rate on a bond is above the equilibrium interest rate, there is excess _________ in the bond market and the interest rate will _________.


Answer: B

8. When the interest rate on a bond is below the equilibrium interest rate, there is excess _________ in the bond market and the interest rate will _________.


Answer: D

9. When the interest rate on a bond is _________ the equilibrium interest rate, there is excess _________ in the bond market and the interest rate will _________.

(a) above; demand; fall(b) above; demand; rise(c) below; supply; fall(d) above; supply; rise

Answer: A

10. When the interest rate on a bond is _________ the equilibrium interest rate, there is excess _________ in the bond market and the interest rate will _________.

(a) below; demand; rise(b) below; demand; fall(c) below; supply; rise(d) above; supply; fall

Answer: C

11. When the demand for bonds _________ or the supply of bonds _________, interest rate rise.

(a) increases; increases(b) increases; decreases(c) decreases; decreases(d) decreases; increases

Answer: D

12. When the demand for bonds _________ or the supply of bonds _________, interest rates fall.


Answer: B

13. When the demand for bonds _________ or the supply of bonds _________, bond prices rise.

(a) increases; decreases(b) decreases; increases(c) decreases; decreases(d) increases; increases

Answer: A

14. When the demand for bonds _________ or the supply of bonds _________, bond prices fall.


Answer: D

15. Factors that determine the demand for an asset include changes in the

(a) wealth of investors.(b) liquidity of bonds relative to alternative assets.(c) expected returns on bonds relative to alternative assets.(d) risk of bonds relative to alternative assets.(e) all of the above.

Answer: E

16. The demand for an asset rises if _________ falls.

(a) risk relative to other assets(b) expected return relative to other assets(c) liquidity relative to other assets(d) wealth

Answer: A

17. The higher the standard deviation of returns on an asset, the _________ is the asset’s _________.

(a) greater; risk(b) smaller; risk(c) greater; expected return(d) smaller; expected return

Answer: A

18. Diversification benefits an investor by

(a) increasing wealth.(b) increasing expected return.(c) reducing risk.(d) increasing liquidity.

Answer: C

19. In a recession when income and wealth are falling, the demand for bonds _________ and the demand curve shifts to the _________.

(a) falls; right(b) falls; left(c) rises; right(d) rises; left

Answer: B

20. During business cycle expansions when income and wealth are rising, the demand for bonds _________ and the demand curve shifts to the _________.

(a) falls; right(b) falls; left(c) rises; right(d) rises; left

Answer: C

21. For a holding period of one year, the expected return on a consol is _________ the higher is the price of the consol today, and _________ the higher is the price of the consol next year.

(a) higher; higher(b) higher; lower(c) lower; higher(d) lower; lower

Answer: C

22. Higher expected interest rates in the future _________ the demand for long-term bonds and shift the demand curve to the _________.

(a) increase; left(b) increase; right(c) decrease; left(d) decrease; right

Answer: C

23. Lower expected interest rates in the future _________ the demand for long-term bonds and shift the demand curve to the _________

(a) increase; left.(b) increase; right.(c) decrease; left.(d) decrease; right.

Answer: B

24. When people begin to expect a large stock market decline, the demand curve for bonds shifts to the _________ and the interest rate _________.

(a) right; falls(b) right; rises(c) left; falls(d) left; rises

Answer: A

25. When people begin to expect a large run up in stock prices, the demand curve for bonds shifts to the _________ and the interest rate _________.

(a) right; rises(b) right; falls(c) left; falls(d) left; rises

Answer: D

26. An increase in the expected rate of inflation will _________ the expected return on bonds relative to that on _________ assets, and shift the _________ curve to the left.

(a) reduce; financial; demand(b) reduce; real; demand(c) raise; financial; supply(d) raise; real; supply

Answer: B

27. A decrease in the expected rate of inflation will _________ the expected return on bonds relative to that on _________ assets.

(a) reduce; financial(b) reduce; real(c) raise; financial(d) raise; real

Answer: D

28. When the expected inflation rate increases, the demand for bonds _________, the supply of bonds _________, and the interest rate _________.

(a) increases; increases; rises(b) decreases; decreases; falls(c) increases; decreases; falls(d) decreases; increases; rises

Answer: D

29. When the expected inflation rate decreases, the demand for bonds _________, the supply of bonds _________, and the interest rate __________.


Answer: C

30. When bond interest rates become more volatile, the demand for bonds _________ and the interest rate _________.

(a) increases; rises

(b) increases; falls(c) decreases; falls(d) decreases; rises

Answer: D

31. When bond interest rates become less volatile, the demand for bonds _________ and the interest rate _________.

(a) increases; rises(b) increases; falls(c) decreases; falls(d) decreases; rises

Answer: B

32. When prices in the stock market become more uncertain, the demand curve for bonds shifts to the _________ and the interest rate _________.


Answer: B

33. When stock prices become less volatile, the demand curve for bonds shifts to the _________ and the interest rate _________.


Answer: D

34. When bonds become more widely traded, and as a consequence the market becomes more liquid, the demand curve for bonds shifts to the _________ and the interest rate _________.


Answer: B

35. When bonds become less widely traded, and as a consequence the market becomes less liquid, the demand curve for bonds shifts to the _________ and the interest rate _________.

(a) right; rises

(b) right; falls(c) left; falls(d) left; rises

Answer: D

36. Factors that cause the demand curve for bonds to shift to the left include

(a) an increase in the inflation rate.(b) an increase in the liquidity of stocks.(c) a decrease in the volatility of stock prices.(d) all of the above.(e) none of the above.

Answer: D

37. Factors that cause the demand curve for bonds to shift to the left include

(a) a decrease in the inflation rate.(b) an increase in the volatility of stock prices.(c) an increase in the liquidity of stocks.(d) all of the above.(e) only (a) and (b) of the above.

Answer: C

38. During an economic expansion, the supply of bonds _________ and the supply curve shifts to the _________.

(a) increases, left(b) increases, right(c) decreases, left(d) decreases, right

Answer: B

39. During a recession, the supply of bonds _________ and the supply curve shifts to the _________.

(a) increases, left(b) increases, right(c) decreases, left(d) decreases, right

Answer: C

40. An increase in expected inflation causes the supply of bonds to _________ and the supply curve to shift to the _________.

(a) increase, left

(b) increase, right(c) decrease, left(d) decrease, right

Answer: B

41. When the federal government’s budget deficit increases, the _________ curve for bonds shifts to the _________.

(a) demand; right(b) demand; left(c) supply; left(d) supply; right

Answer: D

42. When the federal government’s budget deficit decreases, the _________ curve for bonds shifts to the _________.

(a) demand; right(b) demand; left(c) supply; left(d) supply; right

Answer: C

43. When the inflation rate is expected to increase, the expected return on bonds relative to real assets falls for any given interest rate; as a result, the _________ bonds falls and the _________ curve shifts to the left.

(a) demand for; demand(b) demand for; supply(c) supply of; demand(d) supply of; supply

Answer: A

44. When the inflation rate is expected to increase, the real cost of borrowing declines at any given interest rate; as a result, the _________ bonds increases and the _________ curve shifts to the right.

(a) demand for; demand(b) demand for; supply(c) supply of; demand(d) supply of; supply

Answer: D

Figure 4.1

45. In Figure 4.1, the most likely cause of the increase in the equilibrium interest rate from i1 to i2 is

(a) an increase in the price of bonds.(b) a business cycle boom.(c) an increase in the expected inflation rate.(d) a decrease in the expected inflation rate.

Answer: C

46. In Figure 4.1, the most likely cause of the increase in the equilibrium interest rate from i1 to i2 is a(n) _________ in the _________.

(a) increase; expected inflation rate(b) decrease; expected inflation rate.(c) increase; government budget deficit(d) decrease; government budget deficit

Answer: A

47. In Figure 4.1, the most likely cause of a decrease in the equilibrium interest rate from i2 to i1 is

(a) an increase in the expected inflation rate.(b) a decrease in the expected inflation rate.(c) a business cycle expansion.(d) a combination of both (a) and (c) of the above.

Answer: B

48. Factors that can cause the supply curve for bonds to shift to the right include

(a) an expansion in overall economic activity.(b) a decrease in expected inflation.(c) a decrease in government deficits.(d) all of the above.(e) only (a) and (b) of the above.

Answer: A

49. Factors that can cause the supply curve for bonds to shift to the left include

(a) an expansion in overall economic activity.(b) a decrease in expected inflation.(c) an increase in government deficits.(d) only (a) and (c) of the above.

Answer: B

50. The economist Irving Fisher, after whom the Fisher effect is named, explained why interest rates _________ as the expected rate of inflation _________.

(a) rise; increases(b) rise; stabilizes(c) rise; decreases(d) fall; increases(e) fall; stabilizes

Answer: A

51. An increase in the expected rate of inflation causes the demand for bonds to _________ and the supply for bonds to _________.

(a) fall; fall(b) fall; rise(c) rise; fall(d) rise; rise

Answer: B

52. A decrease in the expected rate of inflation causes the demand for bonds to _________ and the supply of bonds to _________.

(a) fall; fall(b) fall; rise(c) rise; fall(d) rise; rise

Answer: C

53. When the economy slips into a recession, normally the demand for bonds _________, the supply of bonds _________, and the interest rate _________.


Answer: B

54. When the economy enters into a boom, normally the demand for bonds _________, the supply of bonds _________, and the interest rate _________.

(a) increases; increases; rises(b) decreases; decreases; falls(c) increases; decreases; rises(d) decreases; increases; rises

Answer: A

Figure 4.2

55. In Figure 4.2, one possible explanation for the increase in the interest rate from i1 to i2 is a(n) _________ in _________.

(a) increase; the expected inflation rate(b) decrease; the expected inflation rate(c) increase; economic growth(d) decrease; economic growth

Answer: C

56. In Figure 4.2, one possible explanation for the increase in the interest rate from i1 to i2 is

(a) an increase in economic growth.(b) an increase in government budget deficits.(c) a decrease in government budget deficits.(d) a decrease in economic growth.(e) a decrease in the riskiness of bonds relative to other investments.

Answer: A

57. In Figure 4.2, one possible explanation for a decrease in the interest rate from i2 to i1 is

(a) an increase in government budget deficits.(b) an increase in expected inflation.(c) a decrease in economic growth.(d) a decrease in the riskiness of bonds relative to other investments.

Answer: C

Questions for Chapter 4, Web Appendix 2: Supply and Demand in the Market for Money: The Liquidity Preference Framework

58. In Keynes’s liquidity preference framework, individuals are assumed to hold their wealth in two forms:

(a) real assets and financial assets.(b) stocks and bonds.(c) money and bonds.(d) money and gold.

Answer: C

59. In his liquidity preference framework, Keynes assumed that money has a zero rate of return; thus, when interest rates _________ the expected return on money falls relative to the expected return on bonds, causing the demand for money to _________.

(a) rise; fall(b) rise; rise(c) fall; fall(d) fall; rise

Answer: A

60. The loanable funds framework is easier to use when analyzing the effects of changes in _________, while the liquidity preference framework provides a simpler analysis of the effects from changes in income, the price level, and the supply of _________

(a) expected inflation; bonds.(b) expected inflation; money.(c) government budget deficits; bonds.(d) the supply of money; bonds.

Answer: B

61. When comparing the loanable funds and liquidity preference frameworks of interest rate determination, which of the following is true?

(a) The liquidity preference framework is easier to use when analyzing the effects of changes in expected inflation.

(b) The loanable funds framework provides a simpler analysis of the effects of changes in income, the price level, and the supply of money.

(c) In most instances, the two approaches to interest rate determination yield the same predictions.


Answer: C

62. A higher level of income causes the demand for money to _________ and the interest rate to _________

(a) decrease; decrease.(b) decrease; increase.(c) increase; decrease.(d) increase; increase.

Answer: D

63. A lower level of income causes the demand for money to _________ and the interest rate to _________

(a) decrease; decrease.(b) decrease; increase.(c) increase; decrease.(d) increase; increase.

Answer: A

64. A rise in the price level causes the demand for money to _________ and the demand curve to shift to the _________

(a) decrease; right.(b) decrease; left.(c) increase; right.(d) increase; left.

Answer: C

65. A decline in the price level causes the demand for money to _________ and the demand curve to shift to the _________


Answer: B

66. A decline in the expected inflation rate causes the demand for money to _________ and the demand curve to shift to the _________


Answer: B

67. Holding everything else constant, an increase in the money supply causes

(a) interest rates to decline initially.(b) interest rates to increase initially.(c) bond prices to decline initially.(d) both (a) and (c) of the above.(e) both (b) and (c) of the above.

Answer: A

68. Holding everything else constant, a decrease in the money supply causes

(a) interest rates to decline initially.(b) interest rates to increase initially.(c) bond prices to increase initially.(d) both (a) and (c) of the above.(e) both (b) and (c) of the above.

Answer: B

Figure 4.3

69. In Figure 4.3, the factor responsible for the decline in the interest rate is

(a) a decline in the price level.(b) a decline in income.(c) an increase in the money supply.(d) a decline in the expected inflation rate.

Answer: C

70. In Figure 4.3, the decrease in the interest rate from i1 to i2 can be explained by

(a) a decrease in money growth.(b) an increase in money growth.(c) a decline in the expected price level.(d) only (a) and (b) of the above.

Answer: B

71. In Figure 4.3, an increase in the interest rate from i2 to i1 can be explained by

(a) a decrease in money growth.(b) an increase in money growth.

(c) a decline in the price level.(d) an increase in the expected price level.

Answer: A

72. Of the four effects on interest rates from an increase in the money supply, the one that works in the opposite direction of the other three is the

(a) liquidity effect.(b) income effect.(c) price level effect.(d) expected inflation effect.

Answer: A

73. Of the four effects on interest rates from an increase in the money supply, the initial effect is, generally, the

(a) income effect.(b) liquidity effect.(c) price level effect.(d) expected inflation effect.

Answer: B

74. If the liquidity effect is smaller than the other effects, and the adjustment of expected inflation is slow, then the

(a) interest rate will fall.(b) interest rate will rise.(c) interest rate will initially fall but eventually climb above the initial level in

response to an increase in money growth.(d) interest rate will initially rise but eventually fall below the initial level in response

to an increase in money growth.

Answer: C

75. When the growth rate of the money supply increases, interest rates end up being permanently lower if

(a) the liquidity effect is larger than the other effects.(b) there is fast adjustment of expected inflation.(c) there is slow adjustment of expected inflation.(d) the expected inflation effect is larger than the liquidity effect.

Answer: A

76. When the growth rate of the money supply decreases, interest rates end up being permanentlylower if

(a) the liquidity effect is larger than the other effects.(b) there is fast adjustment of expected inflation.(c) there is slow adjustment of expected inflation.(d) the expected inflation effect is larger than the liquidity effect.

Answer: D

77. When the growth rate of the money supply is decreased, interest rates will rise immediately if the liquidity effect is _________ than the other effects and if there is _________ adjustment of expected inflation.

(a) larger; rapid(b) larger; slow(c) smaller; slow(d) smaller; rapid

Answer: B

78. When the growth rate of the money supply is increased, interest rates will rise immediately if the liquidity effect is _________ than the other effects and if there is _________ adjustment of expected inflation.

(a) larger; rapid(b) larger; slow(c) smaller; slow(d) smaller; rapid

Answer: D

79. If the Fed wants to permanently lower interest rates, then it should lower the rate of money growth if

(a) there is fast adjustment of expected inflation.(b) there is slow adjustment of expected inflation.(c) the liquidity effect is smaller than the expected inflation effect.(d) the liquidity effect is larger than the other effects.

Answer: C

80. If the Fed wants to permanently lower interest rates, then it should raise the rate of money growth if

(a) there is fast adjustment of expected inflation.(b) there is slow adjustment of expected inflation.(c) the liquidity effect is smaller than the expected inflation effect.(d) the liquidity effect is larger than the other effects.

Answer: D

81. Milton Friedman contends that it is entirely possible that when the money supply rises, interest rates may _________ if the _________ effect is more than offset by changes in income, the price level, and expected inflation.

(a) fall; liquidity(b) fall; risk(c) rise; liquidity(d) rise; risk

Answer: C

Figure 4.4

82. Figure 4.4 illustrates the effect of an increased rate of money supply growth. From the figure, one can conclude that the liquidity effect is _________ than the expected inflation effect and interest rates adjust _________ to changes in expected inflation.

(a) smaller; quickly(b) larger; quickly(c) larger; slowly(d) smaller; slowly

Answer: A

83. Figure 4.4 illustrates the effect of an increased rate of money supply growth. From the figure, one can conclude that the

(a) Fisher effect is dominated by the liquidity effect and interest rates adjust slowly to changes in expected inflation.

(b) liquidity effect is dominated by the Fisher effect and interest rates adjust slowly to changes in expected inflation.

(c) liquidity effect is dominated by the Fisher effect and interest rates adjust quickly to changes in expected inflation.

(d) Fisher effect is smaller than the expected inflation effect and interest rates adjust quickly to changes in expected inflation.

Answer: C

Figure 4.5

84. Figure 4.5 illustrates the effect of an increased rate of money supply growth. From the figure, one can conclude that the liquidity effect is _________ than the expected inflation effect and interest rates adjust _________ to changes in expected inflation.

(a) smaller; quickly(b) larger; quickly(c) larger; slowly(d) smaller; slowly

Answer: C

85. Figure 4.5 illustrates the effect of an increased rate of money supply growth. From the figure, one can conclude that the

(a) Fisher effect is dominated by the liquidity effect and interest rates adjust slowly to changes in expected inflation.

(b) liquidity effect is dominated by the Fisher effect and interest rates adjust slowly to changes in expected inflation.

(c) liquidity effect is dominated by the Fisher effect and interest rates adjust quickly to changes in expected inflation.

(d) Fisher effect is smaller than the expected inflation effect and interest rates adjust quickly to changes in expected inflation.

Answer: A

True/False

1. When interest rates decrease, the demand curve for bonds shifts to the left.

Answer: FALSE

2. When an economy grows out of a recession, normally the demand for bonds increases and the supply of bonds increases.

Answer: TRUE

3. When the federal government’s budget deficit decreases, the demand curve for bonds shifts to the right.

Answer: FALSE

4. Investors make their choices of which assets to hold by comparing the expected return, liquidity, and risk of alternative assets.

Answer: TRUE

5. A person who is risk averse prefers to hold assets that are more, not less, risky.

Answer: FALSE

6. Interest rates are procyclical in that they tend to rise during business cycle expansions and fall during recessions.

Answer: TRUE

7. When income and wealth are rising, the demand for bonds rises and the demand curve shifts to the right.

Answer: TRUE

8. An increase in the inflation rate will cause the demand curve for bonds to shift to the right.

Answer: FALSE

9. The Fisher Effect predicts that an incease in expected inflation will lower the interest rate on bonds.

Answer: FALSE

10. An increase in the federal government budget deficit will raise the interest rate on bonds.

Answer: TRUE

Essay

1. Identify and explain the four factors that influence asset demand. Which of these factors affect total asset demand and which influence investors to demand one asset over another?

2. How is the equilibrium interest rate determined in the bond market? Explain why the interest rate will move toward equilibrium if it is temporarily above or below the equilibrium rate.

3. Use the bond demand and supply framework to explain the Fisher effect and why it occurs.

4. If investors perceive greater interest rate risk, what will happen to the equilibrium interest rate in the bond market? Explain using the bond demand and supply framework.

5. How will a decrease in the federal government’s budget deficit affect the equilibrium interest rate in the bond maket? Explain using the bond demand and supply framework.

6. What is the expected return on a bond if the return is 9% two-thirds of the time and 3% one-third of the time? What is the standard deviation of the returns on this bond? Would you prefer this bond or one with an identical expected return and a standard deviation of 4.5? Why?

Chapter 5How Do Risk and Term Structure Affect Interest

Rates?


1. The term structure of interest rates is

(a) the relationship among interest rates of different bonds with the same maturity.(b) the structure of how interest rates move over time.(c) the relationship among the terms to maturity of different bonds.(d) the relationship among interest rates on bonds with different maturities.

Answer: D

2. The risk structure of interest rates is

(a) the structure of how interest rates move over time.(b) the relationship among interest rates of different bonds with the same maturity.(c) the relationship among the terms to maturity of different bonds.(d) the relationship among interest rates on bonds with different maturities.

Answer: B

3. Which of the following long-term bonds should have the lowest interest rate?

(a) Corporate Baa bonds(b) U.S. Treasury bonds(c) Corporate Aaa bonds(d) Municipal bonds

Answer: D

4. Which of the following long-term bonds should have the highest interest rate?

(a) Corporate Baa bonds(b) U.S. Treasury bonds(c) Corporate Aaa bonds(d) Municipal bonds

Answer: A

5. The risk premium on corporate bonds becomes smaller if

(a) the riskiness of corporate bonds increases.(b) the liquidity of corporate bonds increases.(c) the liquidity of corporate bonds decreases.(d) the riskiness of corporate bonds decreases.(e) either (b) or (d) occur.

Answer: E

6. Bonds with relatively low risk of default are called

(a) zero coupon bonds.(b) junk bonds.(c) investment grade bonds.(d) none of the above.

Answer: C

7. Bonds with relatively high risk of default are called

(a) Brady bonds.(b) junk bonds.(c) zero coupon bonds.(d) investment grade bonds.

Answer: B

8. A corporation suffering big losses might be more likely to suspend interest payments on its bonds, thereby

(a) raising the default risk and causing the demand for its bonds to rise.(b) raising the default risk and causing the demand for its bonds to fall.(c) lowering the default risk and causing the demand for its bonds to rise.(d) lowering the default risk and causing the demand for its bonds to fall.

Answer: B

9. (I) If a corporation suffers big losses, the demand for its bonds will rise because of the higher interest rates the firm must pay. (II) The spread between the interest rates on bonds with default risk and default-free bonds is called the risk premium.


Answer: B

10. Holding everything else constant, if a corporation begins to suffer large losses, then the default risk on its bonds will _________ and the expected return on those bonds will _________.

(a) increase: increase(b) decrease; increase(c) increase; decrease(d) decrease; decrease

Answer: C

11. Holding everything else the same, if a corporation’s earnings rise, then the default risk on its bonds will _________ and the expected return on those bonds will _________.

(a) increase; decrease(b) decrease; decrease(c) increase; increase(d) decrease; increase

Answer: D

12. If a corporation begins to suffer large losses, then the default risk on its bonds will _________ and the equilibrium interest rate on these bonds will _________.

(a) increase; decrease(b) decrease; increase(c) increase; increase(d) decrease; decrease

Answer: C

13. If a corporation’s earnings rise, then the default risk on its bonds will _________ and the equilibrium interest rate on these bonds will _________.

(a) increase; decrease(b) decrease; decrease(c) increase; increase(d) decrease; increase

Answer: B

14. When the default risk on corporate bonds decreases, other things equal, the demand curve for corporate bonds shifts to the _________ and the demand curve for Treasury bonds shifts to the _________.

(a) right; right(b) right; left(c) left; left(d) left; right

Answer: B

15. (I) An increase in default risk on corporate bonds shifts the demand curve for corporate bonds to the right. (II) An increase in default risk on corporate bonds shifts the demand curve for Treasury bonds to the left.


Answer: D

16. (I) An increase in default risk on corporate bonds shifts the demand curve for corporate bonds to the left. (II) An increase in default risk on corporate bonds shifts the demand curve for Treasury bonds to the right.


Answer: C

17. When budget talks between congressional Republicans and President Clinton occurred in late 1995, fear of a government default _________, Treasury bond values _________, and interest rates on Treasury bonds _________.

(a) rose; fell; rose(b) rose; rose; rose(c) fell; rose; fell(d) fell; fell; fell

Answer: A

18. The spread between interest rates on low quality corporate bonds and U.S. government bonds _________ during the Great Depression.

(a) was reversed(b) narrowed significantly(c) widened significantly

(d) did not change

Answer: C

19. As a result of the Enron collapse and bankruptcy, the demand for low quality corporate bonds _________, the demand for high quality corporate bonds _________, and the risk spread _________.

(a) increased; decreased; was unchanged(b) decreased; increased; increased(c) increased; decreased; decreased(d) decreased; increased; was unchanged

Answer: B

20. Moody’s and Standard and Poor’s are agencies that

(a) help investors collect when corporations default on their bonds.(b) advise municipal bond issuers on the tax exempt status of their bonds.(c) produce information about the probability of default on corporate bonds.(d) maintain liquid markets for corporate bonds.

Answer: C

21. If Moody’s or Standard and Poor’s downgrades its rating on a corporate bond, the demand for the bond _________ and its yield _________.

(a) increases; decreases(b) decreases; increases(c) increases; increases(d) decreases; decreases

Answer: B

22. Corporate bonds are not as liquid as government bonds because

(a) fewer bonds for any one corporation are traded, making them more costly to sell.(b) the corporate bond rating must be calculated each time they are traded.(c) corporate bonds are not callable.(d) all of the above.(e) only (a) and (b) of the above.

Answer: A

23. (I) The risk premium widens as the default risk on corporate bonds increases. (II) The risk premium widens as corporate bonds become less liquid.

(a) (I) is true, (II) false.(b) (I) is false, (II) true.(c) Both are true.

(d) Both are false.

Answer: C

24. When the corporate bond market becomes less liquid, other things equal, the demand curve for corporate bonds shifts to the _________ and the demand curve for Treasury bonds shifts to the _________.

(a) right; right(b) right; left(c) left; left(d) left; right.

Answer: D

25. When the corporate bond market becomes more liquid, other things equal, the demand curve for corporate bonds shifts to the _________ and the demand curve for Treasury bonds shifts to the _________.

(a) right; right(b) right; left(c) left; left(d) left; right

Answer B

26. (I) If a corporate bond becomes less liquid, the demand for the bond will fall, causing the interest rate to rise. (II) If a corporate bond becomes less liquid, the demand for Treasury bonds does not change.


Answer: A

27. (I) If a corporate bond becomes less liquid, the interest rate on the bond will fall. (II) If a corporate bond becomes less liquid, the interest rate on Treasury bonds will fall.


Answer: B

28. Which of the following bonds generally has the lowest interest rate?

(a) Treasury bonds(b) Corporate Baa bonds

(c) Municipal bonds(d) Corporate Aaa bonds

Answer: C

29. If income tax rates were lowered, then

(a) the interest rate on municipal bonds would fall.(b) the interest rate on Treasury bonds would rise.(c) the interest rate on municipal bonds would rise.(d) the price of Treasury bonds would fall.

Answer: C

30. If income tax rates rise, then

(a) the prices of municipal bonds will fall.(b) the prices of Treasury bonds will rise.(c) the interest rate on Treasury bonds will rise.(d) the interest rate on municipal bonds will rise.

Answer: C

31. An increase in marginal tax rates would likely have the effect of _________ the demand for municipal bonds and _________ the demand for U.S. government bonds.

(a) increasing; increasing(b) increasing; decreasing(c) decreasing; increasing(d) decreasing; decreasing

Answer: B

32. A decrease in marginal tax rates would likely have the effect of _________ the demand for municipal bonds and _________ the demand for U.S. government bonds.

(a) increasing; increasing(b) increasing; decreasing(c) decreasing; increasing(d) decreasing; decreasing

Answer: C

33. Which of the following statements are true?

(a) Because coupon payments on municipal bonds are exempt from federal income tax, the expected after-tax return on them will be higher for individuals in higher income tax brackets.

(b) An increase in tax rates will increase the demand for municipal bonds, lowering their interest rates.

(c) Interest rates on municipal bonds will be lower than on comparable bonds without the tax exemption.

(d) All of the above are true statements.(e) Only (a) and (b) are true statements.

Answer: D

34. Which of the following statements are true?

(a) Because coupon payments on municipal bonds are exempt from federal income tax, the expected after-tax return on them will be higher for individuals in higher income tax brackets.

(b) An increase in tax rates will increase the demand for Treasury bonds, lowering their interest rates.

(c) Interest rates on municipal bonds will be higher than on comparable bonds without the tax exemption.

(d) Only (a) and (b) are true statements.

Answer: A

35. When a municipal bond is given tax-free status, the demand for municipal bonds shifts _________, causing the interest rate on the bond to _________

(a) leftward; rise.(b) leftward; fall.(c) rightward; rise.(d) rightward; fall.

Answer: D

36. When a municipal bond is given tax-free status, the demand for Treasury bonds shifts _________, and the interest rate on Treasury bonds _________

(a) leftward; rises.(b) leftward; falls.(c) rightward; rises.(d) rightward; falls.

Answer: A

37. If municipal bonds were to lose their tax-free status, then the demand for Treasury bonds would shift _________, and the interest rate on Treasury bonds would _________

(a) rightward; fall.(b) rightward; rise.(c) leftward; fall.(d) leftward; rise.

Answer: A

38. The Bush tax cut passed in 2001 reduces the top income tax bracket from 39 percent to 35 percent over the next ten years. As a result of this tax cut, the demand for municipal bonds should shift to the _________ and the interest rate on municipal bonds should _________.

(a) right; decline

(b) right; increase(c) left; decline(d) left; increase

Answer: D

39. The relationship among interest rates on bonds with identical default risk, but different maturities, is called the

(a) time-risk structure of interest rates.(b) liquidity structure of interest rates.(c) yield curve.(d) bond demand curve.

Answer: C

40. Yield curves can be classified as

(a) upward-sloping.(b) downward-sloping.(c) flat.(d) all of the above.(e) only (a) and (b) of the above.

Answer: D

41. Typically, yield curves are

(a) gently upward-sloping.(b) gently downward-sloping.(c) flat.(d) bowl shaped.(e) mound shaped.

Answer: A

42. When yield curves are steeply upward-sloping,

(a) long-term interest rates are above short-term interest rates.(b) short-term interest rates are above long-term interest rates.(c) short-term interest rates are about the same as long-term interest rates.(d) medium-term interest rates are above both short-term and long-term interest rates.(e) medium-term interest rates are below both short-term and long-term interest rates.

Answer: A

43. Economists’ attempts to explain the term structure of interest rates

(a) illustrate how economists modify theories to improve them when they are inconsistent with the empirical evidence.

(b) illustrate how economists continue to accept theories that fail to explain observed behavior of interest rate movements.

(c) prove that the real world is a special case that tends to get short shrift in theoretical models.

(d) have proved entirely unsatisfactory to date.

Answer: A

44. According to the pure expectations theory of the term structure,

(a) the interest rate on long-term bonds will exceed the average of expected future short-term interest rates.

(b) interest rates on bonds of different maturities move together over time.(c) buyers of bonds prefer short-term to long-term bonds.(d) all of the above.(e) only (a) and (b) of the above.

Answer: B


(a) when the yield curve is steeply upward-sloping, short-term interest rates are expected to rise in the future.

(b) when the yield curve is downward-sloping, short-term interest rates are expected to decline in the future.

(c) buyers of bonds prefer short-term to long-term bonds.(d) all of the above.(e) only (a) and (b) of the above.

Answer: E


(a) when the yield curve is steeply upward-sloping, short-term interest rates are expected to rise in the future.

(b) when the yield curve is downward-sloping, short-term interest rates are expected to remain relatively stable in the future.

(c) investors have strong preferences for short-term relative to long-term bonds, explaining why yield curves typically slope upward.

(d) all of the above.(e) only (a) and (b) of the above.

Answer: A


(a) yield curves should be equally likely to slope downward as to slope upward.(b) when the yield curve is steeply upward-sloping, short-term interest rates are

expected to rise in the future.

(c) when the yield curve is downward-sloping, short-term interest rates are expected to remain relatively stable in the future.


Answer: E

48. If the expected path of one-year interest rates over the next four years is 5 percent, 4 percent,2 percent, and 1 percent, then the pure expectations theory predicts that today’s interest rate on the four-year bond is

(a) 1 percent.(b) 2 percent.(c) 4 percent.(d) none of the above.

Answer: D

49. If the expected path of one-year interest rates over the next five years is 1 percent, 2 percent,3 percent, 4 percent, and 5 percent, the pure expectations theory predicts that the bond with the highest interest rate today is the one with a maturity of

(a) one year.(b) two years.(c) three years.(d) four years.(e) five years.

Answer: E

50. If the expected path of one-year interest rates over the next five years is 2 percent, 4 percent,1 percent, 4 percent, and 3 percent, the pure expectations theory predicts that the bond with the lowest interest rate today is the one with a maturity of

(a) one year.(b) two years.(c) three years.(d) four years.

Answer: A

51. According to the market segmentation theory of the term structure,

(a) the interest rate for bonds of one maturity is determined by supply and demand for bonds of that maturity.

(b) bonds of one maturity are not substitutes for bonds of other maturities; therefore, interest rates on bonds of different maturities do not move together over time.

(c) investors’ strong preference for short-term relative to long-term bonds explains why yield curves typically slope upward.

(d) all of the above.(e) none of the above.

Answer: D

52. According to the market segmentation theory of the term structure,

(a) the interest rate for bonds of one maturity is determined by supply and demand for bonds of that maturity.

(b) bonds of one maturity are not substitutes for bonds of other maturities; therefore, interest rates on bonds of different maturities do not move together over time.

(c) investors’ strong preference for short-term relative to long-term bonds explains why yield curves typically slope downward.

(d) only (a) and (b) of the above.

Answer: D

53. The liquidity premium theory of the term structure

(a) indicates that today’s long-term interest rate equals the average of short-term interest rates that people expect to occur over the life of the long-term bond.

(b) assumes that bonds of different maturities are perfect substitutes.(c) suggests that markets for bonds of different maturities are completely separate

because people have preferred habitats.(d) does none of the above.

Answer: D

54. The liquidity premium theory of the term structure

(a) assumes investors tend to prefer short-term bonds because they have less interest-rate risk.

(b) assumes that interest rates on the long-term bond respond to demand and supply conditions for that bond.

(c) assumes that an average of expected short-term rates is an important component of interest rates on long-term bonds.

(d) assumes all of the above.(e) assumes none of the above.

Answer: D

55. According to the liquidity premium theory of the term structure,

(a) the interest rate on long-term bonds will equal an average of short-term interest rates that people expect to occur over the life of the long-term bonds plus a liquidity premium.

(b) buyers of bonds may prefer bonds of one maturity over another, yet interest rates on bonds of different maturities move together over time.

(c) even with a positive liquidity premium, if future short-term interest rates are expected to fall significantly, then the yield curve will be downward-sloping.


Answer: D

56. According to the liquidity premium theory of the term structure,

(a) because buyers of bonds may prefer bonds of one maturity over another, interest rates on bonds of different maturities do not move together over time.

(b) the interest rate on long-term bonds will equal an average of short-term interest rates that people expect to occur over the life of the long-term bonds plus a term premium.

(c) because of the positive term premium, the yield curve cannot be downward-sloping.


Answer: B

57. If the yield curve slope is flat, the liquidity premium theory indicates that the market is predicting

(a) a mild rise in short-term interest rates in the near future and a mild decline further out in the future.

(b) constant short-term interest rates in the near future and further out in the future.(c) a mild decline in short-term interest rates in the near future and a continuing mild

decline further out in the future.(d) constant short-term interest rates in the near future and a mild decline further out in

the future.

Answer: C

58. If the yield curve has a mild upward slope, the liquidity premium theory indicates that the market is predicting

(a) a rise in short-term interest rates in the near future and a decline further out in the future.

(b) constant short-term interest rates in the near future and further out in the future.(c) a decline in short-term interest rates in the near future and a rise further out in the

future.

(d) a decline in short-term interest rates in the near future and an even steeper decline further out in the future.

Answer: B

59. According to the liquidity premium theory of the term structure, a downward-sloping yield curve indicates that short-term interest rates are expected to

(a) rise in the future.(b) remain unchanged in the future.(c) decline moderately in the future.(d) decline sharply in the future.

Answer: D

60. According to the liquidity premium theory of the term structure, when the yield curve has its usual slope, the market expects

(a) short-term interest rates to rise sharply.(b) short-term interest rates to drop sharply.(c) short-term interest rates to stay near their current levels.(d) none of the above.

Answer: C

61. In actual practice, short-term interest rates are just as likely to fall as to rise; this is the major shortcoming of the

(a) market segmentation theory.(b) pure expectations theory.(c) liquidity premium theory.(d) separable markets theory.

Answer: B

62. Which theory of the term structure proposes that bonds of different maturities are not substitutes for one another?

(a) market segmentation theory(b) pure expectations theory(c) liquidity premium theory(d) separable markets theory

Answer: A

63. Since yield curves are usually upward sloping, the _________ indicates that, on average, people tend to prefer holding short-term bonds to long-term bonds.

(a) market segmentation theory(b) pure expectations theory(c) liquidity premium theory

(d) both (a) and (b) of the above(e) both (a) and (c) of the above

Answer: E

64. _________ cannot explain the empirical fact that interest rates on bonds of different maturities tend to move together.

(a) The market segmentation theory(b) The pure expectations theory(c) The liquidity premium theory(d) Both (a) and (b) of the above(e) Both (a) and (c) of the above

Answer: A

65. Which of the following theories of the term structure is (are) able to explain the fact that interest rates on bonds of different maturities tend to move together over time?

(a) The expectations hypothesis(b) The segmented markets theory(c) The preferred habitat theory(d) Both (a) and (b) of the above(e) Both (a) and (c) of the above

Answer: E

66. Of the four theories that explain how interest rates on bonds with different terms to maturity are related, the one that views long-term interest rates as equaling the average of future short-term rates expected to occur over the life of the bond is the

(a) pure expectations theory.(b) preferred habitat theory.(c) liquidity premium theory.(d) segmented markets theory.

Answer: A

67. Of the four theories that explain how interest rates on bonds with different terms to maturity are related, the one that assumes that bonds of different maturities are not substitutes for one anotheris the

(a) pure expectations theory.(b) segmented markets theory.(c) liquidity premium theory.(d) preferred habitat theory.

Answer: B

68. A moderately upward-sloping yield curve indicates that short-term interest rates are expected to

(a) neither rise nor fall in the near future.(b) remain relatively unchanged, but that long-term rates are expected to fall.(c) neither rise nor fall, but that long-term rates are expected to rise moderately.(d) rise moderately in the near future.

Answer: A

69. A steep upward sloping yield curve indicates that short-term interest rates are expected to

(a) neither rise nor fall in the near future.(b) remain relatively unchanged, but that long-term rates are expected to fall.(c) neither rise nor fall, but that long-term rates are expected to rise moderately.(d) rise moderately in the near future.

Answer: D

True/False

1. The term structure of interest rates describes how interest rates move over time.

Answer: FALSE

2. The risk structure of interest rates describes the relationship between the interest rates of different bonds with the same maturity.

Answer: TRUE

3. Following the Enron bankruptcy, the spread between the interest rates on Baa bonds and Aaa bonds widened.

Answer: TRUE

4. The risk premium on corporate bonds becomes smaller as the liquidity of the bonds falls.

Answer: FALSE

5. An increase in income tax rates will cause the interest rates on tax exempt municipal bonds to fall relative to the interest rate on taxable corporate securities.

Answer: TRUE

6. The interest rates on bonds of different maturities tend to move together over time.

Answer: TRUE

7. The pure expectations theory is able to explain why yield curves are usually upward-sloping.

Answer: FALSE

8. According to the pure expectations theory, the interest rate on a long-term bond is the average of the short-term interest rates expected over the life of the long-term bond.

Answer: TRUE

9. The market segmentation theory is able to explain why interest rates on bonds of different maturities move together over time.

Answer: FALSE

10. Bonds with the lowest risk of default are often referred to as junk bonds.

Answer: FALSE

11. A positive liquidity premium indicates that investors prefer long-term bonds over short-term bonds.

Answer: FALSE

12. A mildly upward sloping yield curve suggests that the market is predicting constant short-term interest rates.

Answer: TRUE

13. An increase in the marginal tax rate would likely increase the demand for municipal bonds, and decrease the demand for U.S. government bonds.

Answer: TRUE

14. When yield curves are downward sloping, long-term interest rates are above short-terminterest rates.

Answer: FALSE

Essay

1. Contrast the liquidity premium theory to the market segmentation theory of the term structure of interest rates.

2. Why would an increase in the income tax rate reduce borrowing costs to municipalities?

3. Discuss what is shown by a yield curve.

4. Why is it unlikely that the pure expectations theory alone is the correct theory for explaining the yield curve?

5. What is meant by the risk structure of interest rates?

6. How would a severe recession affect the risk premium on corporate bonds?

7. Explain why a flight to quality occurred following the Enron bankruptcy and how this affected the interest rates on lower quality and higher quality corporate bonds.

8. What do credit-rating agencies do and why is this work important?

Chapter 6The Money Markets


1. Activity in money markets increased significantly in the late 1970s and early 1980s because of

(a) rising short-term interest rates.(b) regulations that limited what banks could pay for deposits.(c) both (a) and (b).(d) neither (a) nor (b).

Answer: C

2. Money market securities have all the following characteristics except they are not

(a) short term.(b) money.(c) low risk.(d) very liquid.

Answer: B

3. Money market instruments

(a) are usually sold in large denominations.(b) have low default risk.(c) mature in one year or less.(d) are characterized by all of the above.(e) are characterized by only (a) and (b) of the above.

Answer: D

4. The banking industry

(a) should have an efficiency advantage in gathering information that would eliminate the need for the money markets.

(b) exists primarily to mediate the asymmetric information problem between saver-lenders and borrower-spenders.

(c) is subject to more regulations and governmental costs than are the money markets.(d) all of the above are true.(e) only (a) and (b) of the above are true.

Answer: D

5. In situations where asymmetric information problems are not severe,

(a) the money markets have a distinct cost advantage over banks in providing short-term funds.

(b) the money markets have a distinct cost advantage over banks in providing long-term funds.

(c) banks have a distinct cost advantage over the money markets in providing short-term funds.

(d) the money markets cannot allocate short-term funds as efficiently as banks can.

Answer: A

6. Brokerage firms that offered money market security accounts in the 1970s had a cost advantage over banks in attracting funds because the brokerage firms

(a) were not subject to deposit reserve requirements.(b) were not subject to the deposit interest rate ceilings.(c) were not limited in how much they could borrow from depositors.(d) had the advantage of all the above.(e) had the advantage of only (a) and (b) of the above.

Answer: E

7. Which of the following statements about the money market are true?

(a) Not all commercial banks deal for their customers in the secondary market.(b) Money markets are used extensively by businesses both to warehouse surplus funds

and to raise short-term funds.(c) The single most influential participant in the U.S. money market is the U.S.

Treasury Department.(d) All of the above are true.(e) Only (a) and (b) of the above are true.

Answer: E

8. Which of the following statements about the money markets are true?

(a) Most money market securities do not pay interest. Instead the investor pays less for the security than it will be worth when it matures.

(b) Pension funds invest a portion of their assets in the money market to have sufficient liquidity to meet their obligations.

(c) Unlike most participants in the money market, the U.S. Treasury Department is always a demander of money market funds and never a supplier.


Answer: D

9. Which of the following are true statements about participants in the money markets?

(a) Large banks participate in the money markets by selling large negotiable CDs.(b) The U.S. government and corporations borrow in the money markets because cash

inflows and outflows are rarely synchronized.(c) The Federal Reserve is the single most influential participant in the U.S. money

market.(d) All of the above are true.(e) Only (a) and (b) of the above are true.

Answer: D

10. The most influential participant(s) in the U.S. money market

(a) is the Federal Reserve.(b) is the U.S. Treasury Department.(c) are the large money center banks.(d) are the investment banks that underwrite securities.

Answer: A

11. The Fed is an active participant in money markets mainly because of its responsibility to

(a) lower borrowing costs to encourage capital investment.(b) control the money supply.(c) increase the interest income of retirees holding money market instruments.(d) assist the Securities and Exchange Commission in regulating the behavior other

money market participants.

Answer: B

12. Commercial banks are large holders of _________ and are the major issuer of _________.

(a) negotiable certificates of deposit; U.S. government securities(b) U.S. government securities; negotiable certificates of deposit(c) commercial paper; Eurodollars(d) Eurodollars; commercial paper

Answer: B

13. The primary function of large diversified brokerage firms in the money market is to

(a) sell money market securities to the Federal Reserve for its open market operations.(b) make a market for money market securities by maintaining an inventory from

which to buyor sell.

(c) buy money market securities from corporations that need liquidity.(d) buy T-bills from the U.S. Treasury Department.

Answer: B

14. Finance companies raise funds in the money market by selling

(a) commercial paper.(b) federal funds.(c) negotiable certificates of deposit.(d) Eurodollars.

Answer: A

15. Finance companies play a unique role in money markets by

(a) giving consumers indirect access to money markets.(b) combining consumers’ investments to purchase money market securities on their

behalf.(c) borrowing in capital markets to finance purchases of money market securities.(d) assisting the government in its sales of U.S. Treasury securities.

Answer: A

16. When inflation rose in the late 1970s,

(a) consumers moved money out of money market mutual funds because their returns did not keep pace with inflation.

(b) banks solidified their advantage over money markets by offering higher deposit rates.

(c) brokerage houses introduced highly popular money market mutual funds, which drew significant amounts of money out of bank deposits.

(d) consumers were unable to take advantage of higher rates in money markets because of the requirement of large transaction sizes.

Answer: C

17. Which of the following is the largest borrower in the money markets?

(a) commercial banks(b) large corporations(c) the U.S. Treasury(d) U.S. firms engaged in foreign trade

Answer: C

18. Money market instruments issued by the U.S. Treasury are called

(a) Treasury bills.(b) Treasury notes.(c) Treasury bonds.(d) Treasury strips.

Answer: A

19. The Treasury auctions 91-day and 182-day Treasury bills once a week. It auctions 52-week bills

(a) once a month.(b) once every 13 weeks.(c) once a year.(d) every two weeks.

Answer: A

20. Which of the following statements are true of Treasury bills?

(a) The market for Treasury bills is extremely deep and liquid.(b) Occasionally, investors find that earnings on T-bills do not compensate them for

changes in purchasing power due to inflation.(c) By volume, most Treasury bills are sold to individuals who submit noncompetitive

bids.(d) All of the above are true.(e) Only (a) and (b) of the above are true.

Answer: E

21. Suppose that you purchase a 91-day Treasury bill for $9,850 that is worth $10,000 when it matures. The security’s annualized yield if held to maturity is about


Answer: C

22. Suppose that you purchase a 182-day Treasury bill for $9,850 that is worth $10,000 when it matures. The security’s annualized yield if held to maturity is about

(a) 1.5%(b) 2%(c) 3%(d) 6%

Answer: C

23. Treasury bills do not

(a) pay interest.(b) have a maturity date.(c) have a face amount.(d) have an active secondary market.

Answer: A

24. If your competitive bid for a Treasury bill is successful, then you will

(a) certainly pay less than if you had submitted a noncompetitive bid.(b) probably pay more than if you had submitted a noncompetitive bid.(c) pay the average of prices offered in other successful competitive bids.(d) pay the same as other successful competitive bidders.

Answer: B

25. If your noncompetitive bid for a Treasury bill is successful, then you will

(a) certainly pay less than if you had submitted a competitive bid.(b) certainly pay more than if you had submitted a competitive bid.(c) pay the average of prices offered in other noncompetitive bids.(d) pay the same as other successful noncompetitive bidders.

Answer: D

26. Federal funds

(a) are short-term funds transferred between financial institutions, usually for a period of one day.

(b) actually have nothing to do with the federal government.(c) provide banks with an immediate infusion of reserves.(d) are all of the above.(e) are only (a) and (b) of the above.

Answer: D

27. Federal funds are

(a) usually overnight investments.(b) borrowed by banks that have a deficit of reserves.(c) lent by banks that have an excess of reserves.(d) all of the above.(e) only (a) and (b) of the above.

Answer: D

28. The Fed can influence the federal funds interest rate by adjusting the level of reserves available to banks. The Fed can

(a) lower the federal funds interest rate by adding reserves.(b) raise the federal funds interest rate by removing reserves.(c) remove reserves by selling securities.(d) do all of the above.(e) do only (a) and (b) of the above.

Answer: D

29. The Federal Reserve can influence the federal funds interest rate by buying securities, which _________ reserves, thereby _________ the federal funds rate.

(a) adds; raising(b) removes; lowering(c) adds; lowering(d) removes; raising

Answer: C

30. The Fed can lower the federal funds interest rate by _________ securities, thereby _________ reserves.

(a) selling; adding(b) selling; lowering(c) buying; adding(d) buying; lowering

Answer: C

31. If the Fed wants to lower the federal funds interest rate, it will _________ the banking system by _________ securities.

(a) add reserves to; selling(b) add reserves to; buying(c) remove reserves from; selling(d) remove reserves from; buying

Answer: B

32. If the Fed wants to raise the federal funds interest rate, it will _________ securities to _________ the banking system.

(a) sell; add reserves to(b) sell; remove reserves from(c) buy; add reserves to(d) buy; remove reserves from

Answer: B

33. Government securities dealers frequently engage in repos to

(a) manage liquidity.(b) take advantage of anticipated changes in interest rates.(c) lend or borrow for a day or two with what is essentially a collateralized loan.(d) do all of the above.(e) do only (a) and (b) of the above.

Answer: D

34. Repos are

(a) usually low risk loans.(b) usually collateralized with Treasury securities.(c) low interest rate loans.(d) all of the above.(e) only (a) and (b) of the above.

Answer: D

35. A negotiable certificate of deposit

(a) is a term security because it has a specified maturity date.(b) is a bearer instrument, meaning whoever holds the certificate at maturity receives

the principal and interest.(c) can be bought and sold until maturity.(d) all of the above.(e) only (a) and (b) of the above.

Answer: D

36. Negotiable certificates of deposit

(a) are bearer instruments because their holders earn the interest and principal at maturity.

(b) typically have a maturity of one to four months.(c) are usually denominated at $100,000.(d) are all of the above.(e) are only (a) and (b) of the above.

Answer: E

37. Commercial paper securities

(a) are issued only by the largest and most creditworthy corporations, as they are unsecured.

(b) carry an interest rate that varies according to the firm’s level of risk.(c) never have a term to maturity that exceeds 270 days.(d) all of the above.(e) only (a) and (b) of the above.

Answer: D

38. Unlike most money market securities, commercial paper

(a) is not generally traded in a secondary market.(b) usually has a term to maturity that is longer than a year.(c) is not popular with most money market investors because of the high default risk.(d) all of the above.

(e) only (a) and (b) of the above.

Answer: A

39. A banker’s acceptance is

(a) used to finance goods that have not yet been transferred from the seller to the buyer.

(b) an order to pay a specified amount of money to the bearer on a given date.(c) a relatively new money market security that arose in the 1960s as international

trade expanded.(d) all of the above.(e) only (a) and (b) of the above.

Answer: E

40. Banker’s acceptances

(a) can be bought and sold until they mature.(b) are issued only by large money center banks.(c) carry low interest rates because of the very low default risk.(d) are all of the above.(e) are only (a) and (b) of the above.

Answer: D

41. Eurodollars

(a) are time deposits with fixed maturities and are, therefore, somewhat illiquid.(b) may offer the borrower a lower interest rate than can be received in the domestic

market.(c) are limited to London banks.(d) are all of the above.(e) are only (a) and (b) of the above.

Answer: E

42. Which of the following statements about money market securities are true?

(a) The interest rates on all money market instruments move very closely together over time.

(b) The secondary market for Treasury bills is extensive and well developed.(c) There is no well-developed secondary market for commercial paper.(d) All of the above are true.(e) Only (a) and (b) of the above are true.

Answer: D

True/False

1. Money market securities are short-term instruments with an original maturity of less than one year.

Answer: TRUE

2. Money market securities include Treasury bills, commercial paper, federal funds, repurchase agreements, negotiable certificates of deposit, banker’s acceptances, and Eurodollars.

Answer: TRUE

3. The term money market is actually a misnomer, because liquid securities are traded in these markets rather than money.

Answer: TRUE

4. Money markets are referred to as retail markets because small individual investors are the primary buyers of money market securities.

Answer: FALSE

5. The U.S. Treasury Department is the single most influential participant in the U.S. money market.

Answer: FALSE

6. The U.S. Treasury Department is the single largest borrower in the U.S. money market.

Answer: TRUE

7. Banks are unusual participants in the money market because they buy, but do not sell, money market instruments.

Answer: FALSE

8. Money markets are used extensively by businesses both to warehouse surplus funds and to raise short-term funds.

Answer: TRUE

9. The market for U.S. Treasury bills is a shallow market because so few individual investors buyT-bills.

Answer: FALSE

10. The T-bill is not an investment to be used for anything but temporary storage of excess funds because it barely keeps up with inflation.

Answer: TRUE

11. The main purpose for federal funds is to provide banks with an immediate infusion of reserves should they be short.

Answer: TRUE

12. The Fed can influence the federal funds rate by adjusting the level of reserves in the banking system.

Answer: TRUE

13. Commercial paper securities are unsecured promissory notes, issued by corporations, that mature in no more than 270 days.

Answer: TRUE

14. A banker’s acceptance is an order to pay a specified amount of money to the bearer on a given date. Banker’s acceptances have been used since the twelfth century.

Answer: TRUE

15. Interest rates on banker’s acceptances are low because the risk of default is very low.

Answer: TRUE

16. In general, money market instruments are low risk, high yield securities.

Answer: FALSE

Essay

1. Explain why banks, which would seem to have a comparative advantage in gathering information, have not eliminated the need for the money markets.

2. Explain how the Federal Reserve can influence the federal funds interest rate.

3. Explain why the money markets are referred to as wholesale markets.

4. Explain why money market interest rates move so closely together over time.

5. How are Treasury bills sold? How do competitive and noncompetitive bids differ?

6. What are the main characteristics of money market securities?

7. What are the major types of securities and who are the major participants in the money markets?

Chapter 7The Bond Market


1. Compared to money market securities, capital market securities have

(a) more liquidity.(b) longer maturities.(c) lower yields.(d) less risk.

Answer: B

2. (I) Securities that have an original maturity greater than one year are traded in capital markets.(II) The best known capital market securities are stocks and bonds.


Answer: C

3. (I) Securities that have an original maturity greater than one year are traded in money markets.(II) The best known money market securities are stocks and bonds.


Answer: D

4. (I) Firms and individuals use the capital markets for long-term investments. (II) The capital markets provide an alternative to investment in assets such as real estate and gold.


Answer: C

5. The primary reason that individuals and firms choose to borrow long-term is to reduce the risk that interest rates will _________ before they pay off their debt.

(a) rise(b) fall(c) become more volatile(d) become more stable

Answer: A

6. A firm that chooses to finance a new plant by issuing money market securities

(a) must incur the cost of issuing new securities to roll over its debt.(b) runs the risk of having to pay higher interest rates when it rolls over its debt.(c) incurs both the cost of reissuing securities and the risk of having to pay higher

interest rates on the new debt.(d) is more likely to profit if interest rates rise while the plant is being constructed.

Answer: C

7. The primary reason that individuals and firms choose to borrow long-term is to

(a) reduce the risk that interest rates will fall before they pay off their debt.(b) reduce the risk that interest rates will rise before they pay off their debt.(c) reduce monthly interest payments, as interest rates tend to be higher on short-term

thanlong-term debt instruments.

(d) reduce total interest payments over the life of the debt.

Answer: B

8. A firm will borrow long-term

(a) if the extra interest cost of borrowing long-term is less than the expected cost of rising interest rates before it retires its debt.

(b) if the extra interest cost of borrowing short-term due to rising interest rates does not exceed the expected premium that is paid for borrowing long term.

(c) if short-term interest rates are expected to decline during the term of the debt.(d) if long-term interest rates are expected to decline during the term of the debt.

Answer: A

9. The primary issuers of capital market securities include

(a) the federal and local governments.(b) the federal and local governments, and corporations.(c) the federal and local governments, corporations, and financial institutions.(d) local governments and corporations.

Answer: B

10. Governments never issue stock because

(a) they cannot sell ownership claims.(b) the Constitution expressly forbids it.(c) both (a) and (b) of the above.(d) neither (a) nor (b) of the above.

Answer: A

11. (I) The primary issuers of capital market securities are federal and local governments, and corporations. (II) Governments never issue stock because they cannot sell ownership claims.


Answer: C

12. (I) The primary issuers of capital market securities are financial institutions.

(II) The largest purchasers of capital market securities are corporations.


Answer: D

13. The distribution of a firm’s capital between debt and equity is its

(a) leverage ratio.(b) liability structure(c) acid ratio.(d) capital structure.

Answer: D

14. The largest purchasers of capital market securities are

(a) households.(b) corporations(c) governments.(d) central banks.

Answer: A

15. Individuals and households frequently purchase capital market securities through financial institutions such as

(a) mutual funds.(b) pension funds.(c) money market mutual funds.(d) all of the above.(e) only (a) and (b) of the above.

Answer: E

16. (I) There are two types of exchanges in the secondary market for capital securities: organized exchanges and over-the-counter exchanges. (II) When firms sell securities for the very first time, the issue is an initial public offering.


Answer: C

17. (I) Capital market securities fall into two categories: bonds and stocks. (II) Long-term bonds include government bonds and long-term notes, municipal bonds, and corporate bonds.


Answer: B

18. The _________ value of a bond is the amount that the issuer must pay at maturity.

(a) market(b) present(c) discounted(d) face

Answer: D

19. The _________ rate is the rate of interest that the issuer must pay.

(a) market(b) coupon(c) discount(d) funds

Answer: B

20. (I) The coupon rate is the rate of interest that the issuer of the bond must pay.

(II) The coupon rate is usually fixed for the duration of the bond and does not fluctuate with market interest rates.


Answer: C

21. (I) The coupon rate is the rate of interest that the issuer of the bond must pay. (II) The coupon rate on old bonds fluctuates with market interest rates so they will remain attractive to investors.


Answer: A

22. Treasury bonds are subject to _________ risk but are free of _________ risk.

(a) default; interest-rate(b) default; underwriting(c) interest-rate; default(d) interest-rate; underwriting

Answer: C

23. The prices of Treasury notes, bonds, and bills are quoted

(a) as a percentage of the coupon rate.(b) as a percentage of the previous day’s closing value.(c) as a percentage of $100 face value.(d) as a multiple of the annual interest paid.

Answer: C

24. The security with the longest maturity is a Treasury

(a) note.(b) bond.(c) acceptance.(d) bill.

Answer: B

25. (I) To sell an old bond when interest rates have risen, the holder will have to discount the bond until the yield to the buyer is the same as the market rate. (II) The risk that the value of a bond will fall when market interest rates rise is called interest-rate risk.


Answer: C

26. To sell an old bond when interest rates have _________, the holder will have to _________ the price of the bond until the yield to the buyer is the same as the market rate.

(a) risen; lower(b) risen; raise(c) fallen; lower(d) risen; inflate

Answer: A

27. Most of the time, the interest rate on Treasury notes and bonds is _________ that on money market securities because of _________ risk.

(a) above; interest-rate(b) above; default(c) below; interest-rate(d) below; default

Answer: A

28. (I) In most years the rate of return on short-term Treasury bills is below that on the 20-yearTreasury bond. (II) Interest rates on Treasury bills are more volatile than rates on long-term Treasury securities.


Answer: C

29. (I) Because interest rates on Treasury bills are more volatile than rates on long-term securities, the return on short-term Treasury securities is usually above that on longer-term Treasury securities.(II) A Treasury STRIP separates the periodic interest payments from the final principal repayment.

(a) (I) is true, (II) false.(b) (I) is false, (II) true.(c) Both are true.

(d) Both are false.

Answer: B

30. Which of the following statements about Treasury inflation-indexed bonds is not true?

(a) The principal amount used to compute the interest payment varies with the consumerprice index.

(b) The interest payment rises when inflation occurs.(c) The interest rate rises when inflation occurs.(d) At maturity the securities pay the greater of face-value or inflation-adjusted

principal.

Answer: C

31. The interest rates on government agency bonds are

(a) almost identical to those available on Treasury securities since it is unlikely that the federal government would permit its agencies to default on their obligations.

(b) significantly higher than those available on Treasury securities due to their low liquidity.

(c) significantly lower than those available on Treasury securities because agency interest payments are tax exempt.

(d) significantly lower than those available on Treasury securities because the interest-rate risk on agency securities is lower than that on Treasury securities.

Answer: B

32. (I) Municipal bonds that are issued to pay for essential public projects are exempt from federal taxation. (II) General obligation bonds do not have specific assets pledged as security or a specific source of revenue allocated for their repayment.


Answer: C

33. (I) Most corporate bonds have a face value of $1000, pay interest semi-annually, and can be redeemed anytime the issuer wishes. (II) Registered bonds have now been largely replaced by bearer bonds, which do not have coupons.


Answer: A

34. The bond contract that states the lender’s rights and privileges and the borrower’s obligations is called the

(a) bond syndicate.(b) restrictive covenant.(c) bond covenant.(d) bond indenture.

Answer: D

35. Policies that limit the discretion of managers as a way of protecting bondholders’ interests are called

(a) restrictive covenants.(b) debentures.(c) sinking funds.(d) bond indentures.

Answer: A

36. Typically, the interest rate on corporate bonds will be _________ the more restrictions are placed on management through restrictive covenants, because _________.

(a) higher; corporate earnings will be limited by the restrictions(b) higher; the bonds will be considered safer by bondholders(c) lower; the bonds will be considered safer by buyers(d) lower; corporate earnings will be higher with more restrictions in place

Answer: C

37. Restrictive covenants can

(a) limit the amount of dividends the firm can pay.(b) limit the ability of the firm to issue additional debt.(c) restrict the ability of the firm to enter into a merger agreement.(d) do all of the above.(e) do only (a) and (b) of the above.

Answer: D

38. (I) Restrictive covenants often limit the amount of dividends that firms can pay the stockholders.(II) Most corporate indentures include a call provision, which states that the issuer has the right to force the holder to sell the bond back.


Answer: C

39. Call provisions will be exercised when interest rates _________ and bond values _________.

(a) rise; rise(b) fall; rise(c) rise; fall(d) fall; fall

Answer: B

40. A requirement in the bond indenture that the firm pay off a portion of the bond issue each yearis called

(a) a sinking fund.(b) a call provision.(c) a restrictive covenant.(d) a shelf registration.

Answer: A

41. (I) Callable bonds must have a higher yield than comparable noncallable bonds. (II) Convertible bonds are attractive to bondholders and sell for a higher price than comparable nonconvertible bonds.


Answer: C

42. Long-term unsecured bonds that are backed only by the general creditworthiness of the issuerare called

(a) junk bonds.(b) callable bonds.(c) convertible bonds.(d) debentures.

Answer: D

43. A secured bond is backed by

(a) the general creditworthiness of the borrower.(b) an insurance company’s financial guarantee.(c) the expected future earnings of the borrower.

(d) specific collateral.

Answer: D

44. Financial guarantees

(a) are insurance policies to back bond issues.(b) are purchased by financially weaker security issuers.(c) lower the risk of the bonds covered by the guarantee.(d) do all of the above.(e) do only (a) and (b) of the above.

Answer: D

45. Corporate bonds are less risky if they are _________ bonds and municipal bonds are less risky if they are _________ bonds.

(a) secured; revenue(b) secured; general obligation(c) unsecured; revenue(d) unsecured; general obligation

Answer: B

46. Which of the following are true for the current yield?

(a) The current yield is defined as the yearly coupon payment divided by the price of the security.

(b) The formula for the current yield is identical to the formula describing the yield to maturity for a discount bond.

(c) The current yield is always a poor approximation for the yield to maturity.(d) All of the above are true.(e) Only (a) and (b) of the above are true.

Answer: A

47. The nearer a bond’s price is to its par value and the longer the maturity of the bond the more closely _________ approximates _________

(a) current yield; yield to maturity.(b) current yield; coupon rate.(c) yield to maturity; current yield.(d) yield to maturity; coupon rate.

Answer: A

48. Which of the following are true for the current yield?

(a) The current yield is defined as the yearly coupon payment divided by the price of the security.

(b) The current yield and the yield to maturity always move together.

(c) The formula for the current yield is identical to the formula describing the yield to maturity for a discount bond.


Answer: E

49. The current yield is a less accurate approximation of the yield to maturity the _________ the time to maturity of the bond and the _________ the price is from/to the par value.

(a) shorter; closer(b) shorter; farther(c) longer; closer(d) longer; farther

Answer: B

50. The current yield on a $6,000, 10 percent coupon bond selling for $5,000 is


Answer: C

51. The current yield on a $5,000, 8 percent coupon bond selling for $4,000 is

(a) 5 percent.(b) 8 percent.(c) 10 percent.(d) 20 percent.(e) none of the above.

Answer: C

52. For a consol, the current yield is an _________ of the yield to maturity.

(a) underestimate(b) overestimate(c) approximate measure(d) exact measure

Answer: D

53. Which of the following are true of the yield on a discount basis as a measure of the interest rate?

(a) It uses the percentage gain on the face value of the security, rather than the percentage gain on the purchase price of the security.

(b) It puts the yield on the annual basis of a 360-day year.(c) It ignores the time to maturity.(d) All of the above are true.(e) Only (a) and (b) of the above are true.

Answer: E

54. The formula for the measure of the interest rate called the yield on a discount basis is peculiar because

(a) it puts the yield on the annual basis of a 360-day year.(b) it uses the percentage gain on the purchase price of the bill.(c) it ignores the time to maturity.(d) both (a) and (b) of the above.(e) both (a) and (c) of the above.

Answer: A

55. The yield on a discount basis of a 180-day $1,000 Treasury bill selling for $950 is


Answer: A


(a) 5 percent.(b) 10 percent.(c) 15 percent.(d) 20 percent.(e) none of the above.

Answer: D



Answer: D


(a) 10 percent.(b) 20 percent.

(c) 25 percent.(d) 40 percent.

Answer: B

59. When an old bond’s market value is above its par value the bond is selling at a _________. This occurs because the old bond’s coupon rate is _________ the coupon rates of new bonds withsimilar risk.

(a) premium; below(b) premium; above(c) discount; below(d) discount; above

Answer: B

True/False

1. The primary issuers of capital market securities are local governments and corporations.

Answer: FALSE

2. Capital market securuties are less liquid and have longer maturities than money market securities.

Answer: TRUE

3. Governments never issue stock because they cannot sell ownership claims.

Answer: TRUE

4. To sell an old bond when rates have risen, the holder will have to discount the bond until the yield to the buyer is the same as the market rate.

Answer: TRUE

5. Most of the time, the interest rate on Treasury notes is below that on money market securities because of their low default risk.

Answer: FALSE

6. Municipal bonds that are issued to pay for essential public projects are exempt from federal taxation.

Answer: TRUE

7. Most municipal bonds are revenue bonds rather than general obligation bonds.

Answer: FALSE

8. Most corporate bonds have a face value of $1000, are sold at a discount, and can only be redeemed at the maturity date.

Answer: FALSE

9. Registered bonds have now been largely replaced by bearer bonds, which do not have coupons.

Answer: FALSE

10. A sinking fund is a requirement in the bond indenture that the firm pay off a portion of the bond issue each year.

Answer: TRUE

11. Debentures are long-term unsecured bonds that are backed only by the general creditworthiness of the issuer.

Answer: TRUE

12. In a leveraged buy out, a firm greatly increases its debt level by issuing junk bonds to finance the purchase of another firm’s stock.

Answer: TRUE

13. A financial guarantee ensures that the lender (bond purchaser) will be paid both principal and interest in the event the issuer defaults.

Answer: TRUE

14. The current yield on a bond is a good approximation of the bond’s yield to maturity when the bond matures in five years or less and its price differs from its par value by a large amount.

Answer: FALSE

Essay

1. What is the purpose of the capital market? How do cpaital market securities differ from money market securities in their general characteristics?

2. What is a bond indenture?

3. What role do restrictive covenants play in bond markets?

4. What is the difference between a general obligation and a revenue bond?

5. What are Treasury STRIPS?

6. What is a convertible bond? How does the convertibility feature affect the bond’s price andinterest rate?

7. What is a bond’s current yield? How does current yield differ from yield to maturity and what determines how close the two values are?

8. Distinguish between general obligation and revenue municipal bonds.

9. What is a callable bond? How does the callability feature affect the bond’s price and interest rate?.

10. What types of risks should bondholders be aware of and how do these affect bond prices and yields?

Chapter 8The Stock Market


1. (I) A share of common stock in a firm represents an ownership interest in that firm. (II) A share of preferred stock is as much like a bond as it is like common stock.


Answer: C

2. Preferred stockholders hold a claim on assets that has priority over the claims of

(a) both common stockholders and bondholders.(b) neither common stockholders nor bondholders.(c) common stockholders, but after that of bondholders.(d) bondholders, but after that of common stockholders.

Answer: C

3. (I) Preferred stockholders hold a claim on assets that has priority over the claims of common stockholders, but after that of bondholders. (II) Firms issue preferred stock in far greater amounts than common stock.


Answer: A

4. (I) Preferred stockholders hold a claim on assets that has priority over the claims of common stockholders. (II) Bondholders hold a claim on assets that has priority over the claims of preferred stockholders.


Answer: C

5. (I) Firms issue common stock in far greater amounts than preferred stock. (II) The total volume of stock issued is much less than the volume of bonds issued.


Answer: C

6. The riskiest capital market security is

(a) preferred stock.(b) common stock.(c) corporate bonds.(d) Treasury bonds.

Answer: B

7. Organized exchanges account for about _________ percent of the total dollar volume of domestic stock shares traded.

(a) 30(b) 45(c) 60(d) 70

Answer: D

8. Organized exchanges account for about _________ percent of the total dollar volume of domestic stocks traded.

(a) 60(b) 70(c) 80(d) 90

Answer: B

9. (I) The largest of the organized stock exchanges in the United States is the New York Stock Exchange. (II) To be listed on the NYSE, a firm must have a minimum of $100 million dollars in market value or $10 million in revenues.


Answer: A

10. To list on the NYSE, a firm must

(a) have earnings of at least $100 million for each of the last three years.(b) have at least $500 million of market value and $100 million of revenue.(c) have a total of $100 million in market value of publicly traded shares.(d) meet all of the above requirements.(e) meet (a) and (b) of the above requirements.

Answer: E

11. Securities not listed on one of the exchanges trade in the over-the-counter market. In this exchange, dealers “make a market” by

(a) buying stocks for inventory when investors want to sell.(b) selling stocks from inventory when investors want to buy.(c) doing both of the above.(d) doing neither of the above.

Answer: C

12. The most active stock exchange in the world is the

(a) Nikkei Stock Exchange.(b) London Stock Exchange.(c) Shanghai Stock Exchange.(d) New York Stock Exchange.

Answer: A

13. Which of the following statements about trading operations in an organized exchange are correct?

(a) Floor traders all deal in a wide variety of stocks.(b) In most trades, specialists match buy and sell orders.(c) In most trades, specialists buy for or sell from their own inventories.(d) The SuperDOT system is used to expedite large trades of over 100,000 shares.

Answer: B

14. Which of the following is not an advantage of Electronic Communications Networks (ECNs)?

(a) All unfilled orders are available for review by ECN traders.(b) Transactions costs are lower for ECN trades.(c) Trades are made and confirmed faster.(d) ECNs work well for thinly traded stocks.

Answer: D

15. Which of the following statements is false regarding Electronic Communications Networks (ECNs)?

(a) Archipelago and Instinet are two examples of ECNs.(b) Competition from ECNs has forced NASDAQ to cut its fees.(c) Traders benefit from lower trading costs and faster service.(d) ECNs allow institutional investors, but not individuals, to trade after hours.

Answer: D

16. A basic principle of finance is that the value of any investment is

(a) the present value of all future net cash flows generated by the investment.(b) the undiscounted sum of all future net cash flows generated by the investment.(c) unrelated to the future net cash flows generated by the investment.(d) unrelated to the degree of risk associated with the future net cash flows generated

by the investment.

Answer: A

17. A stock currently sells for $25 per share and pays $0.24 per year in dividends. What is an investor’s valuation of this stock if she expects it to be selling for $30 in one year and requires 15 percent return on equity investments?

(a) $30.24(b) $26.30(c) $26.09(d) $27.74

Answer: B

18. A stock currently sells for $30 per share and pays $1.00 per year in dividends. What is an investor’s valuation of this stock if he expects it to be selling for $37 in one year and requires 12 percent return on equity investments?

(a) $38(b) $33.50(c) $34.50(d) $33.93

Answer: D

19. In the one-period valuation model, a stock’s value will be higher

(a) the higher is its expected future price.(b) the lower is its dividend.(c) the higher is the required return on investments in equity.(d) all of the above.

Answer: A

20. In the one-period valuation model, a stock’s value falls if the _________ rises.

(a) dividend(b) expected future price(c) required return on equity(d) current price

Answer: C

21. In the generalized dividend valuation model a stock’s value depend only on

(a) its future dividend payments and its future price.(b) its future dividend payments and the required return on equity.(c) its future price and the required return on investments on equity.(d) its future dividend payments.

Answer: B

22. Which of the following is not an element of the Gordon growth model of stock valuation?

(a) the stock’s most recent dividend paid.(b) the expected constant growth rate of dividends.(c) the required return on investments in equity.(d) the stock’s expected future price.

Answer: D

23. According to the Gordon growth model, what is an investor’s valuation of a stock whose current dividend is $1.00 per year if dividends are expected to grow at a constant rate of 10 percent over a long period of time and the investor’s required return is 11 percent?

(a) $110(b) $100(c) $11(d) $10(e) $5.24

Answer: A

24. According to the Gordon growth model, what is an investor’s valuation of a stock whose current dividend is $1.00 per year if dividends are expected to grow at a constant rate of 10 percent over a long period of time and the investor’s required return is 15 percent?

(a) $20(b) $11(c) $22(d) $7.33(e) $4.40

Answer: C

25. Holding other things constant, a stock’s value will be highest if its dividend growth rate is


Answer: A

26. Holding other things constant, a stock’s value will be highest if its most recent dividend is

(a) $2.00(b) $5.00(c) $0.50(d) $1.00

Answer: B

27. Holding other things constant, a stock’s value will be highest if the investor’s required return on investments in equity is


Answer: D

28. Suppose the average industry PE ratio for auto parts retailers is 20. What is the current price of Auto Zone stock if the retailer’s earnings per share are projected to be $1.85?

(a) $21.85(b) $37(c) $10.81

(d) $9.25

Answer: B

29. Which of the following is true regarding the Gordon growth model?

(a) Dividends are assumed to grow at a constant rate forever.(b) The dividend growth rate is assumed to be greater than the required return on

equity.(c) Both (a) and (b).(d) Neither (a) nor (b).

Answer: A

30. The PE ratio approach to valuing stock is especially useful for valuing

(a) privately held firms.(b) firms that don’t pay dividends.(c) both (a) and (b).(d) neither (a) nor (b).

Answer: C

31. The PE ratio approach to valuing stock is especially useful for valuing

(a) publicly held corporations.(b) firms that regularly pay dividends.(c) both (a) and (b).(d) neither (a) nor (b).

Answer: D

32. A weakness of the PE approach to valuing stock is that it is

(a) difficult to estimate the constant growth rate of a firm’s dividends.(b) difficult to estimate the required return on equity.(c) difficult to predict how much a firm will pay in dividends.(d) based on industry averages rather than firm-specific factors.

Answer: D

33. A firm is expected to pay a dividend of $1.00 next year and the dividend is expected to grow at a constant rate of 4 percent over time. Some investors have required returns on investments in equity of 12 percent, some 10 percent, and some 8 percent. The market price of this firm’s stock will be slightly above

(a) $25(b) $18(c) $16.67(d) $12.50

Answer: C

34. (I) The market price of a security at a given time is the highest value any investor puts on the security. (II) Superior information about a security increases its value by reducing its risk.

(a) (I) is true, (II) is false.(b) (I) is false, (II) is true.(c) Both are true.(d) Both are false.

Answer: B

35. The main cause of fluctuations in stock prices is changes in

(a) tax laws.(b) errors in technical stock analysis.(c) daily trading volume in stock markets.(d) information available to investors.(e) total household wealth in the economy.

Answer: D

36. Stock values computed by valuation models may differ from actual market prices because it is difficult to

(a) estimate future dividend growth rates.(b) estimate the risk of a stock.(c) forecast a stock’s future dividends.(d) all of the above are true.

Answer: D

37. The 2001 terrorist attacks and the Enron financial scandal caused anticipated dividend growth to _________, investors’ required return on equity to _________, and stock prices to _________.

(a) decreases; increase; decrease(b) decrease; increase; increase(c) increase; decrease; decrease(d) increase; decrease; increase

Answer: A

38. Which of the following is not an objective of the Securities and Exchange Commission?

(a) maintain integrity of the securities markets(b) advise investors about which particular stocks are good buys(c) require firms to provide specific information to investors(d) regulate major participants in securities markets

Answer: B

True/False

1. More stock trading in the U.S. occurs in over-the-counter markets rather than on organized exchanges.

Answer: FALSE

2. In over-the-counter markets, dealers increases the liquidity of thinly traded securities.

Answer: TRUE

3. Electronic Communications Networks apply technology to make organized exchanges more efficient and speedy.

Answer: FALSE

4. All stocks pay dividends, as that is the only way an investor can profit from holding stock.

Answer: FALSE

5. Common stock is the riskiest corporate security, followed by preferred stock and then bonds.

Answer: TRUE

6. The Enron financial scandal increased uncertainty about the quality of accounting information and as a result increased required return on investment in stocks.

Answer: TRUE

7. The Dow Jones Industrial Average is the broadest and best indicator of the stock market’sday-to-day performance.

Answer: FALSE

8. The Securities and Exchange Commission requires firms to submit various documents to increase the flow of information to investors but does not verify the accuracy of that information.

Answer: TRUE

9. About half of new equity issues are preferred stock.

Answer: FALSE

10. A stock’s market value will be higher the higher is its expected dividend stream.

Answer: TRUE

11. The Gordon growth model assumes that a stock’s dividend grows at a constant rate forever.

Answer: TRUE

12. A stock’s market value will be higher the higher is the investor’s required rate of return.

Answer: FALSE

Essay

1. How do corporate stocks differ from bonds?

2. How do common stocks differ from preferred stock?

3. How do over-the-counter markets differ from organized exchanges?

4. What is the role of specialists on a stock exchange?

5. What are the advantages and disadvantages of Electronic Communications Networks (ECNs) for trading stocks?

6. What is the role of the required return on equity investments in stock valuation models?

7. Using the Gordon growth model, explain why the 2001 terorist attacks and the Enron financial scandal caused stock prices to decline.

8. What are American Depository Receipts (ADRs)?

9. What are the objectives of the Securities and Exchange Commission?

Chapter 9The Mortgage Market


1. Which of the following are important ways in which mortgage markets differ from the stock and bond markets?

(a) The usual borrowers in the capital markets are government entities and businesses, whereas the usual borrowers in the mortgage markets are individuals.

(b) Most mortgages are secured by real estate, whereas the majority of capital market borrowing is unsecured.

(c) Because mortgages are made for different amounts and different maturities, developing a secondary market has been more difficult.

(d) All of the above are important differences.(e) Only (a) and (b) of the above are important differences.

Answer: D

2. Which of the following are important ways in which mortgage markets differ from stock and bond markets?

(a) The usual borrowers in capital markets are government entities, whereas the usual borrowers in mortgage markets are small businesses.

(b) The usual borrowers in capital markets are government entities and large businesses, whereas the usual borrowers in mortgage markets are small businesses.

(c) The usual borrowers in capital markets are government entities and large businesses, whereas the usual borrowers in mortgage markets are small businesses and individuals.

(d) The usual borrowers in capital markets are businesses and government entities, whereas the usual borrowers in mortgage markets are individuals.

Answer: D

3. Which of the following are true of mortgages?

(a) A mortgage is a long-term loan secured by real estate.(b) A borrower pays off a mortgage in a combination of principal and interest

payments that result in full payment of the debt by maturity.(c) Over 80 percent of mortgage loans finance residential home purchases.(d) All of the above are true of mortgages.(e) Only (a) and (b) of the above are true of mortgages.

Answer: D


(a) A mortgage is a long-term loan secured by real estate.(b) Borrowers pay off mortgages over time in some combination of principal and

interest payments that result in full payment of the debt by maturity.(c) Less than 65 percent of mortgage loans finance residential home purchases.(d) All of the above are true of mortgages.(e) Only (a) and (b) of the above are true of mortgages.

Answer: E


(a) Prior to the 1920s, U.S. banking legislation discouraged mortgage lending by banks.

(b) In the 1920s, most mortgages were balloon loans, which required the borrower to pay the entire loan amount after three to five years.

(c) Because mortgages are long-term loans secured by real estate, mortgage lenders tended to fail when land prices declined, as was often the case during economic recessions.


Answer: D

6. Which of the following is true of mortgage interest rates?

(a) Interest rates on mortgage loans are determined by three factors: current long-term market rates, the term of the mortgage, and the number of discount points paid.

(b) Mortgage interest rates tend to track along with Treasury bond rates.(c) The interest rate on 15-year mortgages is lower than the rate on 30-year mortgages,

all elsethe same.


Answer: D


(a) More than 80 percent of mortgage loans finance residential home purchases.(b) The National Banking Act of 1863 rewarded banks that increased mortgage

lending.(c) Most mortgages during the 1920s and 1930s were balloon loans.(d) All of the above are true.(e) Only (a) and (c) of the above are true.

Answer: E


(a) Longer-term mortgages have lower interest rates than shorter-term mortgages.(b) Mortgage rates are lower than Treasury bond rates, because of the tax-deductibility

of mortgage interest rates.(c) In exchange for points, lenders reduce interest rates on mortgage loans.(d) All of the above are true.(e) Only (a) and (b) of the above are true.

Answer: C

9. Typically, discount points should not be paid if the borrower will pay off the loan in _________ years or less.

(a) 5(b) 10(c) 15(d) 20

Answer: A


(a) Longer-term mortgages have higher interest rates than shorter-term mortgages.

(b) In exchange for points, lenders reduce interest rates on mortgage loans.(c) Mortgage rates are lower than Treasury bond rates because of the tax deductibility

of mortgage interest payments.(d) All of the above are true.(e) Only (a) and (b) of the above are true.

Answer: E

11. Which of the following reduces moral hazard for the mortgage borrower?

(a) Collateral(b) Down payments(c) Private mortgage insurance(d) Borrower qualifications

Answer: B

12. Which of the following protects the mortgage lender’s right to sell property if the underlying loan defaults?

(a) A lien(b) A down payment(c) Private mortgage insurance(d) Borrower qualification(e) Amortization

Answer: A


(a) Mortgage rates are closely tied to Treasury bond rates, but mortgage rates tend to stay below Treasury rates because mortgages are secured with collateral.

(b) Longer-term mortgages have higher interest rates than shorter-term mortgages.(c) Interest rates are higher on mortgage loans on which lenders charge points.(d) All of the above are true.(e) Only (a) and (b) of the above are true.

Answer: B

14. During the early years of an amortizing mortgage loan, the lender applies

(a) most of the monthly payment to the outstanding principal balance.(b) all of the monthly payment to the outstanding principal balance.(c) most of the monthly payment to interest on the loan.(d) all of the monthly payment to interest on the loan.(e) the monthly payment equally to interest on the loan and the outstanding principal

balance.

Answer: C

15. During the last years of an amortizing mortgage loan, the lender applies


balance.

Answer: A

16. During the last years of a balloon mortgage loan, the lender applies


balance.

Answer: D

17. During the early years of a balloon mortgage loan, the lender applies


balance.

Answer: D

18. A borrower who qualifies for an FHA or VA loan enjoys the advantage that

(a) the mortgage payment is much lower.(b) only a very low or zero down payment is required.(c) the cost of private mortgage insurance is lower.(d) the government holds the lien on the property.

Answer: B

19. (I) Conventional mortgages are originated by private lending institutions, and FHA or VA loans are originated by the government. (II) Conventional mortgages are insured by private companies, and FHA or VA loans are insured by the government.


Answer: B

20. Borrowers tend to prefer _________ to _________, whereas lenders prefer _________

(a) fixed-rate loans; ARMs; fixed-rate loans.(b) ARMs; fixed-rate loans; fixed-rate loans.(c) fixed-rate loans; ARMs; ARMs.(d) ARMs; fixed-rate loans; ARMs.

Answer: C

21. (I) ARMs offer lower initial rates and the rate may fall during the life of the loan. (II) Conventional mortgages do not allow a borrower to take advantage of falling interest rates.


Answer: A

22. Growing-equity mortgages (GEMs)

(a) help the borrower pay off the loan in a shorter time.(b) have such low payments in the first few years that the principal balance increases.(c) offer borrowers payments that are initially lower than the payments on a

conventional mortgage.(d) do all of the above.(e) do only (a) and (b) of the above.

Answer: A

23. A borrower with a 30-year loan can create a GEM by

(a) simply increasing the monthly payments beyond what is required and designating that the excess be applied entirely to the principal.

(b) converting his ARM into a conventional mortgage.(c) converting his conventional mortgage into an ARM.(d) converting his conventional mortgage into a GPM.

Answer: A

24. Which of the following are useful for home buyers who expect their income to rise in the future?

(a) GPMs(b) RAMs(c) GEMs(d) (a) and (b)

(e) (a) and (c)

Answer: E

25. Which of the following are useful for home buyers who expect their income to fall in the future?

(a) GPMs(b) RAMs(c) GEMs(d) (a) and (b)(e) (a) and (c)

Answer: B

26. Retired people can live on the equity they have in their homes by using a

(a) GEM.(b) GPM.(c) SAM.(d) RAM.

Answer: D

27. Second mortgages serve the following purposes:

(a) they give borrowers a way to use the equity they have in their homes as security for another loan.

(b) they allow borrowers to get a tax deduction on loans secured by their primary residence or vacation home.

(c) they allow borrowers to convert their conventional mortgages into GEMs.(d) all of the above.(e) only (a) and (b) of the above.

Answer: E

28. Which of the following is a disadvantage of a second mortgage compared to credit card debt?

(a) The loans are secured by the borrower’s home.(b) The borrower gives up the tax deduction on the primary mortgage.(c) The borrower must pay points to get a second mortgage loan.(d) The borrower will find it more difficult to qualify for a second mortgage loan.

Answer: A

29. The share of the mortgage market held by savings and loans is approximately

(a) 50 percent.(b) 40 percent.

(c) 20 percent.(d) 10 percent.

Answer: D

30. The share of the mortgage market held by commercial banks is approximately


Answer: B

31. Which of the following has not been a reason for the development and growth of on-line mortgage lending?

(a) Mortgage lending is an information-based service and no products have to be inventoried or shipped.

(b) The product (a mortgage loan) is homogeneous.(c) It has led to simplification of loan alternatives and made comparison shopping

easier.(d) On-line lenders have lower overhead and can offer loans at lower costs.

Answer: C

True/False

1. Down payments are designed to reduce the likelihood of default on mortgage loans.

Answer: TRUE

2. Discount points (or simply points) are interest payments made at the beginning of a loan.

Answer: TRUE

3. A point on a mortgage loan refers to one monthly payment of principal and interest.

Answer: FALSE

4. Closing for a mortgage loan refers to the moment the loan is paid off.

Answer: FALSE

5. Private mortgage insurance is a policy that guarantees to make up any discrepancy between the value of the property and the loan amount, should a default occur.

Answer: TRUE

6. During the early years of the loan, the lender applies most of the payment to the principal onthe loan.

Answer: FALSE

7. One important advantage to a borrower who qualifies for an FHA or VA loan is the very low interest rate on the mortgage.

Answer: FALSE

8. Adjustable-rate mortgages generally have lower initial interest rates than do fixed-rate mortgages.

Answer: TRUE

9. Mortgage interest rates loosely track interest rates on three-month Treasury bills.

Answer: FALSE

10. An advantage of a graduated-payment mortgage is that borrowers will qualify for a larger loan than if they requested a conventional mortgage.

Answer: TRUE

11. Nearly half the funds for mortgage lending come from mortgage pools and trusts.

Answer: TRUE

12. Many institutions that make mortgage loans do not want to hold large portfolios of long-term securities, because it would subject them to unacceptably high interest-rate risk.

Answer: TRUE

13. A problem that initially hindered the marketability of mortgages in a secondary market was that they were not standardized.

Answer: TRUE

14. Mortgage-backed securities have declined in popularity in recent years as institutional investors have sought higher returns in other markets.

Answer: FALSE

15. Mortgage-backed securities are marketable securities collateralized by a pool of mortgages.

Answer: TRUE

16. Fannie Mae and Freddie Mac together either own or insure the risk on nearly one-fourth of America’s residential mortgages.

Answer: FALSE

Essay

1. How has the modern mortgage market changed over recent years?

2. Explain the features of mortgage loans that are designed to reduce the likelihood of default.

3. What are points? What is their purpose?

4. How does an amortizing mortgage loan differ from a balloon mortgage loan?

5. Evaluate the advantages and disadvantages, from both the lender’s and the borrower’s perspectives, of fixed-rate and adjustable-rate mortgages.

6. Why has the on-line lending market developed in recent years and what are the advantages and disadvantages of this development?

7. Why may Fannie Mae and Freddie Mac pose a threat to the health of the financial system?

8. What are mortgage-backed securities, why were they developed, what types of mortgage-backed securities are there, and how do they work?

Chapter 10The Foreign Exchange Market


1. American firms became less competitive compared to foreign firms during the 1980s because

(a) the quality and productivity of American workers declined.(b) foreign firms were younger than American firms and as a result had more modern

facilities that made use of the latest technology.(c) the U.S. dollar became worth more in terms of foreign currencies.(d) the U.S. dollar became worth less in terms of foreign currencies.

Answer: C

2. A spot transaction in the foreign exchange market involves the

(a) exchange of exports and imports at a specified future date.(b) exchange of bank deposits at a specified future date.(c) immediate (within two days) exchange of exports and imports.(d) immediate (within two days) exchange of bank deposits.

Answer: D

3. When the value of the British pound changes from $1.50 to $1.25, then the pound has _________ and the dollar has _________.

(a) appreciated; appreciated(b) depreciated; appreciated(c) appreciated; depreciated(d) depreciated; depreciated

Answer: B

4. When the value of the dollar changes from £0.5 to £0.75, then the pound has _________ and the dollar has _________.


Answer: B

5. When the exchange rate changes from 1.0 euros to the dollar to 1.2 euros to the dollar, then the euro has _________ and the dollar has _________.


Answer: B

6. When the exchange rate changes from 1.0 euros to the dollar to 0.8 euros to the dollar, then the euro has _________ and the dollar has _________.


Answer: C

7. If the dollar _________ from 1.2 euros per dollar to 0.8 euros per dollar, the euro _________ from 0.83 dollars to 1.25 dollars per euro.

(a) appreciates; appreciates(b) appreciates; depreciates(c) depreciates; depreciates(d) depreciates; appreciates

Answer: D

8. If the dollar appreciates from 0.8 euros per dollar to 1.2 euros per dollar, the euro depreciates from _________ dollars to _________ dollars per euro.

(a) 1.25; 0.83(b) 0.83; 1.25(c) 0.67; 1.50(d) 1.50; 0.67

Answer: A

9. If the dollar depreciates relative to the Swiss franc,

(a) Swiss chocolate will become more expensive in the United States.(b) American computers will become less expensive in Switzerland.(c) Swiss chocolate will become cheaper in the United States.(d) both (a) and (b) of the above.

Answer: D

10. If the dollar appreciates relative to the Swiss franc,

(a) Swiss chocolate will become more expensive in the United States.

(b) American computers will become less expensive in Switzerland.(c) Swiss chocolate will become cheaper in the United States.(d) both (a) and (b) of the above.

Answer: C

11. When the exchange rate for the euro changes from $1.00 to $1.20 then, holding everything else constant, the euro has

(a) appreciated and German cars sold in the United States become more expensive.(b) appreciated and German cars sold in the United States become less expensive.(c) depreciated and American wheat sold in Germany becomes more expensive.(d) depreciated and American wheat sold in Germany becomes less expensive.

Answer: A

12. When the exchange rate for the euro changes from $1.20 to $1.00, then, holding everything else constant, the euro has

(a) appreciated and German cars sold in the United States become more expensive.(b) appreciated and German cars sold in the United States become less expensive.(c) depreciated and American wheat sold in Germany becomes more expensive.(d) depreciated and American wheat sold in Germany becomes less expensive.

Answer: C

13. The starting point for understanding how exchange rates are determined is a simple idea called _________, which states that if two countries produce an identical good, the price of the good should be the same throughout the world no matter which country produces it.

(a) Gresham’s law(b) the law of one price(c) purchasing power parity(d) arbitrage

Answer: B

14. The theory of purchasing power parity is a theory of how exchange rate are determined in

(a) the long run.(b) the short run.(c) both (a) and (b).(d) none of the above.

Answer: A

15. The _________ states that exchange rates between any two currencies will adjust to reflect changes in the price levels of the two countries.

(a) theory of purchasing power parity(b) law of one price(c) theory of money neutrality(d) quantity theory of money

Answer: A

16. The theory of purchasing power parity states that exchange rates between any two currencies will adjust to reflect changes in

(a) the trade balances of the two countries.(b) the current account balances of the two countries.(c) fiscal policies of the two countries.(d) the price levels of the two countries.

Answer: D

17. In the long run, a rise in a country’s price level (relative to the foreign price level) causes its currency to _________, while a rise in the country’s relative productivity causes its currency to _________

(a) appreciate; appreciate.(b) appreciate; depreciate.(c) depreciate; appreciate.(d) depreciate; depreciate.

Answer: C

18. If the 2005 inflation rate in Britain is 6 percent, and the inflation rate in the U.S. is 4 percent, then the theory of purchasing power parity predicts that, during 2005, the value of the British pound in terms of U.S. dollars will

(a) rise by 10 percent.(b) rise by 2 percent.(c) fall by 10 percent.(d) fall by 2 percent.(e) do none of the above.

Answer: D

19. The theory of purchasing power parity cannot fully explain exchange rate movements because

(a) not all goods are identical in different countries.(b) monetary policy differs across countries.(c) some goods are not traded between countries.(d) both (a) and (c) of the above.(e) both (b) and (c) of the above.

Answer: D

20. The theory of purchasing power parity cannot fully explain exchange rate movements because

(a) all goods are identical even if produced in different countries.(b) monetary policy differs across countries.(c) some goods are not traded between countries.(d) fiscal policy differs across countries.

Answer: C

21. Increased demand for a country’s _________ causes its currency to appreciate in the long run, while increased demand for _________ causes its currency to depreciate.

(a) imports; imports(b) imports; exports(c) exports; imports(d) exports; exports

Answer: C

22. If the demand for _________ goods decreases relative to _________ goods, the domestic currency will depreciate.

(a) foreign; domestic(b) foreign; foreign(c) domestic; domestic(d) domestic; foreign

Answer: D

23. Higher tariffs and quotas cause a country’s currency to _________ in the _________ run.

(a) depreciate; short(b) appreciate; short(c) depreciate; long(d) appreciate; long

Answer: D

24. Lower tariffs and quotas cause a country’s currency to _________ in the _________ run.

(a) depreciate; short(b) appreciate; short(c) depreciate; long(d) appreciate; long

Answer: C

25. If the inflation rate in the United States is higher than that in Germany and productivity is growing at a slower rate in the United States than it is in Germany, in the long run,

(a) the euro should appreciate relative to the dollar.(b) the euro should depreciate relative to the dollar.(c) there should be no change in the euro price of dollars.(d) it is not clear what will happen to the euro price of dollars.

Answer: A

26. If the French demand for American exports rises at the same time that U.S. productivity rises relative to French productivity, then, in the long run,

(a) the euro should appreciate relative to the dollar.(b) the dollar should depreciate relative to the euro.(c) the dollar should appreciate relative to the euro.(d) it is not clear whether the euro should appreciate or depreciate relative

to the dollar.

Answer: C

27. The theory of asset demand suggests that the most important factor affecting the demand for domestic and foreign deposits is

(a) the level of trade and capital flows.(b) the expected return on these assets relative to one another.(c) the liquidity of these assets relative to one another.(d) the riskiness of these assets relative to one another.

Answer: B

28. When François the Foreigner considers the expected return on dollar deposits in terms of foreign currency, the expected return must be adjusted for

(a) any expected appreciation or depreciation of the dollar.(b) the interest rates on foreign deposits.(c) both (a) and (b) of the above.(d) neither (a) nor (b) of the above.

Answer: A

29. The expected return on dollar deposits in terms of foreign currency is the _________ the interest rate on dollar deposits and the expected appreciation of the dollar.

(a) product of(b) ratio of(c) sum of(d) difference in

Answer: C

30. If the interest rate on foreign deposits (iF) increases, holding everything else constant,

(a) the expected return on these deposits must also increase.(b) the expected return on domestic deposits must decrease.(c) the expected return on domestic deposits must increase.(d) both (a) and (b) of the above.(e) both (a) and (c) of the above.

Answer: A

31. If the interest rate on dollar deposits is 10 percent, and the dollar is expected to appreciate by7 percent over the coming year, the expected return on dollar deposits in terms of the foreign currency is

(a) 3 percent.(b) 10 percent.(c) 13.5 percent.(d) 17 percent.(e) 24 percent.

Answer: D

True/False

1. The foreign exchange market is organized as an over-the-counter market in which deposits denominated in foreign currencies are bought and sold.

Answer: TRUE

2. When the value of the dollar changes from 0.5 pounds to 0.75 pounds, then the pound has appreciated and the dollar has depreciated.

Answer: FALSE

3. When the exchange rate for the euro changes from $0.90 to $0.85, then holding everything else constant, the euro has depreciated and American wheat sold in Germany becomes more expensive.

Answer: TRUE

4. The theory of purchasing power parity cannot fully explain exchange rate movements because fiscal policy differs across countries.

Answer: FALSE

5. If the dollar depreciates relative to the British pound, British sweaters will become more expensive in the United States.

Answer: TRUE

6. If the dollar appreciates relative to the Swiss franc, Swiss chocolate will become cheaper in the United States.

Answer: TRUE

7. If the exchange rate between the dollar and the Swiss franc changes from 1.8 to 1.5 francs per dollar, the franc depreciates and the dollar appreciates.

Answer: FALSE

8. An increase in tariffs and quotas on imports causes a country’s currency to appreciate.

Answer: TRUE

9. Increased demand for a country’s exports causes its currency to depreciate.

Answer: FALSE

10. As the relative expected return on dollar deposits increases, Americans will want to hold fewer dollar deposits and more foreign deposits.

Answer: FALSE

11. According to the interest rate parity condition, if the domestic interest rate is 12 percent and the foreign interest rate is 10 percent, then the expected appreciation of the foreign currency must be2 percent.

Answer: TRUE

12. A fall in the expected future exchange rate shifts the expected return schedule for domestic deposits to the right and causes the domestic currency to depreciate.

Answer: FALSE

Essay

1. Explain the logic underlying the law of one price and the theory of purchasing power parity.

2. Explain graphically how a change in the domestic price level will affect exchange rates, holding everything else constant.

3. Explain the theory of interest rate parity.

4. Explain graphically how a change in the foreign interest rate will affect exchange rates.

5. Discuss the relationship between changes in domestic real and nominal interest rates and exchange rates.

6. Explain graphically how an increase in a country’s money supply will affect the exchange rate for its currency.

Chapter 11Commercial Banking Industry: Structure and

Competition


1. The modern commercial banking system began in America when the

(a) Bank of the United States was chartered in New York in 1801.(b) Bank of North America was chartered in Philadelphia in 1782.(c) Bank of the United States was chartered in Philadelphia in 1801.(d) Bank of North America was chartered in New York in 1782.

Answer: B

2. A major controversy involving the U.S. banking industry in its early years was

(a) whether banks should both accept deposits and make loans or whether these functions should be separated into different institutions.

(b) whether the federal government or the states should charter banks.(c) what percent of deposits banks should hold as fractional reserves.(d) whether banks should be allowed to issue their own bank notes.

Answer: B

3. The government institution that has responsibility for the amount of money and credit supplied in the economy as a whole is the

(a) central Bank.(b) commercial Bank.(c) bank of settlement.(d) Treasury Department.

Answer: A

4. Because of the abuses by state banks and the clear need for a central bank to help the federal government raise funds during the War of 1812, Congress created the

(a) First Bank of the United States in 1812.(b) Bank of North America in 1814.(c) Second Bank of the United States in 1816.(d) Federal Reserve System in 1813.

Answer: C

5. The Second Bank of the United States was denied a new charter by

(a) President Andrew Jackson.(b) Vice-President John Calhoun.(c) President Benjamin Harrison.(d) President John Q. Adams.

Answer: A

6. Before 1863,

(a) federally-chartered banks had regulatory advantages not granted to state-chartered banks.

(b) the number of federally-chartered banks grew at a much faster rate than at any other time since the end of the Civil War.

(c) banks acquired funds by issuing banknotes.(d) the Federal Reserve System regulated only federally-chartered banks.(e) the Comptroller of the Currency regulated both state- and federally-chartered

banks.

Answer: C

7. Before 1863,

(a) the Federal Reserve System regulated only federally-chartered banks.(b) the Comptroller of the Currency regulated both state- and federally-chartered

banks.(c) the number of federally-chartered banks grew at a much faster rate than at any

other time since the end of the Civil War.(d) none of the above.

Answer: D

8. Although federal banking legislation in the 1860s attempted to eliminate state-chartered banks by imposing a prohibitive tax on banknotes, these banks have been able to stay in business by

(a) issuing credit cards.(b) ignoring the regulations.(c) issuing deposits.(d) branching into other states.

Answer: C

9. The belief that bank failures were regularly caused by fraud or the lack of sufficient bank capital explains, in part, the passage of

(a) the National Bank Charter Amendments of 1918.(b) the Glass-St. Germain Act of 1982.(c) the National Bank Act of 1863.(d) none of the above.

Answer: C

10. To eliminate the abuses of the state-chartered banks, the _________ created a new banking system of federally chartered banks, supervised by the _________

(a) National Banking Act of 1863; Office of the Comptroller of the Currency.(b) Federal Reserve Act of 1863; Office of the Comptroller of the Currency.(c) National Banking Act of 1863; Office of Thrift Supervision.(d) Federal Reserve Act of 1863; Office of Thrift Supervision.

Answer: A

11. The National Banking Act of 1863, and subsequent amendments to it,

(a) created a banking system of federally-chartered banks.(b) established the Office of the Comptroller of the Currency.(c) broadened the regulatory powers of the Federal Reserve.(d) did all of the above.(e) did only (a) and (b) of the above.

Answer: E

12. The regulatory system that has evolved in the United States whereby banks are regulated at the state level, the national level, or both, is known as a

(a) bilateral regulatory system.(b) tiered regulatory system.(c) two-tiered regulatory system.(d) dual banking system.

Answer: D

13. Today the United States has a dual banking system in which banks supervised by the _________ and by the _________ operate side-by-side.

(a) federal government; municipalities(b) state governments; municipalities(c) federal government; states(d) municipalities; states

Answer: C

14. The Federal Reserve Act of 1913 required that

(a) state banks be subject to the same regulations as national banks.(b) national banks establish branches in the cities containing Federal Reserve banks.(c) national banks join the Federal Reserve System.(d) all of the above be done.

Answer: C

15. The Federal Reserve Act required all _________ banks to become members of the Federal Reserve System, while _________ banks could choose to become members of the system.

(a) state; national(b) state; municipal(c) national; state(d) national; municipal

Answer: C

16. With the creation of the Federal Deposit Insurance Corporation, member banks of the Federal Reserve System _________ to purchase FDIC insurance for their depositors, while non-member commercial banks _________ to buy deposit insurance.

(a) could choose; were required(b) could choose; were given the option(c) were required, could choose(d) were required; were required

Answer: C

17. With the creation of the Federal Deposit Insurance Corporation,

(a) member banks of the Federal Reserve System were given the option to purchase FDIC insurance for their depositors, while non-member commercial banks were required to buy deposit insurance.

(b) member banks of the Federal Reserve System were required to purchase FDIC insurance for their depositors, while non-member commercial banks could choose to buy deposit insurance.

(c) both member and non-member banks of the Federal Reserve System were required to purchase FDIC insurance for their depositors.

(d) both member and non-member banks of the Federal Reserve System could choose, but were not required, to purchase FDIC insurance for their depositors.

Answer: B

18. Probably the most significant factor explaining the drastic drop in the number of bank failures since the Great Depression has been

(a) the creation of the FDIC.(b) rapid economic growth since 1941.(c) the employment of new procedures by the Federal Reserve.(d) better bank management.

Answer: A

19. Investment banking activities of the commercial banks were blamed for many bank failures.This led to

(a) the passage of the National Bank Charter Amendments Act of 1918.(b) the passage of the Garn-St. Germain Act of 1982.(c) the passage of the National Bank Act of 1863.(d) the passage of the Glass-Steagall Act of 1933.(e) the establishment of the Federal Deposit Insurance Corporation in 1933.

Answer: D

20. The Glass-Steagall Act prohibited commercial banks from

(a) issuing equity to finance bank expansion.(b) engaging in underwriting of and dealing in corporate securities.(c) selling new issues of government securities.(d) purchasing any debt securities.

Answer: B

21. Which bank regulatory agency has the sole regulatory authority over bank holding companies?

(a) The Federal Deposit Insurance Corporation(b) The Comptroller of the Currency(c) The Federal Bank Holding Company Agency(d) The Federal Reserve System

Answer: D

22. State banks that are not members of the Federal Reserve System are most likely to be examined by the

(a) Federal Reserve System.(b) Federal Deposit Insurance Corporation.(c) Federal Home Loan Bank System.(d) Comptroller of the Currency.

Answer: B

23. Which regulatory body charters national banks?

(a) The Federal Reserve(b) The Federal Deposit Insurance Corporation(c) The Comptroller of the Currency(d) None of the above

Answer: C

24. Which of the following statements concerning bank regulation in the United States are true?

(a) The Office of the Comptroller of the Currency has the primary responsibility for national banks.

(b) The Federal Reserve and the state banking authorities jointly have responsibility for state banks that are members of the Federal Reserve System.

(c) The Fed has sole regulatory responsibility over bank holding companies.(d) All of the above are true.(e) Only (a) and (b) of the above are true.

Answer: D

25. Which of the following statements concerning bank regulation in the United States are true?

(a) The Office of the Comptroller of the Currency has the primary responsibility for state banks that are members of the Federal Reserve System.

(b) The Federal Reserve and the state banking authorities jointly have responsibility for state banks that are members of the Federal Reserve System.

(c) The Office of the Comptroller of the Currency has sole regulatory responsibility over bank holding companies.


Answer: B

26. Which of the following are important factors in determining the degree and timing of financial innovation?

(a) Changes in technology(b) Changes in financial market conditions(c) Changes in regulation(d) All of the above(e) Only (a) and (b) of the above

Answer: D

27. New computer technology has

(a) increased the cost of financial innovation.(b) increased the demand for financial innovation.(c) reduced the cost of financial innovation.(d) reduced the demand for financial innovation.

Answer: C

28. Rising interest-rate risk _________ the _________ financial innovation.

(a) increased; cost of(b) increased; demand for(c) reduced; cost of(d) reduced; demand for

Answer: B

29. Large fluctuations in interest rates lead to

(a) substantial capital gains and losses to owners of securities.(b) greater uncertainty about returns on investments.(c) greater interest-rate risk.(d) all of the above.

Answer: D

30. In the 1950s the interest rate on three-month Treasury bills fluctuated between 1.0% and 3.5%. In the 1980s, the three-month Treasury bill rate ranged from 5% to over 15%. From this one could predict that in the 1980s interest-rate risk was _________ and the demand for financial innovation was _________.

(a) greater; lower(b) greater; greater(c) lower; lower(d) lower; greater

Answer: B

31. The most significant change in the economic environment that changed the demand for financial products since 1970 has been

(a) the aging of the baby-boomer generation.(b) the dramatic increase in the volatility of interest rates.(c) the dramatic increase in competition from foreign banks.(d) the deregulation of financial institutions.

Answer: B

32. Adjustable-rate mortgages

(a) protect households against higher mortgage payments when interest rates rise.(b) keep financial institutions’ earnings high even when interest rates are falling.

(c) have many attractive attributes, explaining why so few households now seek fixed-rate mortgages.

(d) do only (a) and (b) of the above.(e) none of the above.

Answer: E

33. Adjustable-rate mortgages

(a) benefit homeowners when interest rates are falling.(b) reduce financial institutions’ interest-rate risk.(c) reduce households’ risk of having to pay higher mortgage payments when interest

rates rise.(d) do only (a) and (b) of the above.

Answer: D

34. The most important source of the changes in supply conditions that stimulate financial innovation has been the

(a) aging of the baby-boomer generation.(b) dramatic increase in the volatility of interest rates.(c) improvement in information technology.(d) dramatic increase in competition from foreign banks.(e) deregulation of financial institutions.

Answer: C

35. Examples of financial services that became practical realities as the result of new computer technology include

(a) credit cards.(b) electronic banking facilities.(c) checking accounts.(d) all of the above.(e) only (a) and (b) of the above.

Answer: E

36. Credit cards date back to

(a) prior to World War II.(b) just after World War II.(c) the early 1950s.(d) the late 1950s.

Answer: A

37. A firm issuing credit cards earns income from

(a) loans it makes to credit card holders.(b) payments made to it by stores on credit card purchases.(c) payments made to it by manufacturers of the products sold in stores on credit card

purchases.(d) all of the above.(e) only (a) and (b) of the above.

Answer: E

38. The entry of Sears, AT&T and GM into the credit card business is an indication of

(a) government’s efforts to deregulate the provision of financial services.(b) the rising profitability of credit card operations.(c) the reduction in costs of credit card operations since 1990.(d) the sale of unprofitable operations by Bank of America and Citicorp.

Answer: B

39. A smart-card is a form of

(a) stored-value card.(b) credit card.(c) debit card.(d) e-cash card.

Answer: A

40. Which of the following is not a financial innovation stimulated by information technology?

(a) Credit card(b) Debit card(c) Adjustable-rate mortgage(d) Electronic banking

Answer: C

41. Which of the following is an example of a financial innovation introduced to avoid regulations?

(a) Securitization(b) Junk bond(c) Debit card(d) Sweep account

Answer: D

42. “Stripping” a Treasury bond

(a) means selling each of its future payments as a separate zero-coupon bond.(b) decreases the total present discounted value of future payments.(c) both (a) and (b).(d) none of the above.

Answer: A

43. So-called fallen angels differ from junk bonds in that

(a) junk bonds refer to previously issued bonds which have had their credit ratings fall below Baa.

(b) fallen angels refer to newly issued bonds with low credit ratings.(c) junk bonds refer to newly issued bonds with low credit ratings.(d) both (a) and (b) of the above.

Answer: C

44. So-called fallen angels differ from junk bonds in that

(a) junk bonds refer to newly issued bonds with low credit ratings, whereas fallen angels refer to previously issued bonds which have had their credit ratings fall below Baa.

(b) junk bonds refer to previously issued bonds which have had their credit ratings fall below Baa, whereas fallen angels refer to newly issued bonds with low credit ratings.

(c) junk bonds have ratings below Baa, whereas fallen angels have ratings below C.(d) fallen angels have ratings below Baa, whereas junk bonds have ratings below C.

Answer: A

True/False

1. Today the United States has a dual banking system in which banks supervised by the federal government and banks supervised by the states operate side-by-side.

Answer: TRUE

2. Bank holding companies are regulated by the FDIC.

Answer: FALSE

3. The existence of large numbers of banks in the United States indicates the presence of vigorous competition.

Answer: FALSE

4. Even when an ATM is owned by a bank, states typically have special provisions that allow wider establishment of ATMs than is permissible for traditional “brick and mortar” branches.

Answer: TRUE

5. Bank holding companies that have begun to rival the money center banks in size but whose headquarters are not based in one of the money center cities are called superregional banks.

Answer: TRUE

6. The future structure of the U.S. banking industry is likely to be characterized by many more smaller banks, as customers demand neighborhood banks operated by people they know personally.

Answer: FALSE

7. Restrictions on commercial banks’ securities and insurance activities put American banks ata competitive disadvantage relative to foreign banks.

Answer: TRUE

8. Eurodollars are created when deposits in accounts in the United States are transferred to a bank outside the country and are kept in the form of dollars.

Answer: TRUE

9. Financial innovation has widened the cost advantages that banks have in acquiring funds, helping to explain why bank profitability has soared in recent years.

Answer: FALSE

10. Americans are the biggest users of checks in the world but nonetheless are ahead of Europeans in the proportion of noncash payments that are made by electronic means.

Answer: FALSE

11. Securitization is the process of transforming illiquid financial assets such as residential mortgages into marketable securities.

Answer: TRUE

12. Disintermediation occurs when funds are deposited into banks and lent to borrowers.

Answer: FALSE

13. The principle underlying Treasury STRIPS is that an investor will earn a higher interest rate when reinvestment risk is eliminated.

Answer: TRUE

14. Economies of scope come from increasing the size of a given financial activity and economies of scale come from combining different activities to lower their costs.

Answer: FALSE

15. Checkable deposits, a traditional source of low-cost funds for banks, have declined dramatically in importance, falling from over 60 percent of bank liabilities to 10 percent today.

Answer: TRUE

Essay

1. What financial innovations are best explained as attempts to avoid regulations?

2. What new forms of banking have been spawned by the advances in information technology of the past two decades? Is it likely that traditional banks will disappear as a result of these innovations? Why?

3. What new forms of making payments have been spawned by the advances in information technology of the past two decades? Is it likely that ours will become a cashless society anytime soon as a result of these innovations? Why?

4. What are Treasury STRIPS? What roles have reinvestment risk and information technology played in the development of this financial product?

5. What are the reasons for the decline of traditional banking?

6. Is the large number of banking firms in the United States an indication of a competitive banking industry? Explain why or why not.

7. Are bank consolidation and nationwide banking good things? Why?

8. When and why was the Glass-Steagall Act passed? When and why was it repealed?

9. Describe Edge Act corporations, international banking facilities, and the structure of foreign banks in the United States.

Chapter 12Savings Associations and Credit Unions


1. Savings banks

(a) were first established in Scotland and England.(b) were established to encourage saving by the poor.(c) were very conservative with their funds, placing most of them in commercial

banks.(d) all of the above.(e) only (a) and (b) of the above.

Answer: D

2. Which of the following statements about mutual savings banks are true?

(a) There are currently under 200 mutual savings banks in the United States.(b) Most mutual savings banks are federally-chartered.(c) Both (a) and (b).(d) None of the above.

Answer: D

3. Which of the following statements concerning the mutual form of ownership of savings banksare true?

(a) The mutual form of ownership accentuates the principal-agent problem that exists in corporations.

(b) More capital is available, contributing to the safety of mutual savings banks compared to other banking organizations.

(c) Managers of mutual savings banks are more risk averse than in the corporate form, because the value of their ownership does not increase if the firm does well.


Answer: D

4. Savings and loan associations

(a) were established by Congress to encourage home ownership.(b) initially were not permitted to accept demand deposits.(c) held about 85 percent of their assets in the form of mortgages prior to the Great

Depression.(d) all of the above.(e) only (a) and (b) of the above.

Answer: D

5. Savings and loans associations

(a) initially were allowed to attract funds by offering savings accounts that paid a slightly higher interest rate than that offered by commercial banks.

(b) held about 85 percent of their total assets as mortgages prior to the Great Depression.

(c) did not weather the Great Depression well, as thousands of S&Ls failed in the 1930s.


Answer: D

6. Thrifts

(a) fueled the home-building boom from 1934–1978.(b) suffered in the 1970s as inflation rose above deposit interest rate ceilings.(c) have grown in importance in attracting deposits relative to commercial banks since

1980.(d) all of the above.(e) only (a) and (b) of the above.

Answer: E

7. Thrifts suffered problems in the 1970s as

(a) market interest rates rose above the rates thrifts could pay on deposits and savings accounts.

(b) thrift customers moved their funds from thrifts to money market mutual funds.(c) government regulators severely limited the scope of activities that thrifts could

undertake to grow their way out of trouble.(d) all of the above occurred.(e) only (a) and (b) of the above occurred.

Answer: E

8. In the early stages of the 1980s banking crisis, financial institutions were especially hurt by

(a) the sharp increases in interest rates from late 1979 until 1981.(b) the severe recession in 1981–82.(c) the sharp decline in the price level from mid-1980 to early 1983.(d) all of the above.(e) only (a) and (b) of the above.

Answer: E

9. In the early stages of the 1980s banking crisis, financial institutions were especially harmed by

(a) declining interest rates from late 1979 until 1981.(b) the severe recession in 1981–82.(c) the disinflation from mid-1980 to early 1983.(d) all of the above.

Answer: B

10. Savings and loans lost a total of $10 billion in 1981–1982 due to a combination of rising interest rates in 1979–1981 and

(a) the recession of 1981–1982 that reduced real estate prices enough to cause significant loan defaults.

(b) the regulatory restrictions enacted by Congress in 1981 and 1982.(c) the loss of market share to commercial banks that were allowed to compete directly

with thrifts in the real estate market.(d) the acceleration of inflation in 1981–1982 that caused thrifts to lose additional

funds to money market mutual funds.

Answer: A

11. In the 1980s, thrift institutions, which had been almost entirely restricted to making loans for home mortgages only, were allowed by regulators to

(a) finance acquisitions in commercial real estate.(b) extend consumer loans.(c) purchase junk bonds.(d) do all of the above.(e) do only (a) and (b) of the above.

Answer: D

12. The government granted thrifts greater powers in the early 1980s in hopes of turning the industry’s problems around. These powers

(a) required greater expertise in managing risk than many thrift managers possessed.(b) encouraged thrifts to expand lending rapidly in real estate, increasing their

exposure to risk.(c) expanded the scope and complexity of thrift lending activities that went beyond

what regulators could effectively monitor, given their limited resources.(d) did all of the above.(e) did only (a) and (b) of the above.

Answer: D

13. When nearly half of the S&Ls in the United States had a negative net worth and were thus insolvent by the end of 1982, regulators adopted a policy of _________, which amounted to _________ capital requirements.

(a) regulatory forbearance; raising(b) regulatory forbearance; lowering(c) regulatory stringency; raising(d) regulatory stringency; lowering

Answer: B

14. The policy of _________ exacerbated _________ problems as savings and loans took on increasingly huge levels of risk on the slim chance of returning to solvency.

(a) regulatory forbearance; moral hazard(b) regulatory forbearance; adverse selection(c) regulatory stringency; moral hazard(d) regulatory stringency; adverse selection

Answer: A

15. Which of the following reasons explain why federal regulators adopted a policy of regulatory forbearance toward insolvent financial institutions in the early 1980s?

(a) The FSLIC lacked sufficient funds to cover insured deposits in the insolvent S&Ls.

(b) The regulators were reluctant to close the firms that justified their regulatory existence.

(c) The Federal Home Loan Bank Board and the FSLIC were reluctant to admit that they were in over their heads with problems.

(d) All of the above.(e) Only (a) and (b) of the above.

Answer: D

16. The policy of regulatory forbearance

(a) meant delaying the closing of “zombie S&Ls” as their losses mounted during the 1980s.

(b) benefited “zombie S&Ls” at the expense of healthy S&Ls, as healthy institutions lost deposits to insolvent institutions.

(c) contributed to declining profitability in the S&L industry and an increase in the number of “zombie S&Ls.”


Answer: D

17. The policy of regulatory forbearance

(a) meant delaying the closing of “zombie S&Ls” as their losses mounted during the 1980s.

(b) benefited “zombie S&Ls” at the expense of healthy S&Ls, as healthy institutions lost deposits to insolvent institutions.

(c) had the advantage of benefiting healthy S&Ls by giving them the opportunity to attract deposits that began to leave the “zombie S&Ls.”

(d) both (a) and (b) of the above.(e) both (a) and (c) of the above.

Answer: D

18. Which of the following are reasons that explain why regulators pursued a policy of regulatory forbearance toward thrifts in the early 1980s?

(a) Regulators knew that the FSLIC did not have sufficient funds to close insolvent S&Ls and pay off their depositors.

(b) Regulators were probably too close to the people they were supposed to be regulating to close down thrifts and put them out of business.

(c) Regulators preferred to sweep the problems that thrifts were suffering under the rug in the hope that they would go away as the economy improved.

(d) All of the above explain regulatory forbearance.(e) Only (a) and (b) of the above explain regulatory forbearance.

Answer: D

19. Examples of the huge risks that “zombie S&Ls” undertook include

(a) building shopping centers in the desert.(b) buying manufacturing plants to convert manure to methane.(c) purchasing billions of dollars of junk bonds.(d) all of the above.(e) only (a) and (b) of the above.

Answer: D

20. “Zombie S&Ls”

(a) paid above market interest rates to attract deposits to fuel their lending boom.(b) offered loans at below market interest rates to expand their lending.(c) drove down the profitability of solvent S&Ls, threatening to turn them into

“zombies” too.(d) did all of the above.(e) did only (a) and (b) of the above.

Answer: D

21. According to the text, the Competitive Equality in Banking Act of 1987

(a) turned the thrift industry around by providing the necessary funds to close the “zombie S&Ls.”

(b) lowered the cost of bailing out the S&Ls by quickly closing “zombie S&Ls” before they could cause other thrifts to fail.

(c) failed to provide the funds necessary to close ailing S&Ls, and actually encouraged regulators to continue to pursue regulatory forbearance.

(d) did both (a) and (b) of the above.

Answer: C

22. The Competitive Equality in Banking Act of 1987

(a) discouraged regulators from pursuing regulatory forbearance.(b) directed regulators to close “zombie S&Ls” as quickly as administratively possible.(c) encouraged regulators to continue their policy of regulatory forbearance.(d) did both (a) and (b) of the above.

Answer: C

23. The Competitive Equality in Banking Act of 1987

(a) provided insufficient funds to the FSLIC to close down insolvent S&Ls.(b) actually directed S&L regulators to continue to pursue regulatory forbearance,

further delaying the closing of insolvent S&Ls.(c) created a new agency, the Resolution Trust Corporation, to manage insolvent

thrifts.

(d) did all of the above.(e) did only (a) and (b) of the above.

Answer: E

24. The major provisions of the Competitive Equality in Banking Act of 1987 included

(a) expanding the responsibilities of the FDIC, which is now the sole administrator of the federal deposit insurance system.

(b) establishing the Resolution Trust Corporation to manage and resolve insolvent thrifts placed in conservatorship or receivership.

(c) directing the Federal Home Loan Bank Board to continue to pursue regulatory forbearance.


Answer: C

25. The major provisions of the Competitive Equality in Banking Act of 1987 included

(a) abolishing the Federal Home Loan Bank Board and the FSLIC.(b) transferring the regulatory role of the Federal Home Loan Bank Board to the Office

of Thrift Supervision, a bureau within the U.S. Treasury Department.(c) establishing the Resolution Trust Corporation to manage and resolve insolvent

thrifts placed in conservatorship or receivership.(d) all of the above.(e) none of the above.

Answer: E

26. An analysis of the political economy of the savings and loan crisis helps one to understand

(a) why politicians hampered the efforts of thrift regulators, cutting regulatory appropriations and encouraging regulatory forbearance.

(b) why thrift regulators were reluctant to admit that any problem even existed in the thrift industry.

(c) why thrift regulators willingly acceded to pressures placed upon them by members of Congress.


Answer: D

27. An analysis of the political economy of the savings and loan crisis helps one to understand

(a) why politicians aided the efforts of thrift regulators, raising regulatory appropriations and encouraging closing of insolvent thrifts.

(b) why thrift regulators were quick to inform Congress of the problems that existed in the thrift industry.

(c) why thrift regulators willingly acceded to pressures placed upon them by members of Congress.

(d) all of the above.

Answer: C

28. The political economy of the S&L crisis shows that the principal-agent problem occurs in politics. In this instance, the agent-regulators did not act to protect the principal-taxpayers because

(a) regulators wanted to escape blame, hoping the situation would improve before others discovered the problem.

(b) regulators responded to pressure to pursue regulatory forbearance from politicians who had accepted campaign donations from owners of S&Ls.

(c) Congress was unwilling to allocate the necessary funds regulators needed to close insolvent S&Ls.


Answer: D

29. That taxpayers were poorly served by thrift regulators in the 1980s is now quite clear. This poor performance is explained by

(a) regulators’ desire to escape blame for poor performance, leading to a perverse strategy of “regulatory gambling.”

(b) regulators’ incentives to accede to pressures imposed by politicians, who sought to keep regulators from imposing tough regulations on institutions that were major campaign contributors.

(c) Congress’s unwillingness to appropriate sufficient funds to permit regulators to examine the many thrift institutions that needed monitoring.


Answer: D

30. That taxpayers were poorly served by thrift regulators in the 1980s is now quite clear. This poor performance cannot be explained by

(a) regulators’ desire to escape blame for poor performance, leading to a perverse strategy of “regulatory gambling.”

(b) regulators’ incentives to accede to pressures imposed by politicians, who sought to keep regulators from imposing tough regulations on institutions that were major campaign contributors.

(c) Congress’s dogged determination to protect taxpayers from the unsound banking practices of managers at many of the nation’s savings and loans.

(d) any of the above.

Answer: C

31. That several hundred S&Ls were not even examined once in the period January 1984 through June 1986 can be explained by

(a) Congress’s unwillingness to allocate the necessary funds to thrift regulators.(b) regulators’ reluctance to find the specific problem thrifts that they knew existed.(c) prohibitions against onerous regulatory restrictions against S&Ls as mandated in

the Competitive Equality in Banking Act.(d) all of the above.(e) only (a) and (b) of the above.

Answer: A

32. “Bureaucratic gambling” refers to

(a) the belief of thrift managers that they would not be audited by thrift regulators in the 1980s due to the relatively weak bureaucratic power of the regulators.

(b) the risk that thrift regulators took in publicizing the plight of the S&L industry in the early 1980s.

(c) the strategy adopted by thrift regulators of lowering capital requirements and pursuing regulatory forbearance in the 1980s in the hope that conditions in the S&L industry would improve.

(d) none of the above.

Answer: C

33. Charles Keating

(a) was allowed to acquire Lincoln Savings and Loan of Irvine, California, even though he had been accused of fraud by the SEC only four and a half years earlier.

(b) fired Lincoln’s conservative lending officers and internal auditors, even though he had promised regulators he would keep them.

(c) enlisted the help of five senators to delay the seizure of Lincoln’s assets.(d) did all of the above.

Answer: D

34. Examiners from the Federal Home Loan Bank Board of San Francisco recommended that Lincoln Savings and Loan be seized when they discovered that

(a) officials at the thrift had attempted to mislead them.(b) it had exceeded the 10 percent limit on equity investments by $600 million.(c) its owner, Charles Keating, had been convicted of embezzlement ten years before

he purchased the thrift.(d) all of the above.(e) both (a) and (b) of the above.

Answer: E

35. The bailout of the savings and loan industry was much delayed and, therefore, much more costly to taxpayers because

(a) of regulators’ initial attempts to downplay the seriousness of problems within the thrift industry.

(b) politicians who received generous campaign contributions from the savings and loan industry, like regulators, hoped that the problems in the industry would ease over time.

(c) Congress encouraged, and thrift regulators acceded to, a policy of regulatory forbearance.


Answer: D

True/False

1. The mutual form of ownership accentuates the principal-agent problem that exists in corporations.

Answer: TRUE

2. Savings and loans are not as heavily concentrated in mortgages and have had more flexibility in their investing practices than mutual savings banks.

Answer: FALSE

3. The congressionally imposed cap on the interest rate that S&Ls could pay on savings accounts became a serious problem for them in the 1970s when inflation rose.

Answer: TRUE

4. Regulatory forbearance reduces moral hazard because an operating but insolvent S&L will take fewer risks than healthy S&Ls that can take risks and still remain solvent.

Answer: FALSE

5. The Competitive Equality in Banking Act of 1987 allowed the FSLIC to borrow all the funds it needed to close insolvent S&Ls and pay off depositors.

Answer: FALSE

6. In the 1980s, regulators engaged in bureaucratic gambling when they allowed insolvent S&Ls to continue operating.

Answer: TRUE

7. FIRREA imposed new restrictions on thrift activities that, in essence, re-regulated the S&L industry to the asset choices it had before 1982.

Answer: TRUE

8. Most credit unions today have federal charters.

Answer: TRUE

9. Credit unions are owned by stockholders.

Answer: FALSE

10. Federal legislation allows credit unions representing groups with different common bonds to merge into a single credit union.

Answer: TRUE

11. Credit unions view commercial banks as government-supported and hence unfair competitors due to their tax advantages.

Answer: FALSE

12. Mutual savings banks are the only financial institutions that are tax-exempt.

Answer: FALSE

Essay

1. What factors contributed to creating the thrift crisis?

2. Explain why thrift regulators engaged in regulatory forbearance in the 1980s.

3. Explain how the Lincoln Savings and Loan scandal is an application of the principal-agent problem.

4. Why did the Competitive Equality in Banking Act of 1987 fail to solve the problems in the thrift industry?

5. How has the thrift industry been transformed since FIRREA?

6. Why have commercial banks gone to court in an effort to limit the activities of credit unions?

Chapter 13：The Mutual Fund Industry


1. Mutual funds hold about _________ of financial intermediaries’ total assets.

(a) one-sixth(b) one-fourth(c) one-half(d) two-thirds

Answer: A

2. _________ intermediation means that small investors can pool their funds with other investors to purchase high face value securities.

(a) liquidity(b) financial(c) denomination(d) share

Answer: C

3. Mutual funds offer investors all of the following except

(a) greater-than-average returns.(b) diversified portfolios.(c) lower transaction costs.(d) professional investment management.

Answer: A

4. Mutual funds

(a) pool the resources of many small investors by selling these investors shares and using the proceeds to buy securities.

(b) allow small investors to obtain the benefits of lower transaction costs in purchasing securities.

(c) provide small investors a diversified portfolio that reduces risk.(d) do all of the above.(e) do only (a) and (b) of the above.

Answer: D

5. _________ enables mutual funds to consistently outperform a randomly selected group of stocks.

(a) Managerial expertise(b) Diversification(c) Denomination intermediation(d) None of the above

Answer: D

6. At the end of 2003 there over _________ separate mutual funds with total assets over _________.

(a) 800; $10 trillion(b) 8,000; $7 trillion(c) 10,000; $10 trillion(d) 1,000; $7 trillion

Answer: B

7. Most mutual funds are structured in two ways. The most common structure is a(n) _________ fund, from which shares can be redeemed at any time at a price that is tied to the asset value of the fund. A(n) _________ fund has a fixed number of nonredeemable shares that are traded in the over-the-counter market.

(a) closed-end; open-end(b) open-end; closed-end(c) no-load; closed-end(d) no-load; load(e) load; no-load

Answer: B

8. Which of the following is an advantage to investors of an open-end mutual fund?

(a) Once all the shares have been sold, the investor does not have to put in more money.

(b) The investors can sell their shares in the over-the-counter market with low transaction fees.

(c) The fund agrees to redeem shares at any time.(d) The market value of the fund’s shares may be higher than the value of the assets

held bythe fund.

Answer: C

9. The net asset value of a mutual fund is

(a) determined by subtracting the fund’s liabilities from its assets and dividing by the number of shares outstanding.

(b) determined by calculating the net price of the assets owned by the fund.(c) calculated every 15 minutes and used for transactions occurring during the next 15-

minute interval.(d) calculated as the difference between the fund’s assets and its liabilities.

Answer: A

10. _________ funds are the simplest type of investment funds to manage.

(a) Balanced(b) Global equity(c) Growth(d) Index

Answer: D

11. The majority of mutual fund assets are now owned by

(a) individual investors.(b) institutional investors.(c) fiduciaries.(d) business organizations.(e) retirees.

Answer: A

12. Capital appreciation funds select stocks of _________ and tend to be _________ risky than total return funds.

(a) large established companies that pay dividends regularly; more(b) large established companies that pay dividends regularly; less(c) companies expected to grow rapidly; more(d) companies expected to grow rapidly; less

Answer: C

13. From largest to smallest, the four classes of mutual funds are

(a) equity funds, bond funds, hybrid funds, money market funds(b) equity funds, money market funds, bond funds, hybrid funds(c) money market funds, equity funds, hybrid funds, bond funds(d) bond funds, money market funds, equity funds, hybrid funds

Answer: B

14. Measured by assets, the most popular type of bond fund is the _________ bond fund.

(a) state municipal(b) strategic income(c) government(d) high yield

Answer: B

15. In recent years total assets in money market mutual funds have decreased. The most likely reason for this is that

(a) short-term interest rates have been quite low.(b) short-term interest rates have been quite high.(c) long-term interest rates have been quite low.(d) the risk of investing in money market funds has risen.

Answer: A

16. People who take their money out of insured bank deposits to invest in uninsured money market mutual funds have _________ risk because money market funds invest in _________ assets.

(a) high; long-term(b) low; short-term(c) high; short-term(d) low; long-term

Answer: B

17. The largest share of assets held by money market mutual funds is

(a) Treasury bills.(b) certificates of deposit.(c) commercial paper.(d) repurchase agreements.

Answer: C

18. Which of the following is a feature of index funds?

(a) They have lower fees.(b) They select and hold stocks to match the performance of a stock index.(c) They do not require managers to select stocks and decide when to buy and sell.(d) All of the above.

Answer: D

19. A no-load mutual fund charges a commission

(a) when shares are purchased.(b) when shares are sold.(c) both when shares are purchased and when they are sold.(d) when shares are redeemed.

Answer: D

20. Over the past twenty years mutual fund fees have _________, largely because _________.

(a) fallen; SEC fee disclosure rules have led to greater competition(b) risen; investors have learned that funds with high fees provide better performance(c) risen; there has been collusion between large mutual fund companies(d) fallen; advances in information technology have lowered transaction costs

Answer: A

21. Which of the following is most likely to be a no-load fund?

(a) Value funds(b) Hedge funds(c) Growth funds(d) Index funds

Answer: D

22. When investors switch between funds in different families, mutual funds may charge

(a) a contingent deferred sales charge.(b) a redemption fee.(c) an exchange fee.(d) 12b-1 fees.(e) an account maintenance fee.

Answer: C

23. The Securities Acts of 1933 and 1934 did not

(a) regulate the activities of investment funds.(b) require funds to register with the SEC.(c) include antifraud rules covering the purchase and sale of fund shares.(d) apply to investment funds.

Answer: B

24. The largest share of total investment in mutual funds is in

(a) stock funds.(b) hybrid funds(c) bond funds.(d) money market funds.

Answer: A

25. Hedge funds are

(a) low risk because they are market-neutral.(b) low risk if they buy Treasury bonds.(c) low risk because they hedge their investments.(d) high risk because they are market-neutral.(e) high risk, even though they may be market-neutral.

Answer: E

26. The near collapse of Long Term Capital Management was caused by

(a) the high management fees charged by the fund’s two Nobel Prize winners.(b) the fund’s high leverage ratio of 20 to 1.(c) a sharp decrease in the spread between corporate bonds and Treasury bonds.(d) a sharp increase in the spread between corporate bonds and Treasury bonds.(e) the fund’s shift away from a market-neutral investment strategy.

Answer: D

27. Conflicts arise in the mutual funds industry because _________ cannot effectively monitor _________.

(a) investment advisors; directors(b) directors; shareholders(c) shareholders; investment advisors(d) investment advisors; stocks that will outperform the overall market

Answer: C

28. Late trading is the practice of allowing orders received _________ to trade at the _________ net asset value.

(a) before 4:00 pm; 4:00 pm(b) after 4:00 pm; 4:00 pm(c) after 4:00 pm; next day’s(d) before 4:00 pm; previous day’s

Answer: B

29. Market timing

(a) takes advantage of time differences between the east and west coasts of the U.S.(b) takes advantage of arbitrage opportunities in foreign stocks.(c) takes advantage of the time lag between the receipt and execution of orders.(d) is discouraged by the stiff fees mutual funds charge every investor for buying and

then selling shares on the same day.

Answer: B

30. Late trading and market timing

(a) allow large, favored investors in a mutual fund to profit at the expense of other investors inthe fund.

(b) hurt ordinary investors by increasing the number of fund shares and diluting the fund’s net asset value.

(c) both (a) and (b).(d) none of the above.

Answer: C

31. Which of the following is not a proposal to deal with abuses in the mutual fund industry?

(a) Strictly enforce the 4:00 pm net asset value rule(b) Make redemption fees mandatory(c) Disclose compensation arrangements for investment advisors(d) Increase the number of dependent directors

Answer: D

True/False

1. The larger the number of shares traded in a stock transaction, the lower the transaction costs per share.

Answer: TRUE

2. The increase in the number of defined contribution pension funds has slowed the growth ofmutual funds.

Answer: FALSE

3. The dollar amount invested in mutual funds is about the same as the total assets of all commercial banks at the beginning of 2004.

Answer: TRUE

4. Retirement funds account for two-thirds of all mutual fund assets.

Answer: FALSE

5. Open-end mutual funds are more common than closed-end funds.

Answer: TRUE

6. The net asset value of a mutual fund is the average market price of the stocks, bonds, and other assets the fund owns.

Answer: FALSE

7. A mutual fund’s board of directors picks the securities that will be held and makes buy and sell decisions.

Answer: FALSE

8. Money market mutual funds originated when the brokerage firm Merrill Lynch offered its customers an account from which funds could be taken to purchase securities and into which funds could be deposited when securities were sold.

Answer: TRUE

9. A deferred load is a fee charged when shares in a mutual fund are redeemed.

Answer: TRUE

10. SEC research suggests that about three-fourths of mutual funds let privileged shareholders engage in market timing.

Answer: TRUE

11. One factor explaining the rapid growth in mutual funds is that they are financial intermediaries that are not regulated by the federal government.

Answer: FALSE

Essay

1. What benefits do mutual funds offer investors?

2. How is a mutual fund’s net asset value calculated?

3. How did money market mutual funds originate and why did they become especially popular in the late 1970s and early 1980s?

4. How does the governance structure of mutual funds lead to asymmetric information and conflicts of interest?

5. Describe the practices of late trading and market timing and explain how these practices harm a mutual fund’s shareholders.

6. Discuss the proposals that have been made to reduce the conflict of interest abuses in the mutual funds industry.

CONTENTS

Documents

b funds markets

b people

b increases

d financial markets

lower b

b chapter

d increases

c decreases