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					Chapter 1
Why 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 2
Overview of the Financial System


 Multiple Choice Questions

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

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

21. Which of the following statements about financial markets and securities are true?
      (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 3
What Do Interest Rates Mean and What Is Their
Role in Valuation?


 Multiple Choice Questions

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


16. With an interest rate of 8 percent, the present value of $100 received one year from now
is approximately
      (a) $93.
      (b) $96.
      (c) $100.
      (d) $108.
      Answer: A

17.   With an interest rate of 6 percent, the present value of $100 received one year from now
      is approximately
      (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
      (a) 8 percent.
      (b) 10 percent.
      (c) 12 percent.
      (d) 14 percent.
      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

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

30.   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 positively related.
      (c) The yield to maturity is greater than the coupon rate when the bond price is above
          the par value.
      (d) All of the above are true.
      (e) Only (a) and (b) of the above are true.
      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
      (a) 5 percent.
      (b) 10 percent.
      (c) 20 percent.
      (d) 25 percent.
      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
      (a) 10 percent.
      (b) 20 percent.
      (c) 25 percent.
      (d) 40 percent.
      Answer: C

39.   If a $10,000 face value discount bond maturing in one year is selling for $9,000, then
      its yield to maturity is
      (a) 9 percent.
      (b) 10 percent.
      (c) 11 percent.
      (d) 12 percent.
      Answer: C


40. If a $10,000 face value discount bond maturing in one year is selling for $5,000, then its
yield to maturity is
      (a) 5 percent.
      (b) 10 percent.
      (c) 50 percent.
      (d) 100 percent.
      Answer: D

41.   If a $5,000 face value discount bond maturing in one year is selling for $5,000, then its
      yield to maturity is
      (a) 0 percent.
      (b) 5 percent.
      (c) 10 percent.
      (d) 20 percent.
      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.
      (d) All of the above are true.
      (e) Only (a) and (b) of the above are true.
      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.
      (d) All of the above are true.
      (e) Only (a) and (b) of the above are true.
      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.
      (a) (I) is true, (II) false.
      (b) (I) is false, (II) true.
      (c) Both are true.
      (d) Both are false.
      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.
      (a) (I) is true, (II) false.
      (b) (I) is false, (II) true.
      (c) Both are true.
      (d) Both are false.
      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.
      (a) (I) is true, (II) false.
      (b) (I) is false, (II) true.
      (c) Both are true.
      (d) Both are false.
      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 4
Why Do Interest Rates Change?


 Multiple Choice Questions

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 _________.
     (a) demand; rise
     (b) demand; fall
     (c) supply; fall
     (d) supply; rise
     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 _________.
     (a) demand; rise
     (b) demand; fall
     (c) supply; fall
     (d) supply; rise
     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.
      (a) increases; increases
      (b) increases; decreases
      (c) decreases; decreases
      (d) decreases; increases
      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.
      (a) increases; increases
      (b) increases; decreases
      (c) decreases; decreases
      (d) decreases; increases
      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 __________.
      (a) increases; increases; rises
      (b) decreases; decreases; falls
      (c) increases; decreases; falls
      (d) decreases; increases; rises
      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 _________.
      (a) right; rises
      (b) right; falls
      (c) left; falls
      (d) left; rises
      Answer: B

33.   When stock prices become less volatile, 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

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
      _________.
      (a) right; rises
      (b) right; falls
      (c) left; falls
      (d) left; rises
      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 _________.
      (a) increases; increases; rises
      (b) decreases; decreases; falls
      (c) increases; decreases; falls
      (d) decreases; increases; rises
      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.
      (d) All of the above are true.
      (e) Only (a) and (b) of the above are true.
      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 _________
      (a) decrease; right.
      (b) decrease; left.
      (c) increase; right.
      (d) increase; left.
      Answer: B

66.   A decline in the expected inflation rate 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: 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
      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: 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 5
How Do Risk and Term Structure Affect Interest
Rates?


 Multiple Choice Questions

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

45.   According to the pure expectations theory of the term structure,
      (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

46.   According to the pure expectations theory of the term structure,
      (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

47.   According to the pure expectations theory of the term structure,
      (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.
      (d) all of the above.
      (e) only (a) and (b) of the above.
      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.
      (d) all of the above.
      (e) only (a) and (b) of the above.
      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.
      (d) all of the above.
      (e) only (a) and (b) of the above.
      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 another
      is 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-term
      interest 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 6
The Money Markets


 Multiple Choice Questions

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.
     (d) All of the above are true.
     (e) Only (a) and (b) of the above are true.
     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 buy
          or 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
      (a) 4 percent.
      (b) 5 percent.
      (c) 6 percent.
      (d) 7 percent.
      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 buy
      T-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 7
The Bond Market


 Multiple Choice Questions

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.
     (a) (I) is true, (II) false.
     (b) (I) is false, (II) true.
     (c) Both are true.
     (d) Both are false.
     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.
     (a) (I) is true, (II) false.
     (b) (I) is false, (II) true.
     (c) Both are true.
     (d) Both are false.
     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.
     (a) (I) is true, (II) false.
     (b) (I) is false, (II) true.
     (c) Both are true.
     (d) Both are false.
     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
         than
         long-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.
      (a) (I) is true, (II) false.
      (b) (I) is false, (II) true.
      (c) Both are true.
      (d) Both are false.
      Answer: C

12.   (I) The primary issuers of capital market securities are financial institutions.
      (II) The largest purchasers of capital market securities are corporations.
      (a) (I) is true, (II) false.
      (b) (I) is false, (II) true.
      (c) Both are true.
      (d) Both are false.
      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.
      (a) (I) is true, (II) false.
      (b) (I) is false, (II) true.
      (c) Both are true.
      (d) Both are false.
      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.
      (a) (I) is true, (II) false.
      (b) (I) is false, (II) true.
      (c) Both are true.
      (d) Both are false.
      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.
      (a) (I) is true, (II) false.
      (b) (I) is false, (II) true.
      (c) Both are true.
      (d) Both are false.
      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.
      (a) (I) is true, (II) false.
      (b) (I) is false, (II) true.
      (c) Both are true.
      (d) Both are false.
      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.
      (a) (I) is true, (II) false.
      (b) (I) is false, (II) true.
      (c) Both are true.
      (d) Both are false.
      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-year
      Treasury bond. (II) Interest rates on Treasury bills are more volatile than rates on
      long-term Treasury securities.
      (a) (I) is true, (II) false.
      (b) (I) is false, (II) true.
      (c) Both are true.
      (d) Both are false.
      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
          consumer
          price 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.
      (a) (I) is true, (II) false.
      (b) (I) is false, (II) true.
      (c) Both are true.
      (d) Both are false.
      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.
      (a) (I) is true, (II) false.
      (b) (I) is false, (II) true.
      (c) Both are true.
      (d) Both are false.
      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.
      (a) (I) is true, (II) false.
      (b) (I) is false, (II) true.
      (c) Both are true.
      (d) Both are false.
      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 year
is 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.
      (a) (I) is true, (II) false.
      (b) (I) is false, (II) true.
      (c) Both are true.
      (d) Both are false.
      Answer: C

42.   Long-term unsecured bonds that are backed only by the general creditworthiness of the
      issuer
      are 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.
      (d) All of the above are true.
      (e) Only (a) and (b) of the above are true.
      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
      (a) 5 percent.
      (b) 10 percent.
      (c) 12 percent.
      (d) 15 percent.
      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
      (a) 10 percent.
      (b) 20 percent.
      (c) 25 percent.
      (d) 40 percent.
      Answer: A


56. The yield on a discount basis of a 90-day $1,000 Treasury bill selling for $950 is
      (a) 5 percent.
      (b) 10 percent.
      (c) 15 percent.
      (d) 20 percent.
      (e) none of the above.
      Answer: D

57.   The yield on a discount basis of a 90-day $1,000 Treasury bill selling for $900 is
      (a) 10 percent.
      (b) 20 percent.
      (c) 25 percent.
      (d) 40 percent.
      Answer: D

58.   The yield on a discount basis of a 180-day $1,000 Treasury bill selling for $900 is
      (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 with
      similar 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
      and
      interest 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 8
The Stock Market


 Multiple Choice Questions

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.
      (a) (I) is true, (II) false.
      (b) (I) is false, (II) true.
      (c) Both are true.
      (d) Both are false.
      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.
      (a) (I) is true, (II) false.
      (b) (I) is false, (II) true.
      (c) Both are true.
      (d) Both are false.
      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.
      (a) (I) is true, (II) false.
      (b) (I) is false, (II) true.
      (c) Both are true.
      (d) Both are false.
      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.
      (a) (I) is true, (II) false.
      (b) (I) is false, (II) true.
      (c) Both are true.
      (d) Both are false.
      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.
      (a) (I) is true, (II) false.
      (b) (I) is false, (II) true.
      (c) Both are true.
      (d) Both are false.
      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
      (a) 15 percent
      (b) 10 percent
      (c) 5 percent
      (d) 2 percent
      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
      (a) 20 percent
      (b) 15 percent
      (c) 10 percent
      (d) 5 percent
      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’s
      day-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 9
The Mortgage Market


 Multiple Choice Questions

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


4.   Which of the following are true of mortgages?
      (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

5.    Which of the following are true of mortgages?
      (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.
      (d) All of the above are true.
      (e) Only (a) and (b) of the above are true.
      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 else
          the same.
      (d) All of the above are true.
      (e) Only (a) and (b) of the above are true.
      Answer: D

7.    Which of the following are true of mortgages?
      (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

8.    Which of the following is true of mortgage interest rates?
      (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

10.   Which of the following is true of mortgage interest rates?
      (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

13.   Which of the following is true of mortgage interest rates?
      (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
      (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: A

16.   During the last years of a balloon 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: D

17.   During the early years of a balloon 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: 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.
      (a) (I) is true, (II) is false.
      (b) (I) is false, (II) is true.
      (c) Both are true.
      (d) Both are false.
      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.
      (a) (I) is true, (II) is false.
      (b) (I) is false, (II) is true.
      (c) Both are true.
      (d) Both are false.
      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
      (a) 50 percent.
      (b) 25 percent.
      (c) 15 percent.
      (d) 5 percent.
      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 on
      the 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 10
The Foreign Exchange Market


 Multiple Choice Questions

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 _________.
     (a) appreciated; appreciated
     (b) depreciated; appreciated
     (c) appreciated; depreciated
     (d) depreciated; depreciated
     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 _________.
      (a) appreciated; appreciated
      (b) depreciated; appreciated
      (c) appreciated; depreciated
      (d) depreciated; depreciated
      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 _________.
      (a) appreciated; appreciated
      (b) depreciated; appreciated
      (c) appreciated; depreciated
      (d) depreciated; depreciated
      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 by
      7 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 be
      2 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 11
Commercial Banking Industry: Structure and
Competition


 Multiple Choice Questions

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.
      (d) All of the above are true.
      (e) Only (a) and (b) of the above are true.
      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 at
     a 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 12
Savings Associations and Credit Unions


 Multiple Choice Questions

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
     banks
     are 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.
      (d) All of the above are true.
      (e) Only (a) and (b) of the above are true.
      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.
      (d) all of the above.
      (e) only (a) and (b) of the above.
      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.”
      (d) all of the above.
      (e) only (a) and (b) of the above.
      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.
      (d) all of the above.
      (e) only (a) and (b) of the above.
      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.
      (d) all of the above.
      (e) only (a) and (b) of the above.
      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.
      (d) all of the above.
      (e) only (a) and (b) of the above.
      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.
      (d) all of the above.
      (e) only (a) and (b) of the above.
      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.
     (d) all of the above.
     (e) only (a) and (b) of the above.
     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

 Multiple Choice Questions

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 by
          the 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 in
          the 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 of
      mutual 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.

				
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