Economics Test Bank

TEST BANK

CHAPTER 1

TRUE/FALSE QUESTIONS

(T) 1. The purpose of the financial system is to bring savers and borrowers together.

(F) 2. Businesses are never DSUs.

(T) 3. A financial claim is an “IOU” from a deficit spending unit.

(T) 4. Investment bankers help DSUs bring new primary security issues to market.

(F) 5. Deposits in a credit union by a household are an example of direct finance.

(F) 6. When an SSU owns a financial claim created by financial intermediation, its residual claim is against a DSU.

(F) 7. Assets of financial intermediaries include direct financial claims only.

(F) 8. Finance companies take small consumer deposits and make large consumer loans.

(T) 9. Liabilities of financial intermediaries are indirect financial claims.

(T) 10. Direct finance requires a more or less exact match of preferences.

(F) 11. There must be an equal number of DSUs and SSUs in a period.

(T) 12. Every financial claim appears on two balance sheets.

(T) 13. Without a financial sector, real investment must be financed internally by the DSU.

(T) 14. Depository intermediaries issue claims that are for the most part highly liquid.

(T) 15. A household is an SSU when income for the period exceeds spending.

(F) 16. An SSU must hold a claim until its scheduled maturity.

(T) 17. Financial claims or securities are written for the mutual benefit of both SSU and DSU.

(F) 18. DSUs and SSUs always have some contact with each other in financial markets.

(T) 19. Commercial banks lend to businesses in direct financial markets.

(F) 20. “Futures contract” and “forward contract” are interchangeable terms.

(T) 21. Mortgages are capital market debt securities.

(T) 22. Households are the major source of funds to the financial system.

(F) 23. Secondary markets are important because they provide funds directly to DSUs.

(F) 24. Primary markets offer liquidity and ways for investors to alter the risk of their portfolios.

(T) 25. The New York Stock Exchange is an example of an organized exchange.

(T) 26. The money market provides liquidity; the capital market finances economic growth.

(T) 27. Private placements are the simplest form of direct finance.

(T) 28. Competition among financial intermediaries tends to force interest rates downward.

(T) 29. Money markets have a greater variety of investors than borrowers.

(F) 30. Every asset is someone else’s liability, but not every liability is someone else’s asset.

(T) 31. All money market instruments are short-term debt.

(T) 33. The money market is a dealer market, not an exchange, and has no specific location.

(T) 34. Money market borrowers are small in number compared to money market lenders.

(T) 35. The money market is a market where liquidity is bought and sold.

(T) 36. Commercial banks are the major issuer and investor of money market securities.

() 37. Organized exchanges are less “exclusive” than over-the-counter markets.

(F) 38. Dealers bring buyer and seller together; brokers make a market.

(F) 39. OTC markets are not very important any more.

(T) 40. When a stock is listed on an exchange, members may trade it on the floor of the exchange.

MULTIPLE CHOICE QUESTIONS

(b) 1. An SSU’s a. income and expenditures for the period are equal. b. income for the period exceeds expenditures. c. expenditures for the period exceed receipts. d. spending is entirely financed by credit cards

(c) 2. Which of the following is an example of indirect financing? a. an SSU purchasing a financial claim from a DSU b. an SSU purchasing a financial claim from a dealer c. an SSU purchasing a financial claim from a commercial bank d. an SSU purchasing a financial claim from an underwriter

(d) 3. Which of the following does not take deposits? a. commercial banks. b. savings and loan associations. c. credit unions. d. finance companies.

(c) 4. When the financial system has achieved a high degree of efficiency, a. Borrowers are able to finance at the highest possible cost. b. Surplus spending units are able to receive the lowest return on their savings. c. Transaction and intermediation costs are low. d. Lenders will have a limited choice of financial investments.

(c) 5. An efficient financial system a. eliminates search and transactions costs b. is a mere theoretical possibility c. promotes economic growth and social progress d. depends on high volumes of “direct” transactions

(a) 6. Pension funds tend to invest in a. higher-yielding long-term securities b. money market securities exclusively c. government securities exclusively d. none of the above

(d) 7. Financial institutions facilitate the flow of investment funds a. from savers to borrowers b. from SSUs to DSUs c. from the household sector to the business sector d. any of the above

(d) 8. Which sector has been most consistently in a surplus budget position? a. Business b. Government c. Foreign d. Household

(d) 9. Which of the following are “economic units”? a. households b. businesses c. governments d. all of the above

(b) 10. Which of the following best describes the "two faces of debt" concept? a. DSUs are sometimes SSUs. b. Every financial asset is someone else’s liability. c. Intermediaries may own both direct and indirect financial assets. d. The government is unable to control its federal spending.

(a) 11. A dealer offers to buy shares of IBM at $125 and sell to investors at $127. The “bid” is a. $125 b. $127 c. $2 d. none of the preceding

(d) 12. Most financial intermediaries: a. issue direct claims and purchase direct financial assets. b. issue indirect claims and purchase indirect financial assets. c. purchase large amounts of real, tangible assets. d. purchase direct financial claims and issue indirect securities.

(a) 13. Profitability of financial intermediaries derives from all of the following except a. government regulation of interest rates b. economies of scale c. ability to manage credit risk d. control of transactions costs

(c) 14. Denomination intermediation is best exemplified by a. issuing insured deposits and making risky business loans. b. bringing together investors of different religions c. issuing five $3,000 CDs and making one $15,000 loan. d. promising liquidity to SSUs while investing the funds long-term

(a) 15. All but one of the following is comparative advantage of financial intermediaries: a. ability to finance businesses and governments. b. ability to achieve economies of scale. c. ability to reduce transaction costs. d. ability to find confidential information.

(a) 16. Which of the following would tend to hold corporate bonds in significant amounts? a. life insurance company b. credit union c. mutual savings bank d. commercial bank

(d) 17. All but one of the following is a standard characteristic of financial claims: a. They are recognized on two balance sheets. b. They are intangible assets. c. They are IOU's traded for funds. d. They represent ownership of real assets.

(a) 18. Money market mutual funds are a strong competitor for a. depository institutions. b. contractual savings institutions. c. finance companies. d. the real estate market.

(d) 19. All of the following are terms for or examples of financial claims except a. bonds. b. money. c. loans. d. commodities.

(c) 20. Direct finance is best exemplified by a. the purchase of mutual fund shares. b. depositing in a credit union. c. borrowing from a friend or relative. d. employee contributions to a pension fund.

(a) 21. Surplus spending units (SSU) are also called a. lenders. b. borrowers. c. sellers of securities. d. balanced budget units.

(c) 22. During 2008, Bob and Nancy Gutierrez expect total income of about $225,000 and are budgeting total expenditures of about $180,000. For this budget period, the Gutierrez family is most specifically a(n) a. DSU b. business c. SSU d. household

(c) 23. The ease with which a financial claim can be resold is its a. quality. b. risk. c. marketability. d. perpetuity.

(c) 24. The flow of funds from saving to investment through direct financing involves a. the saver holding the lender's IOU. b. two separate contracts. c. the lender holding the borrower's IOU. d. several different financial institutions.

(a) 25. Intermediation, or ____ financing, involves ___ financial claim(s) linking SSU and DSU. a. indirect; two b. direct; two c. indirect; one d. direct; one

(d) 26. In direct financing the lender a. trades a financial claim for money. b. trades money for a financial claim issued by a financial institution. c. trades money with a broker who owns the financial claims of a borrower. d. trades money for the financial claim of the borrower.

(c) 27. All but one is associated with direct financing: a. single financial instrument. b. a broker, dealer or investment banker. c. small denominations. d. dominance of governments and businesses as borrowers.

(b) 28. A sale of an entire security issue to one investor or a small group of investors is a. a dealer arrangement. b. a private placement. c. an underwriting. d. intermediation financing.

(c) 29. Brokers and dealers work in direct financial markets to a. make commissions. b. minimize the bid-ask spread. c. bring sellers and buyers together. d. underwrite new issues of securities.

(d) 30. ______ merely execute buy or sell orders for their clients; _______ “make markets”. a. dealers; brokers b. brokers; investment bankers c. dealers; financial institutions d. brokers; dealers

(a) 31. Hammond Securities holds an inventory of ABC Corp. stock, buying at $65.00 and selling at $67.50. The bid is _____; the bid-ask spread is _____. a. $65.00; $2.50 b. $67.50; $2.50 c. lower than the ask price; higher than the bid price d. higher than the ask price; $2.50

(d) 32. The _____ price is the highest price offered by the dealer to purchase a given security. a. market b. ask c. offering d. bid

(c) 33. Acting as matchmaker and earning a commission, the ______ is an important component in direct financial markets. a. dealer b. investment banker c. broker d. seller

(d) 34. All but one describes a dealer involved in direct financial market: a. provides liquidity to sellers b. buys and sells from inventory c. earns return from bid-ask spread d. transforms claims

(a) 35. All but one of the following is associated with investment banking: a. Taking deposits. b. Marketing new issues of securities. c. Underwriting securities. d. Completing regulatory paperwork and rendering advice.

(b) 36. Hollon Securities is underwriting an issue of Llamas Unlimited, Inc. common stock. Hollon will pay LU $45.00 a share and offer the stock to the public at $48.00. The direct cost of underwriting the issue is $1.00 per share. The underwriting spread is a. $4.00 per share. b. $3.00 per share. c. $2.00 per share. d. not ascertainable from the information above.

(a) 37. Most of the financial claims issued by U.S. financial intermediaries are purchased by a. the household sector. b. the business sector. c. the government sector. d. the foreign sector

(d) 38. The best synonym for “financial intermediation” is a. direct finance b. investment banking c. market making d. transformation of claims

(b) 39. An S&L taking short-term deposits and financing local land development is engaging in a. speculation. b. maturity intermediation. c. denomination intermediation. d. currency transformation

(c) 40. Credit risk diversification occurs when a. adding loans to the portfolio increases the variability of the loan portfolio. b. loans from similar borrowers are combined in a portfolio. c. adding loans to the portfolio decreases the variability of the loan portfolio. d. combining loans with similar payment patterns in a single portfolio.

(c) 41. Currency transformation is an important service because a. most SSUs want to invest in more than one currency b. all financial institutions operate internationally c. few ordinary investors care to hold claims denominated in foreign currency d. DSUs can’t export unless they borrow in the currency of the importing country

(d) 42. A commercial bank provides liquidity when it a. pays the check written by a deposit customer. b. redeems a savings deposit upon demand. c. makes a loan fulfilling a loan commitment. d. All of the above.

(c) 43. Disintermediation is best exemplified by a. purchase of securities. b. sale of securities. c. writing a broker a check to pay for a purchase of IBM stock. d. depositing an insurance settlement with a credit union.

(b) 44. The only “deposit-type” institutions that do not operate for profit are a. thrift institutions b. credit unions c. pension funds d. commercial banks

(a) 45. Credit unions are _____ institutions; pension funds are _______ institutions. a. depository; contractual b. contractual; depository c. federal ; investment d. depository; depository

(b) 46. The financial institution that is the largest issuer of commercial paper is a. commercial banks. b. finance companies. c. property-casualty insurance companies. d. pension funds.

(d) 47. Which of the following is not a debt security? a. corporate bonds. b. U.S. Government securities. c. federal agency securities. d. common stock.

(c) 48. Federal agencies issue high quality securities and invest primarily in claims issued by a. businesses that are “too big to fail”. b. the U.S. Treasury to finance government deficits. c. agricultural or housing-related sectors which have limited access to private credit. d. foreign governments

(d) 49. Money market instruments and capital market instruments differ appreciably in a. maturity b. liquidity c. availability to ordinary individual investors d. all of the above

(d) 50. Potential effects of yield fluctuations on security prices and reinvestment income represent a. credit risk. b. liquidity risk. c. foreign exchange risk. d. interest rate risk.

(c) 51. Which of the following is not an example of capital market securities? a. common stocks b. convertible bonds c. commercial paper d. mortgages

(d) 52. Secondary capital markets have promoted economic growth in the U.S. because a. they have increased marketability of stocks and bonds. b. they have increased the public's access to investment. c. they have helped investors diversify. d. all of the above
(b) 53. Security exchanges provide a valuable function in that they a. create interest in stocks. b. increase the marketability of securities. c. provide a legal way to gamble. d. supply money to deficit spending units.

(d) 54. The difference between “capital spending” and “real investment” is chiefly a difference in a. essential nature and purpose of the assets created or acquired b. relative cost of the assets created or acquired c. susceptibility of the assets created or acquired to amortization or depreciation d. semantics

(a) 55. Primary capital markets are most likely to finance a. plant and equipment b. inventory c. operating expenses d. none of the above

(d) 56. The household sector is the largest surplus sector and invests in the capital market a. directly by purchasing stocks and bonds. b. indirectly through mutual funds. c. indirectly through pension funds d. all of the above

(d) 57. If Boeing splits its outstanding common stock 2-for-1, that is an example of a. “primary market” activity b. “secondary market” activity c. “money market” activity d. financial intermediation

(c) 58. A standardized, exchange-backed contract to deliver assets 3 months from today is a: a. forward contract. b. securitized asset. c. futures contract. d. option contract.

(d) 59. A conditional contract granting its holder the right to buy assets in the future is a: a. put. b. forward contract. c. futures contract. d. call.

(c) 60. Money markets are associated with ; capital markets are associated with a. liquidity; marketability. b. spot; future. c. liquidity; economic investment. d. primary; secondary.

(d) 61. The DSU receives the funds in the primary market; the SSU sells the claim in the a. intermediation market. b. direct financial market. c. federal funds market. d. secondary market.

(b) 62. Which of the following is not a characteristic of money market instruments? a. short-term to maturity b. small denomination c. low default risk d. high marketability

(d) 63. Small investors are likely to invest in the money market ______ through __ ___ . a. directly; commercial paper b. locally; their credit union c. indirectly; negotiable CDs d. indirectly; money market mutual funds

(a) 64. Which of the following statements about the money market is true? a. The money market is a dealer market linked by efficient communications systems. b. Money market transactions are seldom over $1 million. c. Market transactions include more primary than secondary market trades. d. Most money market transactions are conducted by mail.

(a) 65. Which of the following may be a liability of a nonfinancial business? a. commercial paper b. Federal Funds c. Treasury securities d. agency securities

(d) 66. Federal Funds are typically a. Treasury deposits. b. Federal Reserve assets. c. commercial bank deposits at the Federal Reserve. d. overnight loans settled in immediately available funds.

(d) 67. The money market is important because a. it is the world's liquidity market. b. it is the market in which the Fed conducts monetary policy. c. the federal government finances most of its credit needs in the money market. d. all of the above

(d) 68. The money market security represented by the largest dollar amount outstanding is a. commercial paper. b. federal agency issues. c. negotiable CDs. d. Treasury bills.

(c) 69. Which of the following bank money market securities is backed by specified collateral? a. negotiable CDs b. banker's acceptances c. repurchase agreements d. commercial paper

(d) 70. Money market securities have very little a. default risk. b. price risk. c. marketability risk. d. all of the above.

(d) 71. Large industrial U.S. corporations are involved in the money market by a. investing excess cash balances. b. buying and selling goods on credit in international trade. c. issuing commercial paper. d. all of the above

(d) 72. Financial markets provide financial institutions: a. a place to securitize assets. b. a source of generating fee income from trading. c. a source of funding. d. all of the above.

(b) 73. Corporations list their securities on exchanges in order to a. pay an annual listing fee and disclose important information. b. enhance the liquidity of their securities for investors. c. sell more securities. d. increase the size of the firm.

ESSAY QUESTIONS

1. Explain financial intermediation and its benefits.

Answer: Financial institutions mediate unmatched preferences of DSUs and SSUs as to amount, maturity, and risk. Financial intermediaries buy financial claims with one set of characteristics from DSUs, then issue their own liabilities with different characteristics to SSUs. Thus, financial intermediaries “transform”claims to make them more attractive to both DSUs and SSUs. This transformation is the basis for 5 services provided by financial intermediaries:

Denomination Divisibility. DSUs prefer to borrow the full funding need all at once. SSUs tend to save small amounts periodically. Intermediaries pool small savings into large investments.

Currency Transformation. Intermediaries can buy claims denominated in one currency while issuing claims denominated in another. This is difficult for an ordinary SSU. Maturity Flexibility. DSUs generally prefer longer-term financing. SSUs generally prefer shorter-term investments. Intermediaries can offer different ranges of maturities to both.

Credit Risk Diversification. Intermediaries manage risk by evaluating and holding many different securities. SSUs on their own would have to leave “more eggs in one basket.”

Liquidity. Many claims issued by intermediaries are highly liquid because intermediaries substitute their own liquidity for that of DSUs.

Without financial intermediation, financing relationships would arise only when preferences of SSUs and DSUs match more or less exactly. DSUs would not always obtain timely financing for attractive projects and SSUs would under-utilize their savings. The “production possibilities frontier” of the society would be smaller.

2. Explain how and why the secondary capital markets play an important role in our economy. How do secondary markets assist the primary market?

Answer: Secondary markets provide investors with liquidity and the ability to re-balance their portfolios at any time. Constant trading provides a base for selling additional securities (primary issue) into the market and constant price discovery promotes continuing evaluation and feedback. Secondary markets also enable investors to choose their own holding periods

3. List and briefly describe the main risks managed by financial intermediaries.

Answer:

Credit Risk (or default risk) is the possibility that a borrower may not pay as agreed.

Interest Rate Risk is the likelihood that interest rate fluctuations will change a security’s price and reinvestment income.

Liquidity Risk is the possibility that a financial institution may be unable to pay required cash outflows.

Foreign Exchange Risk is the possibility of loss on fluctuations in exchange rates.

Political Risk is the possibility that government action will harm an institution’s interests.

CHAPTER 2

TRUE/FALSE QUESTIONS

(F) 1. Deposits should expand when reserve requirements increase.

(F) 2. The Fed's most influential tool is reserve requirements.

(T) 3. Federal Reserve regulations affect many nonbank institutions.

(T) 4. Depository institutions create money when they lend or invest excess reserves.

(T) 5. The Federal Open Market Committee basically establishes our nation's monetary policy.

(T) 6. A primary function of the Fed is economic stabilization via control of the money supply.

(T) 7. The Fed can substantially control the level of total bank reserves.

(F) 8. The Federal Reserve is independently funded and thus immune to any political pressure.

(F) 9. In the check-clearing system DACI usually exceeds CIPC, creating Fed float.

(T) 10. A decrease in Federal Reserve float decreases member bank reserves.

(F) 11. Currency is an asset of the Federal Reserve Banks.

(F) 12. A decrease in reserve requirements increases the total level of member bank reserves.

(F) 13. An increase in the money supply does not affect the supply of loanable funds.

(F) 14. Open market purchases by the Fed reduce total reserves in the banking system.

(T) 15. Monetary policy is a highly partisan issue.

(T) 16. The Fed can change the level of member bank reserves as well as reserve requirements.

(T) 17. The first impact of monetary policy upon depository institutions is via excess reserves.

(F) 18. Deposits should expand when the Fed sells securities.

(F) 19. The Discount Rate is a direct control on the money supply.

(T) 20. The Fed is this nation's first permanent central bank.

(F) 21. The Federal Reserve System replaced the National Banking system.

(F) 22. Congress is powerless over the Fed.

(F) 23. Excess reserve balances pay interest; required reserve balances do not.

(T) 24. Open Market Operations are the primary tool of monetary policy today.

(F) 25. A Fed governor has a lifetime appointment.

(T) 26. As the Fed expands the monetary base, bank loans and investments should expand also.

(T) 27. Though decentralized in geography, today’s Fed is highly centralized in power structure.

(T) 28. Reserve requirements are not considered a viable tool of monetary policy.

(F) 29. The “monetary base” comprises the Fed’s most important assets.

(T) 30. The Federal Reserve Bank of New York is the “headquarters” of open market operations.

(T) 31. No two Governors may be from the same Federal Reserve District.

(F) 32. Reserve requirements apply only to member banks in Federal Reserve System.

(F) 33. The Chairman of the Fed is highly visible, but not very powerful.

(T) 34. All national banks must join the Federal Reserve System.

(T) 35. Margin requirements are an important regulatory power of the Fed.

(F) 36. Excess reserves cost a depository institution nothing to maintain.

(F) 37. The monetary base comprises currency in circulation and checks not yet cleared.

MULTIPLE-CHOICE QUESTIONS

(b) 1. Number of Federal Reserve Governors plus size of FOMC less number of Federal Reserve banks equals: a. 9. b. 7. c. 14. d. 12.

(d) 2. Which of the following can be associated with original objectives of the Fed? a. coordinate an efficient payments mechanism. b. provide an elastic money supply. c. serve as lender of last resort. d. all of the above

(a) 3. The primary responsibility of the Federal Open Market Committee (FOMC) is to a. set monetary policy b. supervise and examine member banks. c. guarantee excess reserves to National Banks. d. enforce margin requirements

Use this data answer questions 4-6: Total Reserves $80,000,000; Reserve Requirement 5%; Total Deposits $700,000,000.

(b) 4. Using the data above, the level of excess reserves is a. $ 4,000,000 b. $ 45,000,000 c. $ 70,000,000 d. not ascertainable

(d) 5. The data above exemplify a. an arguable underutilization of resources, at least for the moment b. an excess reserve position c. a near-term likelihood that loans and deposits will expand d. all of the above

(a) 6. The data above could exemplify a direct, immediate effect of any of the following except a. an open market sale by the Fed b. a lowering of reserve requirements by the Fed c. a new loan at the Discount Window by the Fed d. an open market purchase by the Fed

(b) 7. The asset of Federal Reserve banks associated with open market operations is a. Federal Reserve notes. b. U.S. government securities. c. loans to member banks. d. float.

(c) 8. The Treasury draws most of its checks upon a. the Comptroller of the Currency. b. national banks. c. Federal Reserve banks. d. its own required reserves

(d) 9. For what purposes do depository institutions keep deposits in the Federal Reserve banks? a. for clearing checks b. to satisfy reserve requirements c. to earn interest d. a and b

(a) 10. Federal Reserve notes held in bank vaults are the liability or obligation of a. the Fed. b. the Treasury. c. the bank. d. none of the above

(b) 11. Federal Reserve float a. is the “lag time” required for monetary policy to take effect b. represents a net extension of credit by the Fed, which increases bank reserves. c. represents a net liability of the Fed. d. is DACI minus CIPC.

(d) 12. When the New York Fed sells Treasury securities to a securities dealer a. depository institutions deposits in the Fed decrease. b. depository institutions deposits in the Fed increase. c. the deposit balance of the security dealer in its bank decreases. d. both a and c above.

(a) 13. Which Fed action does not directly increase total reserves in the banking system? a. Lowering the Discount Rate b. Lowering reserve requirements c. Buying U.S. Government securities on the open market d. None of the above

(a) 14. To increase the money supply immediately but just slightly, the Fed would most likely a. Buy securities on the open market b. Lower the Discount Rate c. Lower reserve requirements d. Any of the above would be suitable for this purpose.

(d) 15. Reserve requirements apply to a. National banks b. State banks c. Savings-and-loan associations d. All of the above

(d) 16. The Fed’s primary tools of monetary policy include all the following except a. changing the discount rate. b. open market operations. c. adjusting reserve requirements. d. changes in the Federal Funds rate.

(b) 17. The 12 Federal Reserve Banks are a. Important and autonomous components of a “decentralized central bank” b. Important components of the Fed, but no longer very autonomous c. Neither important nor autonomous d. All permanently voting members of the FOMC

(b) 18. The purchase of government securities by the Fed will a. decrease the money supply. b. increase security prices. c. increase interest rates. d. decrease credit availability.

(d) 19. Which of the following is in the correct historical order? a. Second Bank of the United States, Federal Reserve Act, Crash of 1907 b. Crash of 1907, Federal Reserve Act, National Banking Acts c. First Bank of the United States, Crash of 1907, National Banking Acts d. Second Bank of the United States, National Banking Acts, Federal Reserve Act

(d) 20. The Fed’s most visible monetary tool is probably a. open market operations. b. change in reserve requirements. c. Reg Z. d. discount rate policy

(c) 21. The Fed’s non-monetary or regulatory powers do not include a. Margin requirements b. Interest rate disclosures on deposits c. Investigation and prosecution of counterfeiting d. Bank holding companies

(d) 22. Which of the following was a responsibility of the early Federal Reserve System? a. to control the money supply b. to safeguard the national payment system c. to establish a more rigorous bank supervisory system d. all of the above

(c) 23. The Federal Reserve System established a. a system for federal chartering of banks. b. a system for controlling bank note issuance. c. a source of liquidity for the banking system. d. the beginning of demand deposit accounts.

(b) 24. Increases in the Fed’s assets a. decrease the monetary base b. increase the monetary base c. have no effect on the monetary base. d. none of the above

(d) 25. Which of the following can be associated with the modern objectives of the Fed? a. coordinate an efficient payments mechanism. b. provide an elastic money supply. c. regulate the financial system. d. all of the above.

(b) 26. Reforms and regulatory changes in U.S. financial institutions are best associated with: a. international events affecting U.S. financial institutions. b. periods of severe economic and financial problems in the U.S. economy. c. voter changing the majority party in Congress. d. recommendations of presidential commissions.

(b) 27. Who among the following does not have a permanent vote on the FOMC? a. President, Federal Reserve Bank of New York b. Chairman, Board of Governors c. President, Federal Reserve Bank of Los Angeles d. Members of the Board of Governors

(d) 28. There are ______ members of the Federal Reserve Board of Governors, _______ members of the Federal Open Market Committee, and ________ Federal Reserve Banks. a. 12; 7; 12 b. 7; 14; 12 c. 14; 12; 12 d. 7; 12; 12

(c) 29. All of the following are locations of Federal Reserve Banks except a. San Francisco b. Dallas c. Washington, DC d. Kansas City

(b) 30. An increase in Federal Reserve float a. decreases bank reserve deposits in the Fed. b. increases bank reserve deposits in the Fed. c. has no impact upon bank reserves deposits in the Fed. d. reduces the net loan granted by the Fed to member banks.

(b) 31. The Discount Window a. is a common way for depository institutions to raise loanable funds b. relates to the Fed’s “lender of last resort” function c. is a relatively recent innovation in the design of the Federal Reserve System d. is available only during emergencies

(c) 32. The Fed’s most important duty is to a. regulate national banks b. print currency c. establish the nation’s monetary policy d. stimulate the economy

ESSAY QUESTIONS

1. Explain why the Federal Reserve is less "independent" than it appears to be.

Answer: What Congress creates, Congress can modify or destroy. Congress has from time to time established guidelines or objectives for the Fed (e.g. Humphrey-Hawkins, 1978). The Fed remains independent because most politicians want it that way. They mostly agree that monetary policy is not a partisan issue. An independent Fed can also absorb blame if the economy falters, and take necessary but unpopular steps to combat various economic ills. If Congress should change its mind, the Fed’s independence could vanish at the stroke of a pen.

2. Compare and contrast the “tools of monetary policy” in terms of their relative usefulness.

Answer: The discount rate and reserve requirements are both original design features of the Fed; open market operations have evolved as the FOMC has evolved. The discount rate was originally a direct control of the cost of funds to member banks; today it is more of a signal of the Fed’s intent, as relatively few institutions borrow at the Window. Reserve requirements have always been a direct control on the ultimate expansion of deposits and loans, but changing them affects the banking system so dramatically that the Fed cannot use them for the “fine tuning” it prefers. Open market operations affect reserve levels directly, immediately, and dollar-for-dollar. Their flexibility and precision make them the most useful—and thus the most important—tool.

3. How has the power structure of the Fed changed since 1913?

Answer: The Fed has centralized as the U.S. has evolved from a confederation of regional economies to a truly national economy. The 12 Federal Reserve Banks, once largely autonomous in their respective regional districts, remain operationally important but have lost their authority to set monetary policy. They are a minority (5 votes out of 12) on the FOMC, which sets U.S. monetary policy under ultimate control of the Board of Governors.

4. Assume the Fed pays $1000 for a government bond on the open market. With a 5% reserve requirement, what is the theoretical ultimate addition to the money supply, and why?

Answer: With a 5% required reserve ratio, the theoretical loan/deposit expansion from the $1000 injection of new reserves, is 1000/.05 or $20,000. An open market purchase creates new excess reserves. Depository institutions, if they are profit maximizers, will lend or sell any excess reserves , expanding assets and deposits until any reserves are again absorbed as required reserves.
5. Why is changing the discount rate not a viable tool for conducting monetary policy?

Answer: Changes to the discount rate will affect the money supply only if depository institutions choose to “go to the Window”. Regulators closely scrutinize Window borrowing, so it is not a first or regular choice for raising liquidity. Most borrowing at the Window that does take place is short-term, so the ultimate effect on the money supply is hard to predict.

6. What are margin requirements, and why do they exist?

Answer: After 1929 stock market crash, the Fed was empowered to regulate buying of securities “on margin” (i.e. with borrowed money). Margin requirements determine how much of the securities’ value can be used as collateral. The Fed uses these regulations to deter the use of borrowed money to finance speculation in the capital markets.

CHAPTER 3
TRUE/FALSE QUESTIONS

(F) 1. The monetary base exceeds the money supply.

(T) 2. The cash-holding behavior of the public affects the monetary base.

(T) 3. The Federal Reserve decreases the monetary base whenever it sells government securities.

(T) 4. When reserve requirements are increased, interest rates should increase.

(F) 5. If cash drains increase, the Fed may offset their effects with open market sales.

(T) 6. The Fed substantially controls M1 by controlling total reserves of depository institutions.

(T) 7. When the Fed sells an asset to the private sector, the monetary base declines.

(T) 8. When a bank orders currency from the Fed, the monetary base does not change.

(F) 9. A significant move by the Fed toward a “tight” money policy is likely to enhance exports.

(T) 10. Housing investment is sensitive to changes in interest rates.

(T) 11. Decreasing interest rates increase financial wealth and encourage consumer spending.

(F) 12. An increase in the money supply should ultimately cause security prices to decrease.

(T) 13. Restrictive monetary policy in the United States may slow down net exports and GNP.

(T) 14. Monetarists think changing the money supply impacts economic units directly rather than just through interest rates.

(F) 15. Increasing interest rates increase wealth of spending limits and encourage spending.

(F) 16. Easy monetary policy strengthens the dollar.

(T) 17. A prolonged “tight” monetary policy can be associated with falling bond prices.

(F) 18. Stable employment is one of the objectives of monetary policy.

(F) 19. There is definitely a tradeoff between stable prices and full employment.

(T) 20. Unexpected high levels of inflation aid debtors at the expense of lenders.

(T) 21. An increase in Federal Reserve float increases the monetary base.

(T) 22. Cash drains decrease the monetary base, but not the money supply.

(F) 23. The Fed exclusively controls the money supply.

(T) 24. Interest rates and the money supply tend to vary inversely, at least in the short term.

(F) 25. Real investment is encouraged by rising interest rates.

(T) 26. Monetary policy first affects financial markets and institutions, then the real economy.

(F) 27. Transaction deposits, such as DDAs, expand when the Fed sells securities.

(F) 28. When the Fed increases the Fed Funds Rate, financial institutions “go to the Window”.

(F) 29. Monetary policy only works in the short term.

(F) 30. Monetary policy only works in the long term.

(T) 31. “Cash drains” are an example of a “technical factor”.

(T) 32. Reserve requirements are not useful for “fine tuning.”

(F) 33. The Fed is powerless against “technical factors”.

(F) 34. High stock prices are a goal of monetary policy.

(T) 35. The goals of U.S. monetary policy were set by Congress.

MULTIPLE-CHOICE QUESTIONS

(c) 1. The monetary base will decrease when: a. banks withdraw currency from the Fed. b. the Fed makes loans at the discount window. c. the Fed sells securities on the open market. d. the Fed buys securities on the open market.

(a) 2. Deposits tend to expand whenever: a. reserve requirements decrease. b. the public holds more cash. c. reserve requirements increase. d. monetary policy “tightens”.

(c) 3. An increase in excess reserves will cause a. the Fed Funds rate to rise. b. planned inventory investment to fall. c. depository institutions to lend more freely. d. foreign investors to buy more T-Bills.

(c) 4. The velocity of money measures: a. the rate of growth of the money supply. b. the relationship between the monetary base and the money supply. c. the relationship between the money supply and economic activity. d. all of the above.

(d) 5. Ordinarily the money supply will decrease if: a. the Fed makes fewer loans at its discount window. b. the Fed sells securities on the open market. c. the Fed raises reserve requirements. d. all of the above.

(d) 6. The money supply a. is exclusively controlled by the Fed. b. is smaller than the monetary base c. excludes any interest-bearing deposits d. none of the above.

(c) 7. Which of the following tools of monetary policy has the greatest impact? a. discount rate b. Regulation Q c. open market operations d. bank examination

(b) 8. An increase in the assets of Federal Reserve banks a. decreases the monetary base. b. increases the monetary base. c. has no effect on monetary base. d. always decreases another Federal Reserve Bank asset.

(b) 9. Consumption spending should increase if a. financial wealth decreases. b. reserve requirements decrease. c. interest rates increase. d. credit availability decreases.

(d) 10. Generally, plant and equipment investment spending will decrease if a. interest rates rise while inflation remains unchanged. b. inflation decreases while interest rates remain unchanged. c. reserve requirements rise. d. any of the above

(d) 11. A decrease in the monetary base is related to a. decrease in credit availability. b. increasing interest rates. c. decreased investment. d. all of the above

(d) 12. A decrease in reserve requirements will definitely cause a. expenditures to fall. b. inflation expectations to fall. c. an increase in the Fed Funds rate. d. excess reserves to increase.

(c) 13. Sustained open market buying by the Fed will cause a. the Fed Funds rate to rise. b. planned inventory investment to fall. c. depository institutions to lend more freely. d. foreign investors to buy more T-Bills.

(c) 14. An expansion in the U.S. money supply a. will increase domestic interest rates b. will cause the exchange value of the dollar to increase. c. will cause U.S. exports to increase. d. will cause U.S. imports to increase.

(a) 15. If the money supply increases too rapidly a. inflationary expectations will rise. b. government spending will decrease. c. bank lending will decrease. d. investment spending will fall.

(b) 16. Unemployment should fall if a. wages increase and people expect prices to rise, too. b. wages increase and people expect prices to be stable. c. interest rates rise more than prices are expected to rise. d. the money supply decreases.

(d) 17. An contraction in the U.S. money supply should a. increase domestic interest rates b. cause the exchange value of the dollar to increase. c. cause U.S. exports to decrease. d. all of the above.

(c) 18. The intended longer run impact of monetary policy is a. to lower interest rates. b. to raise security prices. c. to influence change consumption and investment spending. d. to reduce government spending.

(d) 19. Monetary policy impacts the economy a. by affecting real spending directly. b. by affecting real spending through the financial sector. c. by changing interest rates and the cost of housing. d. all of the above

(c) 20. Restrictive monetary policy first impacts the market, security prices and interest rates. a. money, increasing, decreasing b. capital, increasing, decreasing c. money, decreasing, increasing d. mortgage, increasing, decreasing

(b) 21. Changes in spending caused by changing security values are called the a. liquidity effect b. wealth effect c. income effect d. reactionary effect

(d) 22. Monetary policy probably affects all of the following except a. housing investment. b. consumer durable investment. c. inventory investment. d. federal government budget outlays.

(b) 23. Monetary policies directed toward increased economic growth may have what impact upon the value of the dollar in relation to other currencies? a. increase b. decrease c. no effect d. none of the preceding

(a) 24. Monetarists believe that an increase in the money supply, all else equal, will cause: a. consumption expenditures to rise. b. investment spending to fall. c. national income to fall. d. government expenditures to rise.

(c) 25. M3 includes a. currency in circulation b. demand deposits c. both d. neither

(a) 26. Which of the following is not a channel of transmission of monetary policy? a. Reg Q interest rate ceilings b. consumer spending for durable goods and housing c. net exports d. business investment in real assets

(d) 27. The “tools” of monetary policy, whether “viable” or not, include all the following except a. changing the discount rate. b. open market operations. c. changes in reserve requirements. d. changes in the Federal Funds rate.

(c) 28. Which of the following would most likely decrease the Federal Funds rate? a. decrease in the discount rate. b. sale of securities by the Fed. c. decrease in reserve requirements. d. none of the above

(a) 29. Which of the following was not a responsibility of the early Federal Reserve System? a. replace the National Banking system b. improve the payments system c. establish more rigorous bank supervision d. act as “lender of last resort”
(a) 30. Monetarists and Keynesians agree that a. monetary policy influences the real sector b. changes in the money supply drive changes in interest rates c. changes in interest rates drive changes in the money supply d. monetary policy does not influence the real sector

(d) 31. Velocity of money a. varies inversely with the money supply b. varies directly with GDP c. is not under the Fed’s exclusive control d. all of the above

(c) 32. Influence of monetary policy on the real sector is a. negligible b. decisive c. significant d. insignificant

(b) 33. Influence of monetary policy on the financial sector is a. negligible b. inevitable c. limited d. insignificant

(d) 34. Which of the following was a responsibility of the early Federal Reserve System? a. to control the money supply b. to safeguard the national payment system c. to establish a more rigorous bank supervisory system d. all of the above

(c) 35. The Federal Reserve System established a. a system for federal chartering of banks. b. a system for controlling bank note issuance. c. a source of liquidity for the banking system. d. the beginning of demand deposit accounts.

ESSAY QUESTIONS

1. Explain how the Fed adjusts its balance sheet to increase or decrease the monetary base.

Answer: The Fed controls the bank reserve component of the monetary base and changes the bank reserve account (liability) chiefly through open market operations—buying or selling U.S. government securities (asset). When a Fed asset increases, the monetary base increases.

2. How does the Federal Reserve control the money supply by controlling the size of the monetary base? Note the tools of monetary policy and how each can affect the monetary base and money supply.

Answer: By exclusively controlling the monetary base, the Fed substantially controls the money supply. To meet reserve requirements, depository institutions must deal in monetary base assets by either depositing adequate reserves with the Fed or holding adequate quantities of Federal Reserve Notes in their vaults. Either way, they earn no interest. The more they hold above requirements, the more they want to avoid lost interest income. Excess reserves appear as the Fed buys securities on the open market, lends at the Discount Window, or cuts reserve requirements. As depository institutions lend or invest excess reserves, new loans or investments increase M1 and finance purchases in the real sector. By expanding or contracting the monetary base, the Fed increases or decreases excess reserves, thus raising or lowering incentive to lend or invest, thus encouraging or discouraging expansion in real sector.

3. What should happen to consumption if the monetary base increases? Explain.

Answer: If the Fed increases the monetary base excess reserves will increase, pressuring the “benchmark” Fed Funds Rate downward. As depository institutions lend or invest the excess reserves, the deposit component of M1 will expand. Falling interest rates and increased credit availability will make saving less attractive than spending, increase the value of existing fixed-rate financial assets in which prior savings may have been invested, and lower the financing costs of “big ticket” items, thus encouraging additional consumption.

4. What exactly is the Fed Funds Rate, and why isn’t it considered a “tool of monetary policy?

Answer: The Fed targets but does not set the Fed Funds Rate. The Fed Funds Market is a Fed- sponsored system in which depository institutions lend and borrow excess reserves among themselves.
Thus the Fed Funds Rate is set by market forces as they bargain with each other. The FFR is a
“benchmark” rate in the financial system—it normally represents the lowest possible cost of loanable funds to a depository institution. The Fed substantially influences the FFR in the short term by controlling overall availability of reserves. However, the Fed cannot set the Fed Funds Rate in the long run because factors in the real sector ultimately determine credit demand

5. List and briefly describe the channels of transmission of monetary policy.

Answer:

Business investment in real assets. Present values of future cash flows depend significantly on interest rates, as do costs of financing real assets. Monetary policy thus involves material incentives or disincentives for business investment. Consumer spending for durable goods & housing. Much consumer spending is on credit. Falling interest rates tend to encourage spending; rising rates to discourage spending. Net exports (gross exports minus gross imports). Interest rates affect exchange rates, which affect imports and exports. Monetary policy thus usually affects net exports.

CHAPTER 4

TRUE-FALSE QUESTIONS

(T) 1. The real rate of interest can be viewed as the time value of not consuming.

(F) 2. The current rate of inflation affects the expected level of interest rates.

(T) 3. The market rate of interest can be viewed as the real rate of interest plus a premium for the expected rate of inflation.

(F) 4. Declining interest rates can be caused by an upward shift in the demand for loanable funds relative to the supply of loanable funds.

(F) 5. The expected real rate of interest is likely to be negative.

(T) 6. The realized real rate of interest can be negative if expected inflation is less than actual inflation.

(F) 7. An increase in desired investment shifts the desired savings supply line upward to higher real rates of interest.

(T) 8. Nominal interest rates reflect anticipated inflation.

(F) 9. Expected increased inflation usually drives up bond prices.

(F) 10. Interest rates are directly related to inflation expectations and inversely related to the level of economic activity.

(F) 11. An upward shift in the supply of loanable funds is likely to increase interest rates.

(T) 12. An increase in rates of return on real capital investment will increase real interest rates.

(F) 13. An increase in the desired saving rate will increase real interest rates.

(F) 14. Deficit spending units supply loanable funds.

(F) 15. If yields on thirty-year U. S. Treasury bonds are 8% and the real rate of interest is estimated at 3%, the historical rate of inflation is 5%.

(T) 16. The Fisher Effect holds that nominal interest rates include an expected inflation rate.

(T) 17. Economic models and flow-of-funds are two ways of forecasting interest rates.

(F) 18. Economic models forecast interest rates then estimate measures of economic output.

(T) 19. The flow of funds forecasting method utilizes the concept of supply and demand of loanable funds.

(F) 20. Interest rate forecasting using economic models assumes that financial markets are very efficient.

(T) 21. Nominal rates generally exceed the real rate.

MULTIPLE-CHOICE QUESTIONS

(c) 1. Interest is a. the price of money. b. the rent on money. c. time value of delayed consumption. d. all of the above.

(c) 2. Which one of the following is not an explanation for paying interest on borrowed money? a. Interest is the rental cost of purchasing power. b. Interest is the penalty paid for consuming income before it is earned. c. Interest is always paid at the maturity of a loan. d. Interest is the time value of delayed consumption.

(e) 3. Which of the following factors influence the real rate of interest? a. investor's positive time preference b. the gold supply c. return on capital investments d. the rate of inflation e. both a and c

(a) 4. All but one of the following factors influences the real rate of interest. a. the rate of inflation b. investor positive time preference for current versus future consumption. c. the return on alternative real investments. d. the real level of output in the economy.

(b) 5. ________ real rates are almost always positive; _______real rates may be negative. a. Realized; expected b. Expected; realized c. Government; private d. Expected; expected

(c) 6. Which statement is true about interest rate movements? a. Interest rates move counter-cyclically with the business cycle. b. Long-term interest rates have greater swings than short-term rates. c. The expected rate of inflation impacts the level of interest rates. d. Bond prices and interest rates move directly with one another.

(c) 7. Which one of the following statements about interest rates is incorrect? a. Bond prices and interest rates change inversely with one another. b. The expected rate of inflation affects current market interest rates. c. Short-term interest rates are not as volatile as long-term interest rates. d. Interest rates are directly related to the level of output in the economy.

(b) 8. The Fisher effect is a theory which holds that a. nominal rates include the real rate of interest plus past annual inflation rates. b. nominal rates include the real rate of interest plus expected annual inflation rates. c. real rates are always positive. d. inflation has no impact upon interest rates.

(b) 9. If nominal interest rates are 10% and expected inflation is 5%, a. actual inflation exceeds 10%. b. the real rate of interest is 5%. c. market rates are expected to increase to 15%. d. expected interest rates are 5%.

(d) 10. If the real rate of interest is 4%, actual inflation for the last year was 5%, and expected inflation is 8%, the Fisher effect predicts what current level of nominal interest rates? a. 9% b. 8% c. 13% d. 12%

(a) 11. If current market rates on Treasury bonds are 6 percent and the real growth of the economy has and will be expected to grow at 3 percent, what is the expected rate of inflation, according to the Fisher effect? a. 3% b. 9% c. higher than 6% d. close to zero

(c) 12. The demand for loanable funds may shift upward (increase) from a. a decline in the supply of loanable funds. b. a decline in business prospects. c. an improvement in technology. d. an expectation of an upcoming recession.

(d) 13. Interest rates will decline when the demand for loanable funds a. shifts to the left. b. shifts to the right. c. anticipates reduced growth in the economy. d. "a" and "c" above.

(b) 14. All but one of the following affects the supply of loanable funds? a. the level of income b. the investment opportunities in the economy. c. the savings rate d. Federal Reserve monetary policy actions.

(d) 15. An increase in the rate of expected inflation will a. shift the demand for loanable funds to the left (down). b. shift the supply of loanable funds to the left (down). c. shift demand and supply for loanable funds to the right (up) decreasing interest rates. d. shifts demand and supply for loanable funds to the right (up) increasing interest rates.

(c) 16. Deficit spending units (DSU) are represented in loanable funds theory as a. suppliers of loanable funds. b. demanders of financial claims. c. demanders of loanable funds. d. DSUs are not represented in the loanable funds theory of interest rate determination.

(c) 17. An economic recession would be represented in loanable funds theory as a. a shift in the demand for loanable funds to the right associated with reduced business investment demand and a decline in interest rates. b. a shift in the demand for loanable funds to the left as real investment weakens, a shift to the right of the supply of loanable funds as the Fed expands the money supply, and a decrease in interest rates. c. a movement along the demand for loanable funds as interest rates decline. d. an increase in the supply of loanable funds as the level of savings increases accompanied with an increase in the demand for loanable funds as housing investment is increased, and a decrease in interest rates.

(c) 18. Increased government budget deficits a. shifts the demand for loanable funds to the left, reducing interest rates. b. shifts the supply of loanable funds to the right, reducing interest rates. c. shifts the demand for loanable funs to the right, increasing interest rates. d. shifts the supply of loanable funds to the left, reducing interest rates.

(a) 19. The realized rate of return may be negative if a. investors' expected rate of inflation (Pe) was less than actual inflation (Pa). b. investors' expected rate of inflation (Pe) was greater than actual inflation (Pa). c. investors over-anticipated the level of inflation. d. investors expected more inflation than was realized.

(d) 20. An increase (shift to right) in the supply of loanable funds (SL) may be related to all but one of the following: a. an increase in the money supply. b. an increase in household thriftiness. c. an increase in household income. d. an increase in personal income taxes.

(a) 21. If the real rate of interest is 4% and the expected inflation rate is 7%, a loan at 12% a. would reward the lender at the borrower’s expense b. would reward the borrower at the lender’s expense c. would penalize the lender at the borrower’s expense d. none of the above

(b) 22. If the actual rate of inflation is less than the rate expected during a period, a. borrowers benefited at the expense of lenders. b. lenders benefited at the expense of borrowers. c. both borrowers and lenders benefited. d. neither borrowers nor lenders benefited.

(c) 23. If expected inflation in a period exceeds actual inflation a. borrowers will benefit. b. savers will lose purchasing power. c. SSUs will benefit at the expense of DSUs. d. interest rates are likely to increase in the future.

(b) 24. Interest rates should decease if a. The economy is in a boom. b. Inflationary expectations have decreased. c. The Federal Reserve has decreased M1 and the supply of loanable funds. d. Business investment demand has decreased significantly.

(d) 25. A decrease in interest rates may best be related to a. a recession and a decline in inflationary expectations. b. an acceleration in the growth rate of M1. c. decreased real investment opportunities. d. all of the above

(c) 26. An investor received an 8 percent coupon rate last year on a $1000 bond purchased at par. The inflation rate during the year was 4 percent and is expected to be 5 percent next year. The realized real rate earned by the investor last year was: a. 8% b. 3% c. 4% d. -1 percent.

(a) 27. An investor earned 12 percent last year, a year when actual inflation was 9 percent and was expected to have been 6 percent. The investor realized real rate of return was: a. 3% b. 6% c. 18% d. 12%

(d) 28. Which of the following is more likely to affect long-term bond yields? a. announcement of the last year's inflation rate b. announcement of this month's inflation rate c. a forecast of next month's inflation rate d. a forecast of inflation for the next five years

(c) 29. Which of the following is more likely to adversely affect long-term bond prices? a. a forecast of lower inflation in the future. b. a forecast of a slower economy next year. c. a forecast of higher inflation in the future. d. a forecast of lower government budget deficits.

(a) 30. Negative realized real rates of interest are associated with periods where a. inflation forecasts significantly underestimate inflation. b. nominal interest rates were too high relative to actual inflation. c. prior inflation forecasts overestimated inflation. d. bond prices were priced too low relative to actual inflation.

(c) 31. Basic approaches to forecasting interest rates include a. economic models b. flow-of-funds c. both of the above d. none of the above

(c) 32. Economic models predict interest rates by estimating the statistical relationships between the and the resulting . a. level of interest rates; measures of economic output b. past level of interest rates; future level of interest rates c. measures of economic output; level of interest rates d. prior level of GNP; future level of interest rates

(d) 33. The Federal Reserve Bank of St. Louis develops quarterly forecasts of a number of key economic statistics using only eight equations. The is an example of a. a naive forecasting model. b. the flow of funds approach. c. a hedged forecast. d. an economic forecasting model.

(a) 34. The flow of funds approach to interest rate forecasting is associated with all but one of the following: a. the National Income Accounts. b. the Flow of Funds Accounts. c. the loanable funds theory of interest rate determination. d. the Federal Reserve System.

(d) 35. Which of the following best explains why public interest rate forecasts have a low rate of accuracy? a. Accurate forecasters do not make their forecasts public. b. Reasonably efficient financial markets preclude a forecaster from consistently outguessing the direction of interest rates. c. The level of training of forecasters is lagging an evermore sophisticated economy. d. (a) and (b) above

(b) 36. Which of the following is best associated with interest rate movements and inflation? a. Interest rates move inversely with inflation. b. Interest rates vary directly with expected inflation. c. Interest rates vary directly with past inflation rates. d. Inflation is impacted by expected interest rates.

(c) 37. A decrease in the money stock by the Federal Reserve a. shifts the supply of loanable funds to the left, decreasing interest rates. b. shifts the demand for loanable funds to the left, increasing interest rates. c. shifts the supply of loanable funds to the left, increasing interest rates. d. shifts the supply of loanable funds to the right, increasing interest rates.

(c) 38. On any given day if the market interest rate is above the equilibrium interest rate level, a. the Fed will declare a monetary policy. b. there will be a shortage of loanable funds and interest rates will increase. c. there will be a surplus of loanable funds at that rate and rates will decline to the equilibrium rate. d. there will be a shortage of loanable funds at that rate and rates will increase to the equilibrium rate.

(d) 39. The lower a consumer's positive time preference for consumption, a. the more savings they will accumulate. b. the lower the level of interest rates. c. the greater the supply of loanable funds. d. all of the above.

(b) 40. A person with a very high positive time preference for consumption a. will have a high savings rate. b. will have a low savings rate. c. prefers savings to consumption. d. is not as likely to borrow money as other people with lower positive time preference.

(c) 41. A change from an income tax to a value added tax on consumption a. should decrease the supply of loanable funds. b. would decrease the demand for loanable funds. c. should increase the supply of loanable funds. d. should shift consumers' preferences toward consumption.

(d) 42. An increase in income tax rates a. will decrease the savings rate. b. will decrease the supply of loanable funds. c. will increase interest rates. d. all of the above.

(b) 43. Economies with very high current and expected inflation rates a. will have a significant long-term debt market. b. will have debt instruments with interest rates indexed to the inflation rate. c. will favor long-term financing over short-term. d. will have very low interest rates.

(a) 44. All but one of the following is associated with economies with very high inflation rates? a. Very few people who wish to borrow at a fixed rate. b. Little if any long-term debt market. c. Variable interest rate loans. d. Reliance on short-term debt contracts.

(c) 45. With the real rate at 3 percent, most loans were made at 10 percent last year. This year interest rates have declined to 8 percent. What was the expected inflation rate last year? a. 5% b. 2% c. 7% d. 8%

(c) 46. Interest rates move ______ with expected inflation; _____ with economic activity. a. directly/inversely b. inversely/inversely c. directly/directly d. inversely/directly

(d) 47. Interest rates represent a. allocational forces b. penalties for early consumption c. rewards for deferring consumption d. all of the above

(c) 48. Which of the following actions will reduce the interest rate risk of the lender? a. Make fixed interest rate loans. b. Make fixed interest rate, long-term loans. c. Make variable interest rate loans. d. Invest in fixed rate Treasury bonds.

(d) 49. An investor loaned money at 14 percent with an expected rate of inflation of 11 percent. During the year the actual rate of inflation was 8 percent. The investor's expected real rate of interest was _____ and the realized real rate for the investor was ______? a. 14 percent; 8 percent. b. 6 percent; 3 percent. c. 3 percent; 3 percent. d. 3 percent; 6 percent.

(b) 50. An investor purchased a $1000 face value bond for $925. The bond has an 8 percent coupon rate, paid annually, and matures in five years. The investor sold the bond one year later for $965, while the price level was increasing at 5 percent. Calculate the pre-tax real realized rate of return on the investment? a. -.7% b. 8% c. 3% d. 5%

ESSAY QUESTIONS

1. Using loanable funds theory, discuss how changes in consumer savings, business investment, and in the money supply by the Federal Reserve System can influence the level of interest rates.

Answer: Loanable funds theory holds that the level of interest rates is determined by the intersection of demand and supply for loanable funds. Increased consumer saving shifts supply to the right, decreasing interest rates. Increased business investment demand is represented by an upward shift in demand for loanable funds and an increase in the level of interest rates. An increase in the money supply shifts the supply curve to the right and lowers interest rates.

2. Explain how price expectations influence the level of interest rates. What impact has inflation premiums had on interest rate levels in recent years?

Answer: The Fisher Effect states that investors embody expected inflation in nominal interest rates. The relatively low inflation rates of recent years has dampened expected inflation and lowered nominal interest rates.

3. Explain why realized real rates of interest are sometimes negative, but expected real rates are always positive. Give an example.

Answer: By definition, no lending would occur if the expected return were not positive. Expected real rates of interest, an opportunity cost of real investment returns, will be positive in a growing economy, but realized real rates of interest may be negative if lenders under-anticipate inflation and charge nominal interest rates below the realized rate of inflation.

4. Calculate the price of a $1000 face value bond, maturing in three years with a 9 percent coupon (paid semiannually) if current real rates of interest are 4 percent, historical inflation rates are 3 percent, and expected inflation rates are 4 percent. (Use if next chapter covered in exam)

Answer: If the Fisher Effect applies the market interest rate on this bond is the sum of the real rate plus the expected inflation rate or 8%. Discounting the $90/2 = $45 coupon payment over 3 x 2 = 6 periods at 8%/2 = 4% and a future maturity value of $1000, the present value price of the bond is $1026.21.

5. Sam has just lent Mary $1000 for 1 year 6%. Sam and Mary expect inflation to be 3% over the next year. If inflation turns out to have been only 2%, what is the impact upon Sam and Mary?

Answer: Sam benefits at Mary’s expense. She paid 6% on a loan that should only have yielded 5% if inflation had been correctly forecast.

CHAPTER 5
TRUE-FALSE QUESTIONS

(T) 1. The coupon rate may be the market rate of interest for a bond.

(T) 2. The price of a bond and the market rate of interest are inversely related.

(F) 3. The price of a bond is the present value of future payments discounted at the coupon rate.

(T) 4. Yield to maturity assumes reinvestment of coupons at the same yield.

(T) 5. The realized yield may be influenced by coupon reinvestment rates.

(F) 6. If market interest rates have increased since a bond was purchased, price risk will increase the price of the bond and reinvestment risk will decrease the return on the coupons.

(T) 7. A zero coupon bond has no reinvestment risk.

(T) 8. The higher the coupon rate, the lower the bond price volatility.

(F) 9. Price risk is a measure of bond volatility.

(F) 10. Short-term bonds have greater price risk compared to long-term bonds.

(T) 11. The price risk of a bond tends to offset reinvestment risk somewhat as market interest rates vary.

(F) 12. In a short-term bond price risk is not a problem, but reinvestment risk is a considerable concern.

(T) 13. Price risk is one aspect of interest rate risk.

(T) 14. Price risk is of no concern to the investor if the bond is held to maturity.

(F) 15. Duration is a measure of interest rate volatility.

(T) 16. The duration of a zero coupon bond equals the term to maturity of the bond.

(T) 17. The duration of a coupon bond must be shorter than its term to maturity.

(F) 18. If the coupon rate equals the market rate, a bond is likely to be selling at a discount.

(F) 19. The coupon rate varies inversely with bond prices.

(F) 20. Bonds with lower coupon rates have a shorter duration than similar bonds with high coupon rates.

(F) 21. Money has time value because of inflation.

(F) 22. Duration matching eliminates risk.

(F) 23. A zero-coupon bond bears no interest.

(T) 24. Expected yield is essentially a forecast.
MULTIPLE CHOICE QUESTIONS

(b) 1. Which of the following statements is true? a. Bond prices and interest rates move together. b. Coupon rates are fixed at the time of issue. c. Short-term securities have large price swings relative to long-term securities. d. The higher the coupon, the lower the price of a bond.

(a) 2. Which of the following statements is true about bonds? a. The higher the coupon rate, the shorter the duration. b. The yield on a bond is usually fixed. c. A bond's coupon rate is equal to its face value. d. Most bonds pay interest annually.

(c) 3. $5,000 invested at 6%, compounded quarterly, will be worth how much after 5 years? a. $6,691 b. $16,036 c. $6,734 d. $5,386

(a) 4. Tom deposits $10,000 in a savings deposit paying 4%, compounded monthly. What amount would he have at the end of seven years? a. $13,225 b. $13,159 c. $13,179 d. $13,325

(c) 5. Judy would like to accumulate $70,000 by the time her son starts college in ten years. What amount would she need to deposit now in a deposit account earning 6%, compounded yearly, to accumulate her savings goal? a. $4,200 b. $39,513 c. $39,088 d. $125,359

(c) 6. If a $1000 par value bond has an 8% coupon (annual payments) rate, a 4-year maturity, and similar bonds are yielding 11%, what is the price of the bond? a. $1,000.00 b. $880.22 c. $906.93 d. $910.35

(a) 7. A corporate bond, paying $65 interest at the end of each year for 6 years, has a face value of $1,000. If market rates on newly issued similarly rated corporate bonds are now 7.5%, what is the current market price of this bond? a. $953.06 b. $1,000.00 c. $1,048.41 d. $936.42

(c) 8. A $1000 bond with an 8.2% coupon rate, interest paid semiannually, and maturing in six years is currently yielding 7.6% in the market. What is the current price of the bond? a. $1,027.08 b. $1,131.19 c. $1,028.48 d. $972.00

(b) 9. A $1000 bond with a coupon rate of 7% matures in eight years. The bond is now selling for $950, what is the expected yield to maturity on the bond? a. 6.5% b. 7.9% c. 9.0% d. 8.3%

(c) 10. A $1000 bond with a coupon rate of 10%, interest paid semiannually, matures in eight years and sells for $1120. What is the yield to maturity? a. 10.8% b. 11.0% c. 7.9% d. 7.6%

(c) 11. When a bond's coupon rate is equal to the market rate of interest, the bond will sell for a. a discount. b. a premium. c. par. d. a variable rate.

(b) 12. A bond currently selling at a premium price above face value a. has a yield equal to its coupon rate. b. has a yield below its coupon rate. c. has a yield above its coupon rate. d. has no risk.

(c) 13. If market interest rates fall after a bond is issued, the a. face value of the bond increases. b. investor will sell the bond. c. market value of the bond is increasing. d. market value of the bond is decreasing.

(d) 14. Duration is a measure of a. a bond's price. b. a bond's contractual maturity. c. the length of time it takes to get back the original investment. d. bond price volatility.

(a) 15. Bond A has a duration of 5.6 while bond B has a duration of 6.0. Bond B a. will have greater price variability, given a change in interest rates, relative to bond A. b. will have a longer maturity than bond A. c. will have a higher coupon rate than bond A. d. will have less price variability, given a change in interest rates, relative to bond A.

(a) 16. A 3-year zero coupon bond selling at $900 and yielding 12.18 percent has a duration of a. 3 years. b. 2.78 years. c. 2.50 years. d. 2 years.

(a) 17. A $1000 2-year 10% coupon bond is priced at $1000 in the market. The duration is a. less than two years. b. more than two years. c. 10%. d. 2 years.

(b) 18. The duration of a $1000, 2-year, 7% coupon bond (interest paid annually) is _____ when market rates are 8%? a. 2.036 b. 1.934 c. 1.902 d. 1.856

(c) 19. As bond maturity _________, so does the _________ and ________. a. decreases; coupon rate; market price. b. decreases; duration; face value. c. increases; duration; price variability. d. increases; risk; coupon rate.

(a) 20. In a fixed-rate bond, the variable which changes to determine market rate of return is a. price. b. coupon rate. c. coupon amount. d. face value.

(d) 21. A $1,000 par, 8% Treasury bond maturing in three years is priced to yield 7%. Its market price (assuming semiannual compounding) is a. $974.21 b. $813.50 c. $927.50 d. $1,026.64

(b) 22. Which of the following risks will not affect zero coupon bonds? a. price risk b. reinvestment risk c. credit risk d. default risk

(c) 23. A bond yield measure should capture all of the following except a. coupon payments. b. reinvestment income. c. changing coupon rate levels. d. capital gains or losses.

(a) 24. The yield to maturity measure assumes that coupon interest is reinvested at a. the yield to maturity. b. the changing market rates. c. the coupon rate. d. the treasury bond rate.

(d) 25. Calculate the realized return on a $1,000 face value, 9 percent coupon bond (annual) purchased for $800 and sold one year later for $850. a. 9% b. 11.25% c. 14.5% d. 17.5%

(b) 26. If a 7% coupon (semiannual) bond purchased at par sells 2 years later for $990, what is the realized rate of return (annualized)? a. 8% b. 6.52% c. 7.32% d. 5.75%

(c) 27. Calculate the volatility of $1,000 face value 8% coupon bond whose price has varied from $1,020 to $1,050. a. $30.00 b. 5% c. 3% d. $50.00

(d) 28. Which of the following statements is true? a. Bonds vary directly with interest rates. b. Bond volatility varies inversely with maturity. c. Low coupon bonds have lower bond volatility than high coupon bonds. d. Bond duration increases with maturity.

(c) 29. Interest rate risk is a. duration. b. the extent that coupon rates vary with time. c. the potential variability in the realized rate of return caused by changes in market rates. d. the potential variability in the bond maturity caused by changing discount rates.

(a) 30. Price risk and reinvestment risk a. offset one another to a certain extent as interest rates change. b. are two bond risks related to credit risk. c. work together to magnify the price impact of a change in interest rate. d. both have an effect on bond price.

(b) 31. Jane needs a specific sum of money in five years. She should invest in a. high quality, 20 year Treasury bonds. b. high quality coupon bonds with a duration of five years. c. high quality coupon bonds maturing in five years. d. high credit risk bonds maturing before five years.

(c) 32. Which of the following statements about duration is true? a. Duration is the length of time necessary to pay back the investor's original investment. b. The duration of a bond is some time longer than the maturity of the bond. c. Duration is the investment period necessary to offset price risk and reinvestment risk. d. A bond sold at the duration point will always be priced at $1,000.

(b) 33. What is the price of a $1,000 face value bond with a 10% coupon if the market rate is 10%? a. more than $1,000 b. $1,000 c. less than $1,000 d. cannot ascertain

(c) 34. What is the price of the bond in the above question, if the market rate rises to 12% and the bond matures in 5 years? (Assume semiannual compounding). a. $829.60 b. $1,000.00 c. $926.40 d. $1,040.80

(b) 35. Tom purchased a bond last year for $1240, received $60 in interest return, and sold the bond for $1300 one year later. What is Tom's realized annual rate of return? a. 4.8% b. 9.7% c. 9.2% d. More than 10%.

(c) 36. The bond yield to maturity calculation is a. the guaranteed rate of return to an investor. b. the same as the coupon rate. c. the expected rate of return on the bond. d. the realized rate of return on the bond.

(c) 37. An investor worried about interest rate risk should a. not purchase coupon bonds. b. select bonds whose maturity matches the investor's investment holding period. c. select bonds whose duration matches the investor's investment holding period. d. invest only in U.S. Treasury bonds.

(d) 38. An investor who selects coupon bond maturities matching his/her holding period a. has eliminated price risk, but not reinvestment risk. b. has eliminated just one part of interest rate risk. c. cannot precisely predict the rate of return on the bond. d. All of the above.

(c) 39. Reinvestment risk is the variability of return associated with a. the variability of bond maturities. b. the variability of bond coupon payments. c. the variability of rates of return on reinvested coupons. d. the variability of the market price on the bond.

(a) 40. There is generally a _______ relationship between term to maturity and duration. a. positive b. favorable c. inverse d. large

(a) 41. Bonds with _______ coupon rates have a ________ duration than bonds with ________ coupons of the same maturity. a. higher; shorter; smaller b. lower; longer; smaller c. higher; longer; larger d. higher; shorter; larger

(c) 42. The _______ the interest rate and the ________ the number of compounding periods in a year, the _________ the rate of return on a present sum. a. lower, greater, lower b. higher, fewer, higher c. higher, greater, higher d. lower, lower, higher

(d) 43. If a bond investor receives all the coupon payments on time and the face value on the contract maturity date, investor's return could still vary because of a. default risk b. price risk c. liquidity risk d. reinvestment risk.

(d) 44. Two factors that affect interest rate risk are a. default risk and reinvestment risk. b. liquidity risk and reinvestment risk. c. price risk and political risk. d. price risk and reinvestment risk.

(c) 45. The sum of time weighted discounted cash flows divided by the price of the security is the a. volatility of the security. d. present value of the security cash flows. c. duration of the security. d. always greater than the maturity of the security.

(c) 46. An increase in the supply of bonds in the bond market will a. be associated with a decrease in interest rates. b. always be matched by an increased demand for securities. c. be associated with an increase in bond interest rates. d. not affect interest rates, only security prices.

(b) 47. An increase in the demand for securities a. will be associated with an increase in interest rates. b. will be associated with a decrease in interest rates. c. will have no affect on interest rates. d. will be matched with an increase in the supply of securities.

(d) 48. In a fixed rate bond, the variable which changes to provide the current market rate of return to investors is a. face value b. coupon rate c. maturity d. price

(b) 49. All of the following are contractually fixed except a. par value b. yield c. maturity d. coupon

(a) 50. The duration of any financial instrument a. cannot exceed the instrument’s term to maturity b. is a proxy for the instrument’s default risk c. must exceed the instrument’s term to maturity d. must be calculated before yield to maturity can be accurately determined

ESSAY QUESTIONS

1. Name and discuss the variables that determine the price or value of a fixed-rate coupon bond.

Answer: The market value of a bond is the present value sum of future coupon payments over the life of the bond plus the maturity par value of the bond discounted at the market rate of return (the sum of the real rate + expected inflation + risks associated with the issuer and the bond).

2. Name and discuss the factors that must be considered when calculating the realized rate of return on a bond.

Answer: The risks associated with a bond, default and interest rate risk, may cause the realized return to vary from the expected. Increased default risk increases market discount rates, causing the bond value to fall if sold before maturity(price risk). As market rates vary over time, reinvestment risk may cause the realized return to vary from the expected.

3. What are the relationships between bond price volatility and (a) bond maturity; (b) coupon rate?

Answer: As the maturity of a bond increases, the price risk and price volatility increases. As the coupon rate decreases, the present value is impacted more by the maturity value, so price risk increases.

4. Define and discuss interest rate risk. What are the two risk components of interest rate risk and how do these interact with each other?

Answer: Interest rate risk is the impact of varying market interest rates on the realized rate of return on a bond. The price risk component causes the market price of the bond to vary inversely with changing interest rates and increasingly with longer maturity. Reinvestment risk is the change in the realized return from the expected caused by varying reinvestment yields on the coupon reinvested. Price risk and reinvestment risk offset one another at the duration point.
5. What is bond duration and what are the implications of holding a bond to its duration versus holding the bond to maturity?

Answer: Bond duration is a time-weighted maturity and is the sum of the PV of the time-weighted cash flows divided by the market price. Holding a bond for its duration period yields the expected yield to maturity. The offsetting risks of price risk and reinvestment risk, depending on market rate changes, are neutralized at the duration point. An investor holding to maturity eliminates price risk but still absorbs reinvestment risk.
CHAPTER 6
TRUE/FALSE QUESTIONS

(T) 1. If interest rates are expected to increase in the future, one would expect to see an upward sloping yield curve

(F) 2. The major reason that municipal bonds have lower yields than corporate bonds is that, as a class, municipal debt has less marketability than corporate debt.

(F) 3. A downward sloping yield curve forecasts higher future interest rates.

(F) 4. A downward sloping yield curve is typically seen just before an economic expansion.

(T) 5. The less marketable a security, the higher its yield.

(T) 5. Default risk premiums are usually smaller during periods of high economic growth.

(F) 6. Bonds rated Baa would have higher yields than Aaa bonds, and higher prices, everything else the same.

(T) 7. Callable bonds have higher market yields than noncallable bonds.

(F) 8. The call price of a bond is usually below the bond's par value.

(T) 9. Expected higher rates of inflation will lead to an upward sloping yield curve.

(F) 10. The higher the marginal tax rate of an investor, the lower the after-tax return on any security.

(F) 11. Liquidity premiums cause an observed yield curve to be less upward sloping than that predicted by the expectations theory

(T) 12. A delay in the coupon payment on a bond would imply an increase in default risk.

(T) 13. An investor in the 33 percent tax bracket will buy a 6 percent municipal bond rather than a similarly rated 8.5 percent corporate bond.

(F) 14. A put option sets a "floor" or minimum price of a bond at the exercise price, which is generally at or above par value.

(F) 15. A convertible bond will generally have a higher market yield relative to similar, nonconvertible bonds.

(F) 16. Treasury and corporate security yields may be combined when plotting a yield curve.

(F) 17. Putable bonds offer higher yields than similar non-putable bonds

(F) 18. A descending yield curve forecasts higher short-term rates in the future.
(T) 19. The market segmentation theory allows for the possibility of a discontinuous yield curve.

(T) 20. According to the preferred habitat theory, investors may change their preferred maturity in response to expected yield premiums.

MULTIPLE CHOICE QUESTIONS

(b) 1. Which of the following statements about bonds is not true? a. The greater the default risk, the greater the yield. b. Bonds selling at premium are especially high quality. c. The less marketable a bond, the higher the yield. d. Municipal bonds have lower yields than similar corporate bonds.

(b) 2. Which of the following statements is true? a. Interest rates move inversely with economic activity. b. Default risk premiums vary inversely with economic activity. c. Municipal bond yields are usually higher than similar risk corporate yields. d. Treasury bond yields are always higher than Treasury bill yields.

(a) 3. A bond investor is more likely to exercise a put option in a bond contract if a. interest rates increase. b. interest rates decrease. c. the default risk of a bond decreases. d. tax-free municipals are now available.

(a) 4. The term structure of interest rates a. describes the relationship between maturity and yield for similar securities. b. ranks security yield according to the default risk structure. c. describes how interest rates vary over time. d. describes the pattern of interest rates over the business cycle.

(c) 5. The yield curve is a plot of a. maturity changes as risk changes. b. yields by varied risk-taking of varied bond issuers. c. yields by maturity of securities with similar default risk. d. interest rates over time past.

(d) 6. The source of data for a yield curve might be a. bond yield by issuers over time. b. historical Treasury security yields. c. realized Treasury security yields by time. d. outstanding Treasury security yields by maturity.

(c) 7. An upward sloping yield curve indicates that security investors expect future interest rates to _____ and security prices to ______. a. fall; fall. b. fall; rise. c. rise; fall. d. rise; rise.

(a) 8. A downward sloping yield curve indicates that future short-term rates are expected to ______ and outstanding security prices will _______. a. fall; rise. b. fall; fall. c. rise; rise. d. rise; fall.

(b) 9. According to the expectation theory of the term structure of interest rates a. investors prefer holding short-term securities. b. the shape of the yield curve is determined by investors' expectations of future short-term interest rates. c. institutional investors' maturity preferences determine the shape of the yield curve. d. both a and b are true.

(c) 10. Calculate the one-year forward rate three years from now if three- and four-year rates are 5.50% and 5.80%, respectively? a. The rate cannot be calculated from the information above. b. 6.2% c. 6.7% d. 5.6%

(b) 11. If three-year securities are yielding 6% and two-year securities are yielding 5.5%, future short-term rates are expected to ______, and outstanding security prices are expected to ______. a. fall; fall. b. rise; fall. c. fall; rise. d. rise; rise

(c) 12. With reference to the question above, what is the expected one-year rate two years from now as implied by the two actual rates above? a. 6.4% b 4.7% c. 7.0% d. 5.8%

(d) 13. The major determinants of the bond ratings assigned by Moody's or Standard and Poor is a. marketability. b. tax treatment. c. term to maturity. d. default risk.
(a) 14. Default risk premiums vary _______ with the ________ of the security? a. directly; default risk b. inversely; default risk c. similar; price d. forward; size

The following interest rates prevail in the market and are used to answer the next three questions.

90-day Treasury bills 8.36 percent 180-day Treasury bills 8.48 percent 3-year Treasury securities 9.25 percent 2-year Treasury securities 9.10 percent 90-day Commercial paper 9.15 percent 3-year Corporate bonds (AA) 10.1 percent 3-year Municipal (AA) 7.10 percent Expected 2-year inflation rate 3.50 percent

(d) 15. With reference to the data above, which security below did the market view as having the greatest default risk? a. 90-day Treasury securities b. 180-day Treasury securities c. 10-year Treasury securities d. 90-day Commercial paper

(c) 16. With reference to the data above what is the expected real rate of return on the 2-year Treasury security? a. 12.6% b. 3.5% c. 5.6% d. 4.2%

(c) 17. With reference to the data above, what is the default risk premium on commercial paper? a. 9.15% b. 0.95% c. 0.79% d. 0.55%

(b) 18. With reference to the data above, calculate the one-year forward rate on Treasury securities two years from now? a. 8.86% b. 9.55% c. 9.10% d. 9.18%

(d) 19. At what tax rate would an investor be indifferent between holding the 3-year municipal or 3-year corporate bond? a. 33% b. 18% c. 3% d. 30%

(b) 20. With reference to the data above, calculate the default risk premium on the 3-year corporate bond. a. 0.95% b. 0.85% c. 10.10% d. There is no default risk on the bond.

(d) 21. With reference to the data above, the yield curve slopes _______, indicating the market expectation of ______ future short-term rates. a. downward; falling b. downward; rising c. upward; falling d. upward; rising

(d) 22. Which of the following statements about interest rates is true? a. Interest rates generally tend to move together. b. The expected rate of inflation influences the level of interest rates. c. At the bottom of the business cycle, the yield curve is typically upward sloping. d. all the above are true

(d) 23. Which of the following statements is true? a. The more marketable a security, the higher its yield. b. The longer the term to maturity, the greater its yield. c. Putable bonds offer higher yields than similar non-putable bonds d. Taxable bonds have to offer higher before tax yields than comparable tax-exempt bonds.

(c) 24. Which of the following statements about callable bonds is not true? a. Callable bonds have higher yields than comparable noncallable bonds. b. The call price is usually above the bond's par value. c. The shorter the term to maturity, the greater the call interest premium. d. Investors are notified when bonds are called.

(c) 25. Bond A is not callable; bond B is callable. Investors will want a higher yield on bond __ and will pay ____ for the bond. a. A; less b. A; more c. B; less d. B; more

(d) 26. Federal Agency securities have higher yields than similar Treasury securities because they a. have greater default risk. b. have greater tax liability. c. are less marketable. d. both a and c

(b) 27. Current interest rates are 7 percent. If inflationary expectations increased from the current 5 percent to 3 percent, what would be the new market interest rates? a. 9 percent b. 5 percent c. 10 percent d. 4 percent

Answer the following questions with reference to the following data.

Treasury Bills, 90 days 4.20% Commercial Paper, 90 days 4.84% Treasury Bill, 1 year 4.67% Treasury Note, 2 year 5.25% Corporate Bond AA, 20 year 8.23% Municipal Bond AA, 20 year 6.42% Expected Annual Inflation Rate 3.00%

(d) 28. With reference to the data above, the default risk premium on the 90-day commercial paper above is a. 4.03%. b. 3.39%. c. 0.17%. d. 0.64%.

(b) 29. With reference to the above data, what is the expected default loss rate on the 90-day commercial paper? a. 403 basis points b. 64 basis points c. 17 basis points d. zero basis points

(b) 30. With reference to the data above, the implied one-year forward rate (expected one-year rate one year from now) on Treasuries is a. 4.67%. b. 5.83%. c. 0.58%. d. 4.09%.

(a) 31. With reference to the above data, at what marginal tax rate would an investor be indifferent between owning the corporate bond and the municipal bond? a. 22% b. 28% c. 18% d. 20%

(b) 32. With reference to the above data, what is the approximate expected pre-tax real rate of return on the one-year Treasury bill? a. 3.00 b. 1.67% c. 4.67% d. 0.13%

(c) 33. With reference to the data above, what is the expected after-tax real rate of return on the one-year Treasury Bill for an investor in the 33 percent marginal tax bracket? a. 1.11% b. 3.13% c. 0.13% d. -1.11%

(e) 34. Yield differences between two securities may be explained by differences in a. maturity. b. default risk. c. marketability. d. call provision. e. all of the above

(c) 35. Yield difference in Treasury securities of varied maturities may be explained by a. marketability. b. default risk. c. expectations of future inflation. d. all of the above

(c) 36. Applying the expectations theory, a bank depositor has the option of purchasing a one-year CD at 5 percent and a 5.5 percent two-year CD. If indifferent between the two, the depositor must expect one-year CDs one year from now to have a rate of a. 6.5 percent. b. 4.5 percent. c. 6 percent. d. 5 percent.

(c) 37 The liquidity premium theory of the term structure of interest rates is best supported by what type of yield curve? a. a decreasing curve over time. b. a flat yield curve. c. an increasing yield curve over time. d. none of the above.

(a) 38. What actions by bond investors, given their expectations of increasing interest rates, results in an upward sloping yield curve? a. selling long-term securities and buying short-term securities. b. buying long-term securities and selling short-term securities. c. selling short-term securities and holding cash. d. selling long-term securities and holding cash.

(c) 39. A bondholder in the 30 percent tax bracket owns a $1000 Treasury bond with an 8 percent coupon rate. Calculate the after-tax return on the bond. a. 8 percent b. 2.4 percent c. 5.6 percent d. 30 percent

(c) 40. The yield differentials between an AAA corporate bond and a BAA corporate bond of the same maturity may be explained by a. marketability. b. tax treatment. c. default risk. d. term to maturity.

(b) 41. Which of the following bonds probably has the highest call interest premium? a. a low coupon, short-term corporate note in an increasing rate market b. a high coupon rate bond in a falling interest rate market c. a high coupon rate bond in a rising interest rate market d. a low coupon rate bond in an increasing interest rate market

(c) 42. Which of the following statements explains the liquidity premium theory of the term structure of interest rates? a. Investors will pay higher prices for longer-term securities. b. Investors demand a higher yield for securities that cannot be sold quickly at high prices. c. Investors demand a higher return on longer-term securities with greater price risk and less marketability. d. Investors will pay higher prices for securities with greater price risk and less marketability.

(a) 43. Which of the following theories of the term structure of interest rates best explains discontinuities in the yield curve? a. the market segmentation theory b. the liquidity premium theory c. the expectations theory d. the loanable funds theory

(c) 44. Commercial banks, savings and loan associations, and finance companies traditionally have better profits when a. the level of interest rates were expected to fall sharply. b. the yield curve had a descending slope. c. the yield curve had an ascending slope. d. loan losses were increasing.

(a) 45. Historically, high default premiums have been associated with a. economic recessions. b. economic boom periods. c. generally rising interest rates. d. the number of bonds rated by Moody's and Standard & Poor's.

(b) 46. Bonds are called speculative grade or junk bond if their Moody's and Standard & Poor's rating is a. above Baa (BBB). b. Baa (BBB) and below. c. B1 (B+) and below. d. A1 (A+) and below

(c) 47. All but one of the following are considered when assigning a bond rating? a. the variability of earnings b. the expected cash flow c. the rating on the prior issue of securities sold d. the amount of the fixed contractual cash payments

(a) 48. An investor is more likely to exercise a put option on a bond when a. interest rates are expected to increase. b. interest rates are expected to decrease. c. the security's price is expected to increase. d. the security's rating is upgraded by Moody's.

(b) 49. A convertible bond is most likely to be converted when a. stock price levels are declining. b. stock price levels are increasing. c. the interest levels are decreasing. d. the company's rating have been downgraded by Standard & Poor's.

(c) 50. Which of the following is true? a. Convertible bonds offer higher yields than similar nonconvertible bonds. b. Putable bonds offer higher yields than similar nonputable bonds. c. Bonds with call options must offer higher interest rates than similar noncallable bonds. d. All Treasury securities offer lower rates than any securities issued by business firms.

(c) 51. Contingent Convertible bonds (CoCos) are not similar to ordinary convertible bonds because: a. CoCos are convertible to the firm’s preferred stock while the ordinary convertible bonds are convertible to the firm’s common stock. b. CoCos offer a higher coupon than ordinary convertible bonds. c. Cocos are convertible into stock only if the firm’s stock price hits a certain level. d. Ordinary convertible bonds are converted to the firm’s stock if the firm’s stock falls below a certain level.

(a) 52. Suppose we consider a yield curve that has taken into consideration both the expectations theory and the liquidity premium theory. Assume the yield curve is initially downward sloping. If liquidity premium theory is no longer important, the yield curve you would expect to see would be: a. more steeply downward sloping b. more upward sloping c. less steeply downward sloping d. none of the above.

(b) 53. According to expectations theory, an investor who believes that interest rates are likely to decrease in the near future would

a. would invest in short-term securities immediately. b. would invest in long-term securities immediately. c. would sell long-term securities from her portfolio. d. would sell short-term securities from her portfolio.

(b) 54. According to expectations theory, if the market believes that interest rates are likely to decrease in the near future, it would lead to:

a. An increase in the demand for short-term securities. b. An increase in the demand for long-term securities. c. A decrease in the supply of short-term securities. d. An increase in the supply of long-term securities.

(c) 55. According to expectations theory, if the market believes that interest rates are expected to increase in the near future,

a. borrowers would immediately increase their supply of short-term securities. b. investors would immediately increase their demand for long-term securities. c. borrowers would immediately increase their supply of long-term securities. d. neither borrowers nor investors would do anything until the interest rates actually increased.

ESSAY QUESTIONS

1. List and discuss five basic factors which explain the differences in interest rates on different securities at any point in time.

Answer: Five basic factors, which may explain yield differences include term to maturity, default risk, tax treatment of income of security, marketability, call, put, or convertible options associated with the security.

2. Explain how the term structure of interest rates can be used to help forecast future economic activities.

Answer: The greater weight give to the expectations theory, that long-term yield represent the geometric average of current and expected short-term rates, for explaining the shape of the yield curve, the greater the interest rate forecasting ability of the yield curve. An upward sloping yield curve predicts higher short-term rates in the future.

3. Explain why municipal bonds have lower yields than comparable corporate taxable bonds.

Answer: An investor is concerned with the after-tax yield earned, so will bid up the prices (lower yields). The message: lower taxes; lower interest rates.

4. Define the term default risk premium. Why does the "premium" represent the "expected default loss rate"? Explain how and why default risk premiums vary over the business cycle.

Answer: The default risk premium, the difference between a risky security and a U.S. Treasury security of similar term, is the investors’ expected default loss rate on a portfolio of similarly rated securities. If the investor in a portfolio of similarly rated securities lost the default risk premium every year, the realized yield would equal an investment in a similar term U.S. Treasury security. Default risk premium vary directly with the business cycle, narrowing with growth and expansion of the economy; widening during recession and business restructuring.

5. How do bond options such as a call, put, and convertibility influence the yields on securities relative to bonds without such options?

Answer: Options in bond contracts are valuable for the holder of the option. A call option, the option to redeem the bond issue early, is a valuable option to the bond issuer. Because of call risk, investor will price the callable bond lower or price to yield a higher yield.

CHAPTER 7
TRUE-FALSE QUESTIONS

(T) 1. Many diverse institutions borrow in the money markets, while relatively few invest.

(T) 2. All money market instruments are short-term debt.

(F) 3. Treasury bills are sold on a discount basis, with interest paid separately at maturity.

(T) 4. Commercial banks act as dealers and are major investors in Treasury securities.

(F) 5. For large corporations, commercial paper is more expensive but is a more assured alternative to bank borrowing.

(T) 6. Commercial paper is more likely to be placed directly by large finance companies.

(F) 7. The Federal Funds market is not available for the smaller, regional bank.

(T) 8. Bankers' acceptances are used primarily for financing international trade.

(F) 9. Eurodollars are dollar denominated, foreign-owned deposits in U.S. banks.

(T) 10. The 24-hours-a-day market for U. S. Treasury securities is an example of the globalization of financial markets.

(F) 11. Consumers most often have only indirect access to the money market through commercial banks.

(T) 12. The money market is a dealer market, not an exchange, and has no specific location.

(T) 13. Money market borrowers are small in number compared to money market lenders.

(T) 14. The money market is a market where liquidity is bought and sold.

(T) 15. Commercial banks are the major issuer and investor of money market securities.

(T) 16. Federal Reserve open market operations, reserve requirement changes, and discount rate policy first impact the economy in the money market.

(F) 17. Dealers bring buyer and seller together; brokers make a market.

(F) 18. Much of the added yield provided investors in "agency" issues is attributed to their higher default risk.

(T) 19. Commercial banks are important indirect guarantors of commercial paper.

(F) 20. Interest arbitrage keeps the interest rates of the many money market securities equal.

(F) 21. Lower marginal tax rates increase the demand for tax-exempt securities.

(T) 22. The money market provides liquidity for deficit units; the capital market finances economic growth.

(F) 23. Competitive bids in T-bill auctions require the bidder to specify only the quantity desired.

(T) 24. Non-competitive bidders in the U. S. Treasury security auctions pay the weighted average price of all accepted competitive bids.

(F) 25. Reverse repos are contracts that require a firm to first sell securities with the agreement to buy them back in a short period at a higher price.

MULTIPLE-CHOICE QUESTIONS

(b) 1. Which of the following is not a characteristic of money market instruments? a. short-term to maturity b. small denomination c. low default risk d. high marketability

(d) 2. Small investors are likely to invest in the money market through . a. directly; commercial paper b. locally; their credit union c. indirectly; negotiable CDs d. indirectly; money market mutual funds

(a) 3. Which of the following statements about the money market is true? a. The money market is a dealer market linked by efficient communications systems. b. Money market transactions are seldom over $1 million. c. Market transactions include more "primary market" trades for a security than secondary market trades. d. Most money market transactions are conducted by mail.

(d) 4. Which statement is not true about Treasury bills? a. They have maturities less than one year. b. Most are sold by "book-entry" method. c. They are sold at a discount. d. They are tax free.

(a) 5. Which of the following may be a liability of a non-financial business corporation? a. commercial paper b. Federal Funds c. Treasury securities d. agency securities

(d) 6. Federal Funds are typically a. Treasury deposits. b. Federal Reserve assets. c. commercial bank deposits at the Federal Reserve. d. overnight loans settled in immediately available funds.

(c) 7. The most important money market instrument utilized in the Fed's open market operation is a. Federal Funds. b. commercial paper. c. Treasury bills. d. Agency securities.

(d) 8. Banks can satisfy their short-term borrowing needs by a. Federal Funds purchased. b. Federal Funds sold. c. issuing negotiable CDs. d. both a and c

(c) 9. Which of the following statements is not true about repurchase agreements? a. These are a form of secured borrowing by a bank. b. They are settled in federal funds. c. These are seldom used by the Federal Reserve for making temporary reserve positions adjustments. d. Treasury securities are often used in this type of transaction.

(b) 10. Which of the following money market instruments would typically be used in international transactions? a. a Treasury bill b. a banker's acceptance c. commercial paper d. a negotiable CD

(d) 11. The money market is an important financial market because a. the money market is the world's liquidity market. b. it is the market in which the Fed conducts monetary policy. c. the federal government finances most of its credit needs in the money market. d. all of the above

(a) 12. Which of the following money market securities is usually not found on a commercial bank's balance sheet? a. Ba rated corporate bonds b. Treasury bills c. certificates of deposit d. banker's acceptance

(d) 13. The money market security represented by the largest dollar amount outstanding is a. commercial paper. b. federal agency issues. c. negotiable CDs. d. Treasury bills.

(c) 14. Which of the following bank money market securities is backed by specified collateral? a. negotiable CDs b. banker's acceptances c. repurchase agreements d. commercial paper

(d) 15. Money market securities have very little a. default risk. b. price risk. c. marketability risk. d. all of the above.

(d) 16. An important economic function of the U.S. government security dealer is to a. underwrite Treasury securities. b. "make a market" for Treasury securities. c. support open market operations of the Federal Reserve. d. all of the above

(d) 17. Large industrial U.S. corporations are involved in the money market by a. investing excess cash balances. b. buying and selling goods on credit in international trade. c. issuing commercial paper. d. all of the above

(d) 18. Banks invest in government securities for a variety of reasons except a. income. b. safety. c. acceptable for collateral. d. high relative yield.

(a) 19. Even a small bank can even finance in the money market by a. investing in negotiable CDs. b. selling federal funds. c. purchasing federal funds. d. buying banker's acceptances.

(a) 20. Which of the following money market rates is studied closely for indicators of changes in Federal Reserve monetary policy? a. Federal Funds b. Treasury bills c. commercial paper d. banker's acceptances
(b) 21. When firms issuing commercial paper use a backup line of credit, it: a. increases the credit risk for investors b. decreases the credit risk for investors c. has no impact on investors d. decreases the marketability of commercial paper

(b) 22. The bank discount rate on a $100,000 face value T-bill priced at $97,500, maturing in 181 days is: a. 4.84% b. 4.97% c. 5.10% d. 5.17%

(b) 23. The bank discount rate (ask) on a 91-day T-bill is 5.35%. What is the price of the $1000 T-bill? a. $976.40 b. $986.48 c. $981.20 d. $989.45

(c) 24. The bank discount rate (ask) on a 71-day T-bill is 4.86%. What is the bond equivalent yield on the T-bill? a. 4.86% b. 4.92% c. 4.98% d. 5.14%

(b) 25. Calculate the holding period return on a 52-day T-bill selling for 98.555% of its face value. a. 10.85% b. 10.75% c. 10.54% d. 10.29%

(c) 26. The following yield calculation on a Treasury bill provides the best comparison yield for competing coupon bearing securities of the same maturity? a. bank discount rate b. CD equivalent rate c. bond equivalent rate d. the true rate.

(a) 27. The T-bill rate quoted by the Federal Reserve banks is the a. bank discount rate. b. the true rate. c. effective annual rate. d. bond equivalent rate.

(c) 28. The Wall Street Journal publishes T-bill price (bid/ask) based on the ___________ rate; with the __________ rate provided as the quoted (ask) yield on the T-bill? a. bond equivalent; bank discount b. effective annual; bank discount c. bank discount; bond equivalent d. bank equivalent; bank discount

(c) 29. Which of the following will give the higher yield given the price and maturity of a T-bill? a. the true rate b. bond equivalent rate c. bank discount rate d. none of the above.

(b) 30. Purchasing T-bill via a computerized account without actually receiving the securities is achieved through a. a Direct Purchase Account. b. a Treasury Direct Account. c. a Fed Purchase Account. d. a Clinton Benefit Account.

(a) 31. Federal Agency securities have higher yields than equivalent Treasury securities because a. there are less marketable than Treasury securities. b. they have higher exchange rate risk than Treasuries. c. they are more affected by interest rate risk. d. they are associated with mortgages that are riskier securities.

(c) 32. Yields on three-month T-bills are more similar to a. Two-year Treasury notes rates. b. Ninety-day commercial paper rates. c. federal funds rates. d. Aaa-rated corporate bond rates.

(b) 33. A repurchase agreement is like a secured loan because a. it involves two parties. b. it involves collateral, in this case the sale of a security under agreement to repurchase. c. it is backed by a mortgage on real property. d. it is like the secured lending in that a mortgage is effected by the lender.

(d) 34. A bank agrees to buy T-bills from a securities dealer for $997,250, and promises to sell the securities back to the dealer in 4 days for $997,575. The yield on this reverse repo for the bank is: a. 2.97% b. 2.91% c. 2.86% d. 2.93%

(a) 35. A firm buys $1,000,000 of a 30-day commercial paper issue $995,450. The yield on this commercial paper is: a. 5.56% b. 5.46% c. 5.49% d. 5.54%

(b) 36. A reverse repurchase agreement calls for a. a firm to first sell securities with the agreement to buy them back in a short period at a higher price. b. a firm to first buy securities with the agreement to sell them back in a short period at a higher price. c. a firm to first sell securities with the agreement to buy them back in a short period at a lower price. d. a firm to first buy securities with the agreement to sell them back in a short period at a lower price.

(a) 37. A repurchase agreement calls for a. a firm to first sell securities with the agreement to buy them back in a short period at a higher price. b. a firm to first buy securities with the agreement to sell them back in a short period at a higher price. c. a firm to first sell securities with the agreement to buy them back in a short period at a lower price. d. a firm to first buy securities with the agreement to sell them back in a short period at a lower price.

(d) 38. A competitive bid in the Treasury securities auction market has all of the following characteristics except: a. the bidder specifying the quantity of bills desired b. the price the investor wishes to pay c. large, institutional investors d. bids for a maximum of $1,000,000.

(d) 39. A non-competitive bid in the Treasury securities auction market is characterized by: a. the bidder specifying the quantity of bills desired b. bids less than $1,000,000 c. the bidders paying a price equal to the weighted average price of all competitive bids accepted. d. all of the above.

(d) 40. The fed funds rate is very important to the economy because: a. it measures the return on the most liquid of all the financial assets traded b. it is closely related to the conduct of monetary policy c. it measures directly the availability of excess reserves in the banking system d. all of the above
ESSAY QUESTIONS

1. What are the fundamental characteristics of money market debt instruments? Explain why these characteristics are important to money market participants who are investing and financing.

Answer: Money market securities are attractive to investors for three reasons. They are high quality (low default risk), marketable, and short-term. They protect the investor’s principal and offer liquidity via a ready market or maturity in the near future. Lastly they provide income. For the borrower, the money market is a constant source of relatively cheap funds, available with very low financing costs.

2. Explain the economic function of money markets.

Answer: The money market is a “liquidity” market. Liquidity of many of the world’s investors is stored there; liquidity for high quality borrowers is provided there.

3. Explain why most short- and long-term interest rates tend to move together over time.

Answer: To the extent that securities with various terms are substitutable (investors are willing to hold up and down the term scale), as a particular maturity offers a relatively high rate (low security price) investors will rush in and purchase the security. This is especially true of the U.S. Treasury market, where the yield curve is relatively smooth, reflecting the substitutability of various terms.

4. What is a banker's acceptance? Why are banker's acceptances ideally suited for foreign trade transactions?

Answer: A banker’s acceptance is a trade bill of exchange (draft on a counter party in a transaction) that has been “accepted” (liability of the bank) by a third party with an excellent credit rating, in this case a large commercial bank. With limited knowledge of counter parties in transactions, a third party “accepter” or guarantor is welcome. Banks and competitors that participate in acceptances “grease the wheels” of international trade.

5. In the stock market crashes of 1987, 1989, and shortly after “September 11th,” money market yields dropped. What caused this drop in money market interest rates? Discuss.

Answer: There were a couple major factors. First the Fed opened the discount window and purchased large amount of Treasuries expanding bank reserves expanding the supply of loanable funds, but the major factor was the surge of funds from around the world and out of more risky security markets into money market instruments, bidding up the price and lowering yields.

CHAPTER 8
TRUE/FALSE QUESTIONS

(T) 1. Capital market securities are used to finance real capital investments.

(F) 2. Capital market securities have better liquidity than capital market securities.

(T) 3. Money market securities are all debt securities, while capital market securities are either debt or equity securities.

(T) 4. Capital market interest rates tend to be higher than money market rates for any issuer.

(T) 5. Life insurance companies are more likely to invest in corporate capital market securities than commercial banks.

(T) 6. Investors may invest in capital market securities either directly or indirectly.

(F) 7. Both governments and businesses issue both debt and equity capital market securities.

(F) 8. Households owe more financially than they own.

(T) 9. Financial institutions and households own about the same amount of financial assets.

(T) 10. In the U.S. there are more mortgages outstanding than corporate bonds.

(F) 11. Yields on U.S. Treasury "ask" prices are higher than yields quoted on "bid" prices.

(T) 12. A U.S. Treasury STRIP is a zero-coupon bond.

(T) 13. Most State and Local government bonds are sold to finance education.

(T) 14. A serial bond issue matures over a period of years.

(T) 15. Households are the major investor in municipal bonds.

(F) 16. U.S. Treasury TIPS protect investors primarily from default risk.

(T) 17. A state turnpike authority is more likely to issue revenue bonds than general obligation bonds.

(F) 18. Lower marginal tax rates increase the demand for tax-exempt securities.

(T) 19. The money market provides liquidity for deficit units; the capital market finances economic growth.

(T) 20. The primary market for junk bonds expanded for higher risk firms as the secondary market for junk bonds developed.

(T) 21. Capital market borrowing by businesses is generally repaid from the cash flow generated by the assets financed.

(F) 22. Commercial banks purchase more tax-exempt securities when loan losses increase.

(F) 23. One of the fastest growing loan areas for commercial banks in the 1980s was financial guarantees.

(T) 24. Revenue bonds are generally considered more risky than general obligation bonds.

(F) 25. The after-tax return on a 9 percent tax-exempt municipal bond to a commercial bank in the 34 percent tax bracket is 5.94 percent.
MULTIPLE-CHOICE QUESTIONS

(c) 1. Which of the following is not an example of capital market securities? a. common stocks b. convertible bonds c. commercial paper d. mortgages

(c) 2. Most general obligation bonds are sold through a. direct placement. b. negotiated bids. c. competitive bids. d. all of the above.

(b) 3. Which of the following firms is least likely to hold tax-exempt municipal bonds? a. commercial banks b. pension funds c. mutual funds d. households

(d) 4. The secondary markets for capital market securities have facilitated economic growth in our country because a. they help provide marketability for capital market claims. b. they have increased people's willingness to buy capital market claims. c. they make people more willing to invest because they can more easily diversify their risk. d. all of the above

(a) 5. Everything else being equal, a bond will sell at a higher yield if it a. has a call provision. b. has low default risk. c. can be converted to stock. d. is listed on an exchange.

(d) 6. Which of the following would be least likely to purchase a tax-exempt municipal bond? a. commercial bank b. casualty insurance company c. mutual fund d. individuals in low tax brackets

(d) 7. The biggest supplier of funds in the capital markets are a. financial institutions b. state and local governments c. federal government d. households and non profits

(d) 8. Regulators provide a valuable function for the capital markets because they a. try to keep the market participants honest. b. try to prevent excessive speculation from destabilizing the market. c. make sure all pertinent information about publicly traded securities is disclosed. d. all of the above

(b) 9. In the 1980s low credit quality businesses were able to first issue their new bond securities in which market? a. municipal bond market b. junk bond market c. stock market d. secondary market

(a) 10. A capital market financing is most likely to finance a. new plant and equipment. b. seasonal inventory needs. c. a quarterly dividend payment. d. the sale of common stock.

(d) 11. The household sector is the largest surplus sector and invests in the capital market a. directly by purchasing stocks and bonds. b. directly by issuing assets payable in the capital market. c. both directly (owning stocks) and indirectly (pension fund reserves, etc.) d. both a and c above

(a) 12. Letters of credit are mostly associated with a. financial guarantees. b. investment banking. c. a bond indenture. d. a commercial bank seasonal loan.

(c) 13. Life insurance companies and pension funds buy corporate bonds for which two major reasons? a. tax sheltering and high yield b. liquidity and high after-tax returns c. liability maturity matching and high after-tax returns d. low risk and liquidity

(b) 14. All of the following bond terms relate to maturity except a. serial. b. indenture. c. sinking fund. d. call provision.

(c) 15. An investor in the 34 percent federal tax bracket would probably select what investment (all with similar default risk)? a. 7% municipal bond b. 10% corporate bond c. 11% mortgage d. 9% Treasury bond

(d) 16. If average corporate bond and tax-exempt municipal bond rates were 8.33% and 6.25% respectively, at what marginal tax rate would an investor be indifferent between the two? a. 30% b. 18% c. 33% d. 25%

(a) 17. With reference to the question above, an investor in the 34 percent marginal corporate tax bracket would purchase a. the tax-exempt bond. b. the corporate bond. c. neither security. d. the higher pre-tax yield.

(c) 18. The three major investors in municipal bonds are a. casualty insurance companies, pension funds, and individual investors. b. commercial banks, casualty insurance companies, and life insurance companies. c. individual investors, commercial banks, and casualty insurance companies. d. mutual funds, pension funds, and commercial banks.

(d) 19. The incentive to securitize a portfolio of loans is a. the profit from the loan revenue. b. the profit from the interest on the asset-backed securities issued. c. the profit from the fees paid for financial guarantees. d. the profit from the difference between the loan revenue and the costs of guarantees and return on the asset-backed securities.

(c) 20. Securitization of loan portfolios, such as credit card loans and mortgage loans, will occur if a. the financial market will pay more for the loan portfolio than the issued asset-backed securities. b. a financial guarantee is obtained from a commercial bank. c. the financial market will pay more for the issued asset-backed securities than the loan portfolio. d. the borrowers permit their loan to be securitized.

(d) 21. All but one of the following are associated with credit enhancements for asset-backed securities? a. Cash-collateral accounts that are deposits set aside to cover losses. b. Financial guarantees from bond insurance companies. c. Standby letters of credit from major commercial banks. d. A guarantee to pay from the borrowers.

(b) 22. Credit-rating agency ratings are associated with which of the following investor risks? a. interest rate risk b. default risk c. purchasing power risk d. reinvestment risk

(c) 23. Bonds issued by foreign entities in the United States are called: a. foreign bonds b. American depository receipts c. Yankee bonds d. Samurai bonds

(d) 24. All but one of the following may be associated with the increased globalization of bond markets? a. the globalization of business activity b. increased volatility in foreign exchange rates c. Improved computer and telecommunications technology d. the reduction in trade barriers and standardization of regulations.

(c) 25. Investors in U.S. Treasury STRIPS are primarily interested in eliminating which of the following bond investor risks? a. default risk b. price risk c. reinvestment risk d. foreign exchange risk

(c) 26. Industrial development bonds (IDBs) are debt securities issued by: a. the federal government b. non profit organizations c. state and local government agencies d. non financial businesses.

(d) 27. The largest investor in municipal bonds is: a. commercial banks b. property and casualty insurance companies c. life insurance companies d. households

(b) 28. The fastest growing debt sector in the U. S. is: a. Treasury debt b. federal agency debt c. mortgage debt d. corporate debt

(d) 29. The demand for junk bonds came primarily from a. life insurance companies b. savings & loans association c. pension funds d. all of the above

(a) 30. The quality of a financial guarantee depends on the reputation and financial strength of the a. the guarantor b. the investor c. the borrower d. none of the above

ESSAY QUESTIONS

1. Compare and contrast the characteristics of the securities of the money market with those of the capital market.

Answer: Money market securities are short-term, usually less than nine months, while capital market securities are from five to one hundred years. The money market is largely a “primary” market with secondary market activity. The capital market is a secondary market with some primary market additions. All money market securities are unsecured debt, while equities and debt, some collateralized, make up the capital market.

2. What might determine whether an individual investor buys corporate or municipal bonds? Give an example.

Answer: Everything else being the same, an individual investor would select the higher after-tax return; so the relative yields and marginal tax rate of the investor will likely determine the choice of corporate bonds or muni’s. For example with a 7% yield available on a corporate bond, for an individual in the 28% marginal tax bracket would have to find an equivalent (term and rating) 5.04% municipal or state bond. For individuals’ pension money in a tax-deferred program, one would invest in the taxable securities.

3. List and discuss the risks faced by bond investors.

Answer: Bond investors may face a variety of risk including default risk, inflation risk, price risk and reinvestment risk (coupon bond), foreign exchange risk and/or political risk if an international investment, and market risk (risk of a constant ready market).

4. U.S. Treasury STRIPS are of interest to individuals with IRA's or $401k pension plans. Why?

Answer: Zero coupon bonds are of interest to individuals investing via tax deferred pension plans for a couple reasons. One, an individual, buying a STRIP outside a qualified pension plan will pay annual interest on the imputed rate on the zeros, but not if in a qualified plan. Second, zeros held to maturity earn the expected yield to maturity and are not subject to reinvestment risk. One will know the “pile” of cash in the plan at the end of the maturity.

5. What factors have contributed to the increased globalization of bond markets?

Answer: There have been a number of cumulative factors that, overtime, has contributed to the increased globalization of bond markets. The development of standardized legal remedies, the development of markets in more stable economies, and a vast amount of quality government debt has attracted investors into financial investment. Exchange rate stability, computerization, and information processing technology have provided the ability for markets to develop as well.

CHAPTER 9
TRUE-FALSE QUESTIONS

(T) 1. Mortgage insurance was an important factor in the development of secondary mortgage markets.

(T) 2. Commercial banks are the largest institutional investor of mortgages.

(T) 3. Mortgage borrowers expecting interest rates to fall significantly are likely to find ARM mortgages at rates very close to FRM mortgage rates.

(T) 4. FNMA is a privately owned corporation with a line of credit from the U.S. Treasury.

(T) 5. The cash flow to investors by CMO securities can be predicted with certainty.

(T) 6. Mortgage originators may retain the servicing right and fees even though the mortgage has been sold to a governmental agency.

(T) 7. A lender with a fixed-rate mortgage bears the risk of future inflation.

(F) 8. Mortgages are issued in standard denominations like corporate and municipal bonds.

(T) 9. Most mortgage loans are amortized over the maturity of the loan with interest computed on the declining principal.

(T) 10. In a conventional mortgage agreement the borrower owns the mortgaged home; the lender takes a lien against the home.

(F) 11. An ARM, compared to a FRM, shifts the interest rate risk from the borrower to the lender.

(F) 12. CMO residual tranches have the first claim on the cash flow from a pool of mortgages.

(F) 13. Mortgage-backed securities have improved mortgage liquidity for home buyers.

(T) 14. Mortgage pool securities have encouraged individuals, insurance companies, and pension funds to provide indirect mortgage financing.

(T) 15. Home equity credit lines are a form of second mortgage financing.

(T) 16. Pass-through mortgage securities have standard denominations but uncertain cash flow.

(F) 17. Pass-through securities pass through all principal and interest payments collected from homeowners, providing a predictable stream of cash flow to the investor.

(F) 18. REMIC securities are a form of collateralized mortgage obligation that provide tax-free income to investor.

(F) 19. The residual investor in a CMO issue will always earn a higher return than the CMO debt investor.

(F) 20. FHMLC buys FHA/VA insured mortgages from loan originators.
MULTIPLE CHOICE QUESTIONS

(d) 1. Which of the following types of mortgages would be most advantageous to have on your house if you expected the annual rate of inflation would be higher than most people thought? a. reverse annuity mortgage b. interest only mortgage c. adjustable-rate mortgage d. fixed-rate mortgage

(a) 2. Which one of the following is not true about Privately Issued Pass Throughs (PIP)

a. They are similar to “Ginnie Maes” in that they are backed by mortgages that qualify for FHA or VA guarantees. b PIPs are issued by private institutions or mortgage bankers. c. They are similar to “Ginnie Maes” except that they are backed by conventional mortgages that do not qualify for FHA or VA guarantees. d Typically used to securitize large, non-conforming mortgage loans called jumbo loans.

(b) 3. A contract designed to use the equity in a home for retirement income without any required payments is called a. rollover mortgage b. reverse annuity mortgage c. adjustable-rate mortgage d. home equity loan

(b) 4. What is the monthly payment on a $200,000 conventional fixed-rate mortgage, 7 percent, financed for 15 years? a. $1830 b. $1797 c. $1679 d. $1721

(d) 5. With reference to the question above, what is the loan balance after 10 years if paid as agreed? a. $92,721 b. $83,581 c. $85,492 d. $90.785

(b) 6. What is the monthly payment on a $100,000 fixed rate loan with a 6.5% rate with a term of 30 years? a. $657 b. $632 c. $638 d. $612

(a) 7. With reference to the question above, if you added $100 to the monthly payment, how soon would your loan be paid off? a. 249 months b. 227 months c. 185 months d. 278 months

(c) 8. You have just purchased a home and borrowed $50,000, 7 percent for 25 years, payable monthly. What is your monthly payment? a. $338 b. $339 c. $353 d. $369

(d) 9. With reference to the question above, what was the amount of interest paid in the first month of the loan? (Assume a January payment in a 365 day year) a. $305 b $265 c. $257 d. $297

(a) 10. How long does it take to repay one-half of the principal on a $70,000, 7 percent, 15 year mortgage loan? a. 112 months b. 95 months c. 123 months d. 131 months

(c) 11. Which of the following mortgages would you most like to hold if you were a lender and you expected inflation of uncertain magnitude? a. reverse annuity mortgage b. conventional fixed-rate mortgage c. adjustable-rate mortgage loan d. none of the above

(c) 12. Which of the following holds the largest percentage of mortgages outstanding in the United States? a. life insurance companies and pension funds b. government agencies c. mortgage pools d. thrift institutions

(c) 13. If you were a manager of a thrift institution and you expected interest rates to increase, what type of mortgage would you most like to hold? a. balloon payment, ten years b. ROM, two years c. adjustable-rate mortgage, monthly d. fixed-rate mortgage, 15 years

(c) 14. Which of the following statements is not true of all pass-through securities? a. They may not be repaid in full for 25 to 30 years. b. They are viewed, in the capital markets, as having average maturities of much less than 30 years. c. Their interest and principal repayments are predictable. d. They pass through all payments of principal and interest from the underlying pool of mortgages.

(c) 16. State and local governments make mortgage loans at below-market rates of interest because a. they want to compete with the thrifts. b. they want to help local thrift institutions. c. they can obtain funds for mortgage financing cheaply by selling tax-exempt securities. d. they lend to lower income, larger home buyers.

(d) 17. Two mortgage investors, who have increased the percentage of mortgages outstanding in the last 20 years, are a. thrift institutions and commercial banks. b. commercial banks and insurance companies/pension funds. c. mortgage pools and thrift institutions. d. mortgage pools and commercial banks.

(d) 18. Private mortgage insurance protects the a. seller of the home. b. FHA. c. borrower. d. lender.

(d) 19. Which of the following is true about GNMA pass through securities? a. Interest and principal from borrowers are passed-through to investor. b. Federally insured imply mortgage loans guaranteed by the FHA, VA, and other authorized federal agencies. c. GNMA pass-throughs are secured by mortgage pools originated by mortgage banks, commercial banks, or other mortgage lending institutions. d. all of the above

(c) 20. A savings and loan with a very low net worth position would take which action? a. invest in conventional fixed-rate loans b. invest in variable-rate loans c. make and sell eligible loans to the FHLMC d. make equity-participation mortgages

(b) 21. What is the monthly payment on a home costing $150,000, 30 percent down, 25 years at 9 percent? a. $636.09 b. $881.16 c. $763.31 d. $677.82

(b) 22. With reference to the question above, what was the amount of interest paid in the first month of the loan? a. $702.32 b. $787.50 c. $726.31 d. $583.33

(d) 23. With reference to the two questions above, what is the remaining balance on the mortgage after 60 months? a. $ 81,450 b. $100,666 c. $ 79,097 d. $ 97,936

(b) 24. Which of the following is true about Ginnie Mae I pass through securities? a. Ginnie Mae I are pass-throughs secured by a mortgage pool consisting of the same type of mortgage loans. b. Have the same interest rate. c. Are originated by the same lender. d. all of the above.

(c) 25. A savings and loan writing ARMs and expecting mortgage interest rates to decrease in the future would want a. an interest rate "cap" on their loans. b. a second mortgage on the home. c. to lengthen the "adjusting" time period. d. no limits on the variability of the rates.

(b) 26. Which of the following is not used to adjust ARM rates? a. Treasury security rates b. Dow Jones Mortgage Rate Index c. S&L cost of funds index d. current fixed rate mortgage rate index

(a) 27. In an increasing rate environment a thrift institution would probably make the following ARM adjustments: a. increase the borrower's payments. b. extend the maturity of the loan. c. increase the principal of the loan. d. decrease the borrower's payments.

(c) 28. Which of the following statements is not true about the Federal National Mortgage Association? a. FNMA is a privately owned corporation. b. The FNMA has a line of credit from the U.S. Treasury. c. The FNMA issues pass-through mortgage securities on federally-insured mortgages only. d. Government representatives sat on the board of directors of FNMA.

(a) 29. Which of the following questions about REMIC securities is false? a. REMIC securities provide tax-free income to investors. b. REMIC securities provide level cash flows similar to CMOs. c. REMIC securities may be backed by pass-through securities issued by FHLMC or FNMA. d. The Tax Reform Act of 1986 encouraged the use of REMICs.

(c) 30. Mortgage loans are different from other capital market securities in all but one way? a. They are secured by the pledge of real property b. Mortgages have varying long-term maturities. c. Issuers are small, risky borrowers. d. FRMs are all long-term contracts.

(c) 31. “Amortizing “ a mortgage loan means: a. Converting a long-term loan to a short-term loan. b. the equity in the home declines as the loan is paid down. c. The loan is repaid in equal, consecutive payments. d. interest is paid first, and then the principal

(d) 32. Conventional mortgages are usually insured by what governmental agency? a. Federal Housing Administration b. Government National Mortgage Association c. Veterans Administration d. None of the above

(b) 33. Mortgage-backed securities often have payment patterns that are "doubly convex," which means a. the contract is very complex. b. that significant changes in the level of interest rates, up and down, produces losses for the investor. c. that conventional mortgages have double the default risk than other types of mortgages. d. that investors are exposed to both interest rate risk and default risk.

(a) 34. Flexible ARMs protects both lender and borrower from interest rate risk because a. the mortgage contract stays fixed for a time before it begins to vary with interest rates. b. flexible ARMs guarantee the lender a fixed return and borrowers a fixed payment. c. rates and house payments will vary quite frequently. d. these mortgages are insured by the FHA.

(d) 35. Flexible ARMs would be preferred by borrowers a. seeking a rate lower than comparable fixed rates. b. who may be selling their home soon. c. seeking a fixed payment for a few years. d. all of the above.

(b) 36. The Tax Reform Act of 1986 increased the popularity of home equity lines of credit because a. the deductibility of interest for homeowners was reduced. b. interest incurred under home equity lines were deductible, but interest on other household financing was not. c. banks and savings and loans were given tax incentives to make home equity lines of credit. d. the law reduced the rates charged on home equity loans.

(d) 37. All but one of the following are reasonable expectations for investors in pass-through mortgage securities? a. The securities are readily marketable. b. They have little default risk. c. The investor receives cash flows in proportion to his/her ownership proportion. d. The timing of the cash flow return from the securities is quite predictable.

(b) 38. The original purpose of the Federal Home Loan Mortgage Corporation (Freddie Mac) was to a. make home loans to low income individuals. b. purchase the conventional mortgages from thrift institutions. c. purchase the insured conventional mortgages from financial institutions. d. purchase the government insured mortgages from thrift institutions.

(b) 39. All but one of the following are advantages of mortgage-backed bonds compared to investing in direct mortgages? a. They are issued in standard denominations. b. They are issued by individuals with limited credit experience. c. They are usually insured and highly collateralized. d. They have cash flow returns similar to corporate bonds.

(d) 40. Interest rate caps or rate caps a. limit the size of the increase in the loan rate in any year. b. limit the size of the increase in the loan rate over the loan’s life. c. Typically, the annual cap is 1-2%, and the lifetime cap is 5%. d. all of the above

(b) 41. An investor in a first-level tranche with claims on a pool of mortgages is likely to a. have a much higher risk position than lower level tranches. b. have more certain returns and less default-risk exposure. c. must wait until all tranches are paid before receiving a return. d. has lower risk but a much more varied return than lower level tranches.

(c) 42. Mortgages with government or private mortgage insurance a. are likely to sell at lower prices and lower rates than comparable conventional mortgages. b. are less likely to default that conventional mortgages. c. offer the investor less default risk than conventional mortgages. d. will be written under the credit standards of the originator, and not the standards of the agency or insurance company.

(d) 43. All but one of the following has been associated with the increased efficiency of the mortgage markets? a. The deregulation of financial institutions. b. The extensive use of mortgage insurance. c. Improved communications technology enhancing and reducing the cost of borrower information. d. The use of varied types of mortgage contracts.

(a) 44. Mortgage bankers are mostly likely to be involved in the _______ of a mortgage contract? a. origination b. funding c. servicing d. insuring

(b) 45. All but one of the following is associated with tightened mortgage credit standards? a. More time on the current job required. b. An increase in the required loan/value ratio. c. A decrease in the maximum total debt payments per month per amount of monthly income. d. Decreased maximums in the payment/income ratio of borrowers.

(b) 46. Which of the following is associated with a loosening of mortgage credit standards? a. Increased down payments. b. Increased loan/value ratios. c. Decreased in maximum total debt to income ratios d. Increased required use of mortgage insurance

(c) 47. All but one of the following is associated with determining the creditworthiness of a mortgage borrower? a. income stability b. job stability c. loan/value ratio d. prior credit history

(a) 48. All but one of the following is more likely to be associated with mortgage banking activity. a. permanently funding the mortgage b. originating the mortgage c. servicing the mortgage d. collecting the monthly payments from the borrower

(d) 49. Mortgage rates, relative to other capital market rates, a. tend to vary with other rates. b. tend to be higher than other rates. c. are becoming more uniform across the country. d. all of the above.

(b) 50. The largest sector of the capital debt market is associated with a. corporate bonds b. mortgages c. state and municipal bonds d. U.S. Treasury debt

(b) 51. Which of the following is not true about Interest Only Mortgages? a. Low payments in initial years (10 to 15 years) – only includes interest on borrowed amount. b. Low payments in initial years (10 to 15 years) – only includes principal repayment on borrowed amount. c. After initial period, payments increase such that entire loan amount is amortized by the end of 30 years. d. Borrower pays interest for a considerable period on the entire loan balance, but avoids having to pay down balance in initial years.

(b) 52. Which of the following is not true about Construction-to Permanent Mortgages? a. Bridge financing is provided by lender over the time frame required by the borrower to purchase land and construct the house. b. Both interest and principal payment are made until construction is completed. c. Loan is financed in increments as construction payments have to be made. d. On completion of the construction, loan balance is rolled over into the type of mortgage contract desired by borrower.

(e) 53. Which of the following is true about Reverse Annuity Mortgages (RAMs)? a. RAMs allow homeowners to borrow against the equity on their homes at low rates. b. Typically obtained by older people whose home loans have been paid off, but can use income of the real estate investment they own. c. Typical term is no more than 20 years and could be for borrower’s lifetime as an annuity. d. Homeowners’ equity declines by amount borrowed. e. all of the above are true.

(d) 54. All but one of the following is true of Balloon Payment Mortgages a. It is a traditional loan where interest is paid until a time when the principal is due. b. Terms can be 3, 5 or 7 years. c. Loan is amortized over 15 or 30 year period so that monthly payments are no different than a FRM of equal maturity. d. Rate is variable over the contract term.

(d) 55. Which of the following statements about FHA and VA mortgages is false? a. They are insured by the government. b. They charge for their insurance. c. They have low down payments. d. The borrower is protected in case of default

ESSAY QUESTIONS

1. Commercial banks and mortgage pools recently overtook thrift institutions as major investors in mortgages. List and discuss several factors responsible for this change.

Answer: More volatile capital market rates, a troubled thrift industry, increased focus on the origination and service function by thrifts and banks, increased technology (computing and information processing), subsidization of Fannie Mae, Ginnie Mae,, and Freddie Mac), and a thirst by pension funds for alternative investments has fueled the growth of mortgage pools and mortgaged-backed securities.

2. Explain the ways in which the federal government fostered the development of the secondary mortgage markets.

Answer: The VA and FHA guarantees/insurance plus the creation of Fannie Mae, Ginnie Mae, Freddie Mac providing a secondary market and liquidity for mortgage securities has been the major areas of assistance for mortgage markets.

3. Why do mortgage-backed securities, guaranteed by Federal government agencies, often have yields above U.S. Treasury bond rates?

Answer: The demand for a prepayment risk premium, in case interest rates decline significantly in the investment period, is the primary reason for the higher yields on mortgage-backed, guaranteed securities.

4. A change in the rate of an adjustable-rate mortgage can affect the borrower's mortgage three ways. Discuss

Answer: A mortgage may be adjustable a number of ways including, monthly payments, varying maturity, and loan expansion/contraction adjustments.

5. Mortgages are now originated, funded, serviced, and insured by different parties. What developments are associated with this unbundling of loan cash flows in recent years?

Answer: Increased computing technology, competition, and desire for unbundling by financial institutions and investors have been the major factors behind the separation of origination, servicing, and funding.

CHAPTER 10
TRUE/FALSE QUESTIONS

(T) 1. The Dow Jones Industrial Average is a price-weighted index.

(F) 2. The NASDAQ is associated with a stock exchange.

(F) 3. The secondary market for capital market securities is important because it provides funds directly to deficit spending units.

(F) 4. Primary capital market securities provide marketability and possibilities for investors to alter the riskiness of their portfolios.
(F) 5. Stock with betas less than one tend to have more price variability than the market.

(F) 6. Limited liability of stockholders protects them from losses on their stock portfolio.

(T) 7. The New York Stock Exchange is an example of a secondary market.

(T) 8. A wide spread between the bid/ask prices of a security dealer may represent weak market operational efficiency.

(T) 9. The specialist in a NYSE listed stock exercises the limit orders at the stock trading post.

(T) 10. Diversification attempts to lower or eliminate the unsystematic risk of a portfolio of securities.

(T) 11. A market with breadth has a large number of diverse investors.

(T) 12. The underwriter's spread is inversely related to the size of the primary offering.

(F) 13. Cumulative preferred stockholders are assured of receiving dividends each year.

(T) 14. A stock, which is expected to pay a $4 dividend next year, growing constantly at 6%, is priced to yield a required return of 18%, is selling for $33.33.

(F) 15. The market rate of return on a $100 par value preferred stock, priced at $90, paying an $8.00 annual dividend, is 8 per cent.

MULTIPLE-CHOICE QUESTIONS

(c) 1. Which of the following is not an example of capital market securities? a. common stocks b. convertible bonds c. commercial paper d. mortgages

(c) 2. All but one of the following is associated with characteristics of common stock? a. residual claim on income and assets b. proxy c. cumulative dividends d. dual-class stock

(b) 3. Investors with 30 per cent of the voting stock of a corporation, interested in a seat on the board of directors, had better have __________ voting privileges. a. straight b. cumulative c. proxy d. limited

(d) 4. The secondary markets for capital market securities have facilitated economic growth in our country because a. they help provide marketability for capital market claims. b. they have increased investors' willingness to buy capital market claims. c. they make people more willing to invest because they can more easily diversify their risk. d. all of the above

(d) 5. The capital market is allocationally efficient if a. funds are channeled to their most productive use. b. market makers such as dealers and brokers are making reasonable, not excessive rates of return. c. only if informational and operational market efficiencies are high. d. both a and c.

(c) 6. The term shareholder equity implies a. a right to dividends. b. a contractual relationship with a corporation. c. an ownership claim. d. a prior claim on income and assets.

(a) 7. All but one of the following are terms associated with common stock? a. contractual b. residual c. ownership d. limited liability

(b) 8. Security exchanges provide a valuable function in that they a. create interest in stocks. b. increase the marketability of securities. c. provide a legal way to gamble. d. supply money to deficit spending units.

(d) 9. Regulators provide a valuable function for the capital markets because they a. try to keep the market participants honest. b. try to prevent excessive speculation from destabilizing the market. c. make sure all pertinent information about publicly traded securities is disclosed. d. all of the above

(b) 10. A shareholder in a troubled corporation is not likely to lose his/her a. money invested in the stock. b. house. c. dividends declared. d. par value.

(d) 11 Which of the following is not true about American Depository Receipts (ADR)? a. An American Depository Receipt (ADR) is a negotiable issued by the U.S. financial intermediaries (FIs) against shares in foreign companies, with the shares held in custody by the FIs for investors. b. ADRs are issued in the U.S. and are denominated in U.S. dollars. All cash flows to the investor are in dollars. c. Enhances a company’s visibility, status and profile in the U.S. and internationally among investors, consumers and customers. d. Decreases the foreign firm’s U.S. liquidity (and potentially total global issuer liquidity).

(d) 12. The globalization of the equity markets has led to: a. Electronically linking equity dealer and exchange markets is slowly leading toward a national market system. b. Electronically linking international markets has created 24 hour trading opportunities for some stocks. c. U. S. stock exchanges have extended (after hours) their normal trading hours in which shares are traded electronically, linking U. S. with the hours of international markets. d. all of the above

(d) 13. The household sector is the largest surplus sector and invests in the capital market a. directly by purchasing stocks and bonds. b. directly by issuing assets payable in the capital market. c. both directly (owning stocks) and indirectly (pension fund reserves, etc.) d. both a and c above

(c) 14. A stock purchased at $40 at the beginning of the year paid $10 in dividends and was sold for a net price of $42 at the end of the year. The total annual return is a. 25 per cent b. 100 per cent c. 30 per cent d. 28.6 per cent
(b) 15. In a board of directors election for five directors and straight voting, a majority group of shareholders will elect a. four directors. b. five directors. c. four or five depending on how the cumulative voters vote. d. the same proportional share of directors as their ownership share.

(c) 16. The sale of securities to the public via an investment banker by a new corporation raising funds is called a. a seasoned offering. b. a secondary offering. c. an initial public offering. d. a best efforts offering.

(a) 17. Sampson Corporation, through its investment banker, First Ohio Securities, recently sold an 200,000 issue of stock to the public, grossing $7.4 million. Issuing expenses, paid by Sampson totaled $200,000, and the underwriter's spread was $3 per share. Sampson Corporation was able to net how much financing in the deal? a. $6.6 million b. $7.2 million c. $6.5 million d. $7.0 million

(b) 18. The underwriter's spread (%) is a. directly related to the size of the primary offering. b. directly related to the riskiness of the issue. c. greater when the shelf registration process is used. d. smaller for stocks than for bonds.

(d) 19. The New York Stock Exchange is a(n) ________ market. a. auction b. exchange c. secondary d. all of the above

(a) 20. Which of the four secondary markets listed below involves considerable costs and no third party? a. direct search b. brokered c. dealer d. auction

(b) 21. Which of the four secondary markets listed below achieves economies of scale in search costs, but does not guarantee that orders will be executed promptly? a. direct search b. brokered c. dealer d. auction

(c) 22. Which of the four secondary markets listed below minimizes price risk, but search costs are often high? a. direct search b. brokered c. dealer d. auction

(d) 23. Which of the four secondary markets listed below has low search costs, price risk, and the expense of a bid/ask spread? a. direct search b. brokered c. dealer d. auction

(b) 24. The bid-ask spread for equity securities a. is higher with higher priced stocks. b. is large (%) for very small and very large transactions. c. is less for less than round lot trades. d. all of the above.

(a) 25. The bid-ask spread for equity securities tends to be _______ for more frequently traded stocks and _______ for stocks which have more traders with inside information. a. less; more b. less; less c. more; more d. more; less

(c) 26. The over-the-counter market trades ______ stocks than exchanges, and exchanges tend to list ________ companies. a. less; smaller b. less; larger c. more; larger d. more; smaller

(d) 27. All but one of the following are reasons for not listing a stock on an exchange? a. limited trading in the stock b. small issue size c. having excellent support by NASD dealers d. having a large number of public shareholders

(d) 28. All but one of the following is associated with the over-the-counter market for stocks? a. NASD b. NASDAQ c. unlisted d. auction market

(d) 29. A broker seeking to purchase an OTC stock a. must find a dealer in the stock. b. must find the most favorable price of the stock. c. might use a level 2 NASDAQ monitor. d. all of the above.

(b) 30. The NASDAQ system provides price input capability for a. brokers. b. dealers. c. stock-trading customers of dealers. d. the Securities and Exchange Commission.

(c) 31. The daily pink sheets of the OTC market were replaced a. by the emerging dealer market. b. by the brokers relaying information to their customers. c. by the NASDAQ system. d. when the NASD required that dealers be registered.

(b) 32. All but one of the following are three major sources of active bids and offerings in a stock issue at a stock trading post on an exchange? a. floor brokers handling customer orders. b. limit price orders held by floor brokers. c. the specialists making trades for his/her own account. d. the specialist executing limit price orders.

(c) 33. An order to the New York Stock Exchange to buy or sell at the best price available is called a. a limit order. b. a stop order. c. a market order. d. none of the above.

(a) 34. Advances in technology and competition have created all but one of the following in equity markets? a. higher transaction costs b. the development of a national market system c. 24-hour trading of some stocks d. globalization of equity markets

(e) 35. Which of the following is true about secondary markets? a. A buyer may incur search costs and find a seller on their own, called a direct search. b. A broker may bring buyer and seller together, charging a commission. c. A dealer may sell/buy (bid/ask) securities from an inventory of securities, reducing search costs. The dealer's return is the bid/ask spread. d. An auction market allocates the selling shares to the highest bidder, providing a buyer/seller. e. all of the above are true.

(c) 36. In response to competition from foreign stock exchanges, U.S. stock exchanges have a. shortened their trading hours to decrease the volatility of stock prices. b. implemented after-hours discussion session between floor brokers and customers. c. expanded electronic after-hour trading for stocks. d. listed more stocks to compete with foreign stock exchanges.

(d) 37. The primary federal regulator of stock markets a. are the state securities commissions in fifty states. b. is the NASD. c. is the Securities Investor Protection Corporation. d. is the Securities and Exchange Commission.

(d) 38. The federal legislation that made the Securities and Exchange Commission responsible for the broad oversight of securities markets was a. Securities Act of 1933. b. Securities Exchange Act of 1935. c. The Investment Company Act of 1940. d. none of the above.

(b) 39. What is the value of a stock expected to pay a constant $5 dividend each year forever, if the market required rate of return is 18%? a. $90 b. $28 c. $36 d. $23

(b) 40. What is the price of a stock, now priced at $20, which promises to pay $3 dividend for one year and offer an 18 per cent total return? a. $23 b. $20 c. $111 d. none of the above

(c) 41. Ace Corporation is selling an IPO of stock. They expect to pay the new shares equivalent of $3 dividend per share and expect the stock to be priced at $40 in four years. The market required rate of return is estimated to be 18 per cent. What is value of the stock today? a. $24.64 b. $26.50 c. $28.70 d. $40.00

(b) 42. What is the estimated value of a stock, which paid a $5 dividend last year, expects dividends to grow at 6 per cent, and requires a 20 per cent return? a. $35.71 b. $37.86 c. $25.00 d. $20.38

(a) 43. A stock, currently trading at $50 expects to pay a $4.50 dividend this year. The dividends and stock price has been growing at 8 per cent for 10 years. What is the expected total return on the stock this year? a. 17 per cent b. 18 per cent c. 180 per cent d. below the required market rate of return

(c) 44. Investors in well diversified stock portfolios are concerned about ________ risk. a. specific stock b. unsystematic c. systematic d. diversifiable

(c) 45. Stocks with beta values of one a. will have very predictable rates of return. b. will have little risk compared to the market portfolio. c. has had price variability similar to the market. d. has had a constant rate of return.

(b) 46. The security market line represents a. the amount of risk demanded for each unit of return. b. the rate of return for each unit of risk. c. the sum of the systematic and unsystematic risks. d. the risk/return tradeoff over time.

(b) 47. Using the security market line, calculate the required rate of return on a stock when the risk-free rate is 7%, the return on the market portfolio is 15%, and the beta is 1.5? a. 12 % b. 19% c. 29.5% d. 33%

(b) 48. When constructing a stock market index, two items below are needed to start the index? a. the starting date and an estimate of future prices. b. the starting date and the base index value. c. the starting and ending date of the index. d. 100 is the base value, combined with the starting date.

(c) 49. At the beginning of year one, the stock market index had a value of 225.4. Two years later the value was 298. What was the average annual rate of return on the index portfolio? a. 28.6% b. 30.0% c. 15.0% d. 14.3%

(c) 50. Stocks XX, YY, and ZZ, currently priced at $35, $65, and $72, respectively, comprise a price-weighted index with a base value of 100. One year later the stocks above were valued at $40, $69, and $87. What was the value of the index at the end of year one? a. 100 b. 196 c. 114 d. 88

CHAPTER 11
TRUE-FALSE QUESTIONS

(F) 1. Hedgers always buy futures contracts.

(T) 2. Writing calls can generate potentially unlimited losses.

(T) 3. The price sensitivity rule assists the hedger by estimating the number of futures contracts to trade.

(F) 4. Most forward market contracts are settled before delivery.

(T) 5. The open interest is the number of outstanding futures contracts.

(F) 6. The financial futures hedger loses when futures contracts are marked to market.

(T) 7. A depository institution can guarantee its costs of funds by selling CD futures.

(T) 8. Basis risk involves the risk that the price of futures contracts will not vary in exactly the same way as the price of the item being hedged.

(F) 9. Margin risk involves the chance that initial margin requirements will be raised.

(F) 10. A swap entails buying and selling a futures contract at the same time.

(T) 11. A S&L with a high negative GAP might swap future fixed rate interest for variable rate interest.

(T) 12. A futures contract involves a hedger (risk averter) and a speculator (risk taker).

(T) 13. Options premiums vary directly with the maturity of the option.

(T) 14. Futures markets involve more standardized contracts compared to forward markets.

(F) 15. An interest rate swap dealer combines two parties into one swap contract.

(T) 16. Margin requirements relate to the amount of cash down payment or equity one must have deposited before participating in any trade.

(F) 17. A pension fund manager is likely to buy stock index futures contracts to protect his/her recent price gains.

(F) 18. The Chicago Board Options Exchange is the primary regulator of options contracts.

(T) 19. Bid-ask price spreads narrow with more traders and more trades.

(F) 20. A hedger always owns the financial contract or is producing the commodity.

MULTIPLE-CHOICE QUESTIONS

(d) 1. A hedger in the financial futures market a. usually buys futures contracts. b. usually sells futures contracts. c. either buys or sells so that underlying asset gains/losses are directly related to futures contract gains/losses. d. either buys or sells so that underlying asset gains/losses are inversely related to futures contract gains/losses.

(c) 2. A hedger in the financial futures market a. seeks a position in the spot market to offset the price risk, which exists in the futures market. b. will purchase financial futures if holding financial assets in the spot market. c. seeks to offset the price risk in its spot market position with the nearly equal but opposite price risk of the futures position. d. will always short financial futures to perfect the hedge.

(c) 3. The purchase of one million dollars of Treasury Bonds, delivered in 60 days, from a government securities dealer is: a. a call. b. a swap. c. a forward contract. d. a put.

(b) 4. An agreement between a business and a large money center bank to sell 10 million dollars of T-Bills in sixty days is called a a. a call option. b. a forward contract. c. a put option. d. a long futures position.

(a) 5. Futures contracts differ from forward contracts in all of the following ways except: a. Forward contracts involve an intermediary or exchange. b. Futures contracts are standardized; forward contracts are not. c. Futures markets are more formal than forward markets. d. Delivery is made most often in forward contracts.

(b) 6. The purchase of U.S. Treasury bonds for immediate delivery is a _______ market transaction. a. stock b. spot c. futures d. forward

(d) 7. What is the relationship between spot market prices and forward market prices of a good or financial asset? a. Spot prices represent expected forward prices. b. Forward prices are always higher than spot prices. c. Spot prices are always higher than forward prices. d. Forward prices are expected future spot prices.

(b) 8. In a forward contract one party to the contract deals with a. the futures exchange. b. the counter-party of the forward contract. c. the opposite swap party. d. the hedger.

(c) 9. Futures contracts differ from forward contracts in that a. futures contracts are between the individual hedger and speculator. b. futures contracts are personalized, unique contracts; forwards are standardized. c. futures contracts are marked to market daily with changes in value added or subtracted from buyer and seller. d. forward contracts always require a margin deposit.

(b) 10. An investor planning to buy IBM stock in 30 days can protect himself against price risk by a. selling a IBM put option that matures in 30 days b. buying a IBM call option that matures in 30 days c. selling a IBM call option that matures in 30 days d. buying a IBM put option that matures in 30 days

(b) 11. A portfolio manager is concerned that the expected drop in interest rates is going to lower the yield on the $1,000,000 of T-Bill she plans to buy in 3 months. She can hedge this potential interest rate risk by: a. Taking a short position in 3-month T-bill futures contract. b. Taking a long position in 3-month T-bill futures contract. c. She cannot hedge her situation in the futures market. d. none of the above

(c) 12. If a corporation wanted to guarantee its long-term costs of financing an investment project, it could a. sell T-bill futures for when the funds were needed. b. buy T-bill futures for when the funds were needed. c. sell T-bond futures for when the funds were needed. d. buy T-bond futures for when the funds were needed.

(d) 13. Which of the following intentionally assumes price risk? a. speculators b. hedgers c. traders d. both a and c

(a) 14. A hedger who holds his futures position after his spot risk has abated is a a. double hedger. b. speculator. c. trader. d. counter-party.

(d) 15. An agreement with the futures exchange to buy is a ______ position; to sell, a ________ position? a. spot; futures b. high; low c. long; short d. short; long

(b) 16. A margin call on a futures position, which has moved adversely, is called a(an) ______ margin requirement? a. initial b. maintenance c. ante d. daily settlement

(d) 17. The price sensitivity rule may help a. determine the number of futures contracts to trade. b. present conditions for a hedge to occur. c. determine the relative price variability of a futures contract and underlying assets given a change in interest rates. d. all of the above.

(d) 18. All of the following will gain if the price of any underlying instrument falls except: a. the seller of a futures contract b. the buyer of a put c. the writer of a call d. the buyer of a futures contract

(c) 19. All of the following is true except: a. A swap is like a forward contract in that it guarantees the exchange of two items of value at some future point in time. b. Only the net interest difference is swapped in an interest rate swap. c. Swap parties usually have the same level of credit risk. d. Unlike a forward contract the exact terms of exchange of the swap will vary with changes in interest rates.

(c) 20. Which is not a function of the CFTC? a. to approve new futures contracts b. to monitor enforcement of exchange rules c. to make sure people maintain their margin level d. to investigate violations of laws

(d) 21. A farmer growing wheat is in wheat and may hedge price risk by wheat futures. a. short; long b. buying; selling c. selling; buying d. long; selling

(a) 22. A(n) margin is deposited at the beginning (purchase/sale) of the futures contract; thereafter, a margin is required depending on the movement in the price of the futures contract. a. initial; maintenance b. initial; profit c. net; seller's d. safe; lower

(c) 23. First National Bank recently purchased a T-bill futures contract to hedge a risk position at the bank. If the price of the futures contract is increasing a. First National is "gaining." b. First National is "losing." c. First National is neither "gaining" nor "losing." d. none of the above

(b) 24. Daily changes in futures prices means one party (hedger or speculator) has gained; another lost money on the contract. How are the exchanges able to keep the "daily" loser in the contract and prevent default? a. by the threat of bankruptcy b. by daily margin calls if needed c. by loans d. by guarantees by third parties

(d) 25. An S&L with a high negative GAP position wishing to hedge all or part of its interest rate risk might a. sell financial futures. b. purchase financial futures. c. sell puts on financial futures. d. both a and c

(a) 26. A small commercial bank with rate sensitive assets greater than rate sensitive liabilities sells T-bill financial futures. The bank is a. speculating. b. hedging. c. neither hedging nor speculating. d. both hedging and speculating.

(c) 27. A five-member federal regulatory commission which serves as the primary regulator of the futures market is the a. Chicago Mercantile Exchange. b. Federal Commodity Futures Commission. c. Commodity Futures Trading Commission. d. Chicago Board of Trade.

(b) 28. An insurance company can invest funds, which are coming to the company in the future, at today's interest rates by a. speculation in financial futures. b. buying financial futures. c. selling financial futures. d. taking no action.

(b) 29. A bank which hedges its future funding costs in the T-bill futures market is a. hedging perfectly. b. accepting some basis risk. c. speculating. d. not hedging at all.

(b) 30. Which of the following is true about hedging using duration analysis? a. The institution may hedge its earnings and its net worth. b. If market value weighted asset duration is greater than the liability counterpart, sell financial futures to "immunize." c. If market value weighted asset duration is greater than the liability counterpart, buy financial futures to "immunize." d. Maturity hedging provides the same hedging as duration hedging.

(d) 31. Which one of the following statements is true about derivative securities? a. Derivative securities are used to minimize or eliminate an investor’s or a firm’s exposure to various types of risk that they may be exposed to. b. Derivatives are financial securities which are based upon or derived from existing securities. c. Risk to an investor or a firm can be caused by interest rate changes or foreign exchange rate changes, commodity prices or stock prices. d. all of the above

(d). 32. The value of an option varies directly with: a. the price variance of the underlying commodity. b. the time to expiration. c. the level of interest rates. d. all of the above. e. both a and b above.

(c) 33. All of the following are risks associated with futures contracts except: a. margin risk. b. basis risk. c. price risk. d. manipulation risk.

(b) 34. What action would the holder of a maturing call option take with an option which cost $300, had a strike price of $50 and the market value of the stock was $52? a. let the option expire unexercised b. exercise the option c. request that the $300 be returned d. none of the above

(a) 35. An European option is an option contract that allows the holder to a. exercise the option only on the expiration date b. exercise the option on or before the expiration date c exercise the option before the expiration date b. none of the above

ESSAY QUESTIONS

1. Explain how a savings and loan manager could use futures or options to hedge against the possibility that interest rates will rise.

Answer: The S&L manager likely faces a negative funding GAP and the S&L's net interest margin or equity value would be hurt if interest rates were to increase in the future. To hedge all or a part of its interest rate risk, the S&L manager would sell futures (T-Bill) or buy puts on T-Bill futures. The sale of futures establishes a gain in the futures if interest rates rise, locking in selling price for the futures, offsetting the "hurt" in the S&L. Buying put options on T-Bill futures provides one-way insurance for the price of the premium paid for the put. If interest rates increase (futures prices fall, put value increases). If interest rates fall, the futures loss would offset the gain in the "spot" or business. If interest rates fall, the puts are out of the money and the cost is the premium paid for the puts.

2. Explain how forward and futures markets differ.

Answer: A forward contract, between two parties (large bank and business), is negotiated for the specific amount needed. It is an off-the-exchange, negotiated contract. A futures contract, traded on an exchange, is a standardized contract on a quantity of a commodity or financial securities. The exchange is the counter party for buyer/sellers of futures contracts, requiring a margin down payment and daily settlement. The forward contract has a chance of default, whereas the futures contract does not. With only a few standardized futures contracts traded, one can seldom get a perfect hedge with futures, whereas a forward contract can hedge a transaction to the penny.

3. What determines where a futures buyer or seller is a hedger or a speculator?

Answer: A speculator in a derivative transaction has no "spot" interest in the underlying asset or buys/sells a quantity of derivatives contracts unlike his/her "spot" interest in the underlying asset. A hedger will buy/sell a quantity of derivative securities to match the underlying amount in the "spot" market. The hedger buys/sells so as to gain in the derivative securities if adverse price movement occur in the spot market.

4. What role does the SEC have in regulating option markets?

Answer: The SEC regulates any options on stocks, including stock index options, based on its regulatory authority of equity markets. The Commodity Futures Trading Commission does regulate any options on "equity" contracts.

5. A portfolio manager, managing a large portfolio of common stocks, has earned a respectable return by October, and would like to protect that return for the year. How might it "lock in" the portfolio return with trades in derivative securities?

Answer: The portfolio managed by the portfolio manager seems to be large and well diversified, so stock index futures (S&P 500) or options on stock index futures can be used to lock in their rate of return so far this year. Buying put options on S&P stock index futures (contracts approx. equal to portfolio) will establish a floor price for the portfolio and protect the return for the year for the price of premium paid for the put contract. If stock prices fall, the manager's "spot" exposure will experience a loss, but the value of the put options will increase, offsetting the loss in the portfolio.

CHAPTER 12

TRUE/FALSE QUESTIONS

(T) 1. If interest rates are higher in Japan than in the United States, the cost of a yen per U.S. dollar in the spot market will be higher than in the forward market.

(F) 2. A country's forward exchange rate will increase relative to its spot exchange rate when people expect it to have more inflation than other countries.

(T) 3. A weak U. S. dollar will lead to increased employment in the domestic economy.

(T) 4. Rapid economic growth of a country, relative to its trading partner nations, will cause its currency to depreciate.

(T) 5. In the balance of payments, he difference between current account flows and capital account flows is shown as statistical discrepancy.

(T) 6. A strong dollar would make imports cheaper, and force domestic producers of goods with import substitutes to lower prices.

(T) 7. Eurobonds are bearer bonds and do not have to be registered which makes them more marketable.

(T) 8. If a government buys domestic foreign exchange (currency) from foreigners, its exchange rate will rise.

(T) 9. Governments encourage long-term foreign investment in their countries because it helps their balance of payments.

(T) 10. A Canadian dollar cost $0.84 in U.S. dollars and later costs $0.86. The U.S. dollar has depreciated relative to the Canadian dollar.

(F) 11. If a Canadian dollar costs $0.83 in U.S. dollars, a U.S. dollar costs a Canadian $1.00 in Canadian dollars.

(F) 12. When the foreign demand for a country's goods and services increases, the demand for the foreign country's currency also increases.

(F) 13. Exports grow rapidly when the dollar cost of units of foreign currency decreases.

(T) 14. A "flight of capital" from a country would tend to reduce the value of the country's currency relative to other countries.

(F) 15. If a U.S. exporter agrees to receive payment in 60 days in pounds, the British importer has assumed the exchange risk in the transaction.

(T) 16. The demand for foreign exchange by an importer is a demand derived from a pending economic transaction.

(T) 17. If a country's inflation rate increases relative to its trading partners, then the country's Current Account balance is likely to decrease.

(T) 18. A deficit in the trade balance of payments puts downward pressure on the exchange rate.

(T) 19. In balance of payments accounting, a deficit in the Balance on Current Accounts prompts an offsetting surplus in accounts below the line.

(T) 20. If merchandise imports exceed merchandise exports, the trade balance is in a deficit position.

MULTIPLE-CHOICE QUESTIONS

(a) 1. Differences in real interest rates between countries produce the following type of capital flows. a. investment capital flows. b. political capital flows c. speculative capital flows d. capital flight

(b) 2. If a government wanted to promote exports and a trade surplus, it might institute all of the following policies except: a. Establish import trade barriers and quotas. b. Sell domestic currency in the foreign exchange markets. c. Provide low cost financing for export industries. d. Buy foreign financial assets.

(a) 3. A Detroit bank pays 6% for a $100,000 six-month certificate of deposit, while a Windsor, Ontario bank advertises a rate of 7.5%. If it costs approximately $50 in travel and forward contract commissions to invest in Canada, which CD should the Detroit investor take? Refer to the foreign exchange rates below. U.S. Equiv. Rates Canada (dollar) $0.8345 180 day Forward $0.8225

a. Make the U.S. CD investment. b. Make the Canadian CD investment. c. The investor is indifferent between the two because of interest parity. d. One is unable to make this calculation with the data provided

(a) 4. If a country experiences inflation, generally a. its forward exchange rate will fall relative to countries with lower inflation b. its exports will increase significantly. c. its interest rates will fall. d. the forward exchange rate will fall relative to all other countries.

(c) 5. If the spot rate on the Swiss Franc(SF) was $0.7900, and the 1-year forward rate was $0.8295/SF, one could profit by a. buying SF now and selling SF in the forward market whenever short-term rates sin the U.S. are at least 5% above those in Switzerland. b. selling dollars now and buying dollars in the future whenever short-term rates sin the U.S. are at least 5% above those in Switzerland. c. buying SF now and selling SF in the future whenever short-term rates sin the U.S. are less than 5% above those in Switzerland. d. selling SF now and buying SF in the future whenever short-term rates sin the U.S. are less than 5% above those in Switzerland.

(a) 6. Foreign merchants often conduct transactions in U.S. dollars because a. the dollar is a generally acceptable medium of exchange in international transactions. b. they don't have enough money of their own. c. interest rates on the dollar are higher than on their currency. d. inflation is higher in the United States.

(c) 7. If inflation in the United States is below that in Britain, one would expect a. U.S. imports from Britain to increase significantly. b. the United States would experience balance of payments problems in the future. c. the forward exchange value of the dollar to be higher relative to the pound than spot exchange rates. d. U.S. interest rates to be above British rates.

(d) 8. The United States can import more goods that it exports without experiencing a decline in its exchange rate if a. foreigners are buying more long-term investments in the United States than U.S. citizens are buying abroad. b. foreigners wants to hold additional dollars to help them mediate their financial institutions. c. foreign governments loan their excess dollars to the Unites States. d. all of the above

(c) 9. When a commercial bank issues a payment guarantee on behalf of an importer, that guarantee is a. a sight draft. b. a time draft. c. a letter of credit. d. a documented transfer.

(d) 10. A Japanese auto in 1995 was priced at $15,000 when a yen cost $0.00725. What is the cost today if the exchange rate stands at ¥135/$? a. ¥2,400,000 b. ¥2,025,000 c. $12,656 d. $17,778

(c) 11. When a firm adds international trade to domestic sales all of the following factors are added to the transaction except: a. foreign exchange rates. b. possible trade restrictions and regulations between countries. c. the price of the goods traded must be established. d. two legal and judicial systems are involved.

(a) 12. If a Canadian dollar costs $0.84 in U.S. dollars today and traded for $0.86 last year, the U.S. dollar a. has appreciated against the Canadian dollar. b. has depreciated against the Canadian dollar. c. has more buying power in England. d. none of the above

(b) 13. The Eurocurrency market serves as a place to store excess liquidity for multinational corporations, countries and individuals because of all of the following except: a. Lack of regulation allows investors to hold debt securities in bearer form. b. The presence of a withholding of tax. c. Investments earn higher returns. d. Eurocurrency deposits are highly liquid because of very short maturities with nearly 90 percent of deposits being less than 180 days.

(d) 14. Which of the following tend to keep exchange rates the same in all world markets? a. foreign exchange deals b. forward markets c. futures markets d. arbitragers

(d) 15. A. U.S. importer of English china would participate in which of the following in foreign exchange markets? a. supply dollars b. demand pounds c. supply pounds d. both a and b above

(d) 16. A foreign exchange transaction may be motivated by a. trade. b. speculation. c. flight of capital. d. all of the above

(c) 17. When a Balance of Payments trade balance is in a surplus position a. another trade or service account must balance it. b. the entire balance of payments will be in a surplus position. c. other accounts, or capital movements offset the surplus to provide a balance. d. a shift of capital must balance the trade surplus.

(d) 18. The characteristics of trade in the Current Account section of the Balance of Payments include(s) a. a flow of income in the period. b. non-reversible transactions. c. current flows that do not involve expectations of future rates d. all of the above.

(a) 19. A government that wants to promote domestic exports would take which action? a. buy assets (securities) abroad b. sell assets (securities) abroad c. buy dollars in foreign exchange markets d. impose severe import restrictions

(a) 20. An importer who must pay yen in 60 days may hedge the foreign exchange risk a. in the forward market. b. in the spot market today. c. in the spot market 60 days from now. d. all of the above
(d) 21. All but one of the following are factors associated with international trade not faced by domestic traders? a. One party in the trade has to be concerned about foreign exchange risk. b. No one legal authority has control over the transaction and legal remedies. c. Credit information on opposite parties is often incomplete. d. There is one currency involved.

(b) 22. French importers of U.S. merchandise may be involved in foreign exchange markets a. by demanding Euros in return for U.S. dollars. b. by supplying Euros in return for U.S. dollars. c. by demanding Japanese yen in return for dollars. d. by supplying U.S. dollars in return for Euros.

(c) 23. Foreign exchange rates are best described as a. the cost of a unit of foreign currency. b. the current interest rates of varying countries. c. the cost of a unit of foreign currency in terms of another currency. d. the expected change in prices of international goods.

(c) 24. Exchange rate risk is best described as a. the cost of a unit of currency in terms of another. b. the variability in the current accounts balance of the balance of payments. c. the variability of investment returns or prices of goods and services caused by changes in the value of one currency versus another. d. the difference between domestic and international interest rates.

(c) 25. If the cost of yen per dollar changes from 100 to 110 yen per dollar, a. The yen has appreciated against the dollar. b. The dollar has depreciated against the yen. c. The dollar has appreciated against the yen. d. the cost of a yen has increased in terms of dollars.

(a) 26. The action of foreign exchange _______ tends to keep exchange rates among different currencies consistent with each other. a. arbitragers b. traders c. brokers d. bankers

(d) 27. Exchange rates are influenced by a. trade flows. b. financial flows. c. governmental intervention. d. all of the above.

(c) 28. Significant trade deficits, imports exceeding exports, should have what effect on a country's exchange rate? a. Trade levels do not affect exchange rates. b. The country's currency should appreciate in value relative to their major trading countries. c. The country's currency should depreciate in value relative to their major trading countries. d. None of the above are correct.

(b) 29. From a trade basis, if U.S. trade deficits with Japan continues, and if U.S. inflation rates exceed that of Japan, a. the yen is likely to appreciate against the dollar moving from 110 yen per dollar to 120 yen per dollar. b. the yen is likely to appreciate against the dollar moving from 120 yen per dollar to 110 yen per dollar. c. U.S. interest rates will be less than comparable rates in Japan. d. the dollar is likely to appreciate against the yen.

(d) 30. All but one of the following are factors most likely to influence exchange rates? a. trade flows of goods and services b. financial capital flows c. governmental intervention d. An expansion in the number of traders of foreign exchange

(c) 31. If purchasing power parity existed in foreign exchange rates, a. foreign exchange rate will remain constant. b. the prices of goods and services will cost the same in terms of dollars everywhere in the world. c. the prices of goods and services will cost the same in each local currency. d. the prices of foreign exchange will be the same any where in the world markets.

(a) 32. If an item costs $5.00 in the U.S. and 525 yen in Japan, if purchasing power parity holds, what the yen/dollar exchange rate? a. 105 yen/dollar b. 525 yen/dollar c. 100 yen/dollar d. .0095 yen/dollar

(b) 33. If an item costs 4 Euros in Germany, assuming purchasing power parity with current exchange rates of $1.3135/€, what is the price of the item in the U.S.? a. $0.33 b. $5.25 c. $3.05 d. €4.00

(d) 34. A __________ draft would be paid on demand; whereas a bank would pay a __________ draft at maturity as stated in the __________. a. time; sight; bill of lading b. sight; time; bill of lading c. time; sight; letter of credit d. sight; time; letter of credit
(c) 35. A Mexican importer of computer parts from Canada would take which action in the foreign exchange markets? a. supply Canadian dollars b. demand pesos c. demand Canadian dollars d. none of the above

(b) 36. Capital accounts transactions may involve all of the following except: a. are made with the expectation of a future gain or to settle a debt. b. are reversible. c. represent a flow of income. d. represent a geographic repositioning of wealth.

(c) 37. A Detroit investor purchased a $100,000 Canadian dollar CD in Windsor 180 days ago at a rate of 7 percent. The Canadian spot rate was 1.367 C$/U.S.$ when the investment was made. The U.S. dollar cost of the investment was ________ and the total amount of Canadian investment was _________ Canadian $ after 180 days? a. 136,700; 107,000 b. $100,000; 107,000 c. $73,153; 103,500 d. $136,700; 103,500

(d) 38. With reference to the question above, if the U.S. investor had purchased a 180 day forward foreign exchange contract for 1.386 C$/U.S.$, what equivalent U.S. annual rate 180 days ago would have made the investor indifferent between a Detroit bank CD and the Windsor, Canada CD above? a. 5.23 percent b. 7.00 percent c. 3.50 percent d. 4.16 percent

(b) 39. A major reason that exchange rates do not adjust so purchasing power parity holds precisely is that a. investors are using forward contracts when trading. b. financial or capital flows may affect foreign exchange rates. c. consumers and businesses of each country are not concerned about the cost of goods in other countries. d. purchasing power parity is only a theory.

(b) 40. If the rate of inflation in the U.S. is twice the rate in Japan, a. purchasing power parity will not be attained. b. the yen/dollar exchange rate is likely to decrease. c. the yen/dollar exchange rate is likely to increase. d. the exchange rate will not change because inflation has no effect on exchange rates.

(b) 41. Investment flows from one country to another occur based on the investors' a. nominal rate of return on the foreign investment b. the expected real rate of return on the foreign investment. c. spot exchange rate when making the investment. d. the realized real rate of return on the foreign investment.
(a) 42. Under freely floating exchange rates a government would a. do nothing. b. sell assets to foreign investors for foreign exchange to buy the domestic currency. c. buy assets to foreign investors for domestic currency. d. intervene in the markets for the benefit of its exporters.

(d) 43. Which of the following is true about Eurobonds? a. They are underwritten by a multinational syndicate of investment banks. b. Eurobonds are bearer bonds and do not have to be registered which makes them more marketable. c. Interest or coupon payments are annual and are calculated on a 360-day year. d. all of the above.

(c) 44. With reference to international balance of payment accounting, if a country's merchandise imports exceed merchandise exports for a period, a. the country has a surplus in the balance on current account. b. the country has a deficit in the capital accounts for the period. c. the country has a deficit in the merchandise trade account. d. the country has a surplus in the merchandise trade account.

(d) 45. The balance on current accounts is a component of the balance of payments accounting for a. trade in merchandise goods. b. investment income. c. trade in merchandise services. d. all of the above.

(b) 46. Exchange rates are unlikely to change if a. the U.S. inflation rate is twice that of other developed nations. b. current account budget deficits/surpluses are offset by reverse capital flows. c. the current account deficits in the U.S. are offset by capital flows much larger than the current account deficit. d. central banks want them stable.

(a) 47. All but one of the following are associated with the reason that foreign exchange markets exist? a. to provide for efficient exchange between governments. b. in order to exchange purchasing power between trading partners with different local currencies. c. to provide a means for passing the risk associated with changes in foreign exchange rates to professional risk-takers. d. to accommodate credit extension and delayed payments for goods and services between countries.

(c) 48. Eurodollars are best associated with a. the use of dollar currency ($100 bills) in less-developed countries in Europe. b. the financing of Europeans by domestic U.S. banks. c. the holding of a dollar denominated bank deposit outside the U. S. d. the development of a common currency in Europe.

(c) 49. A U.S. commercial bank must pay C$20 Canadian dollars in 90 days. It wishes to hedge the risk in the futures market. To do so the bank should a. sell $20 million in Canadian dollar futures with two months maturity. b. buy $20 million in Canadian dollar futures. c. buy C$20 million in Canadian dollar futures. d. sell C$20 million in Canadian dollar futures.

(d) 50. Eurocurrency markets are a source of attractively priced working capital loans for multinational firms because: a. Lower regulatory costs allow lender to offer lower cost loans b. With minimum transactions starting at $500,000, economies of scale provide better pricing c. Lower costs of credit checking and other processing costs lowers lending rates d. all of the above

ESSAY QUESTIONS

1. Explain how and why the U.S. forward exchange rates are related to short-term interest rates in the United States and Germany.

Answer: Interest rate differentials between developed countries are reflected in the forward/spot differential, affected by covered interest arbitrage activities of investors.

2. Explain why a decline in a country's exchange rate will generally increase the demand for its goods and reduce its demand for foreign goods.

Answer: A decline in a countries exchange rate, the amount of a foreign currency purchased with a unit of domestic currency, makes foreign goods more expensive and a country’s exports more attractive to foreign consumers.

3. With reference to the concepts and terms related to the International Payments Flow (balance of payments), under which conditions could a country have a sizable deficit in its trade balance and still have an appreciating currency.

Answer: Such has been the case for the United States, which has an enormous trade balance deficit for years. That alone should decrease the value of the dollar relative to trading partners, but investors’ financial flows into the U.S. financial markets have, at times, more than offset the glut of dollars into forex markets from the trade deficit. Always consider the possible effects on “real” as well as “financial” flows and the impact upon forex values.

4. Increased U.S. inflation, relative to other trading partner nations, should have what impact on the value of the U.S. dollar? Explain thoroughly.

Answer: Increased U.S. inflation and higher U.S. prices relative to other trading countries, should decrease the value of the U.S. dollar as U.S. trade deficits (purchasing cheaper foreign goods) increase. One also must consider financial flows in and out of direct and financial investment in a country. The U.S. has had large trade deficit, but the dollar has remained strong as long as U.S. financial markets and estimated real rates of return in the U.S. attract foreign direct and financial investment.

5. List a number of reasons for the increased internationalization of financial markets in the last two decades.

1. The demise of fixed exchange rates in Eastern Europe and in Asia. 2. The revitalization of Eastern Europe. 3. The extraordinary budget and trade deficits of the United States since 2001. 4. The slow down of Japan’s growth being offset by the developing economies in Asia, Eastern Europe and Latin America. 5. The development toward a unified European Economic Community, a common central bank, and currency has begun to congregate a powerful economic force, especially since 2003. 6. The global trends toward financial deregulation. 7. The continuing integration of international product and service markets. 8. Improved telecommunications and computer technology leading to round the clock trading.

CHAPTER 13
TRUE-FALSE QUESTIONS

(F) 1. Banks which assume higher risk will always earn higher returns.

(F) 2. Banks operate under the same regulatory structure as any other financial services firms.

(F) 3. Banks usually pay low explicit interest rates on demand deposit accounts.

(T) 4. Savings deposits are a larger percent of funding for small banks, compared to large banks.

(F) 5. Most banks issue negotiable certificates of deposits.

(F) 6. Fed Funds purchased is an important short-term asset for large banks.

(F) 7. Eurodollars are dollar denominated deposits owned by foreigners.

(F) 8. Banks hold a substantial volume of low-risk corporate bonds because of their high yields.

(F) 9. The prime rate is the lowest loan rate offered by banks.

(F) 10. With interest rates expected to decrease in the future, banks would prefer to make floating-rate loans rather than fixed rate loans.

(F) 11. Demand deposits represent the largest deposit source of funds for commercial banks.

(T) 12. A bank's investment account provides liquidity and income.

(F) 13. Matched-funding loan pricing is a practical application of term structure.

(T) 14. Loan pricing must attempt a competitive rate of return on bank shareholder's equity.

(F) 15. Unlike loan sales, the originating bank continues to earn interest on its securitized loans.

(F) 16. Fed Funds sold represent an important source of borrowed funds for commercial banks.

(T) 17. Capital notes are a nondeposit liability of banks.

(T) 18. A sale of Fed Funds by a bank most likely represents a decrease in its excess reserves.

(F) 19. “Off-balance-sheet” activities are exempt from regulation.

(T) 20. A bank holding company might apply for a “financial” holding company status from the Fed if it were planning to purchase a life insurance company.

MULTIPLE-CHOICE QUESTIONS

(c) 1. The number of U.S. bank charters has been ___ but the number of branches has been __. a. rising/falling b. falling/stable c. falling/rising d. rising/rising.

(d) 2. Which is the ultimate goal of a commercial bank? a. long-term growth b. deposit growth c. bank safety d. long-term profit maximization

(c) 3. Which of the following is not characteristic of small banks compared to large banks? a. they have proportionally more fixed assets b. they have proportionally more agricultural loans c. they have proportionally less capital d. they have proportionally more deposits

(b) 4. The major form of organization for commercial banks in the U.S. is the a. partnership b. bank holding company c. single charter d. branch

(d) 5. The number of bank branches continues to increase because a. banks have sought to locate close to their customers. b. states have eased bank branching restrictions. c. state and federal bank regulators prefer branches to bank holding companies. d. "a" and "b"

(a) 6. While most U.S. commercial banks are ____, the ________ dominate in terms of assets. a. small; large banks. b. large; large banks. c. small; small banks. d. large; bank holding companies

(d) 7. The fastest-growing U.S. bank holding companies can attribute most of their growth to a. an increasing number of branches. b. the rapid growth of deposits from the growing number of households. c. improved technological financial innovation. d. merger of banks and bank holding companies.

(b) 8. Most of the assets of a commercial bank can best be described as a. real assets. b. the financial liabilities of deficit spending units in the economy. c. deposits from many sectors of the economy. d. reserves.

(a) 9. All but one of the following is a bank asset. a. fed funds purchased b. consumer loans c. deposits in other banks d. government securities

(c) 10. What balance sheet account of commercial banks is a component of M1? a. U.S. Treasury deposits b. deposits in other banks c. demand deposits d. certificates of deposit

(a) 11. The largest deposit source of funds for commercial banks is a. time deposits. b. demand deposits. c. U.S. Treasury deposits. d. interest-bearing transaction deposits.

(c) 12. Small banks tend to have more ________ and fewer ________ compared to large banks. a. transaction accounts; time deposits b. borrowed funds; capital stock c. time deposits; borrowed funds d. large time deposits > $100,000; transaction accounts

(b) 13. Small bank deposits in larger money center banks are called a. reserves b. correspondent deposits c. flexibility accounts d. fed funds

(a) 14. Which one of the following is not an interest-bearing deposit account? a. demand deposit b. NOW account c. savings account d. MMDA

(d) 15. Banks use the holding company form of organization for all the following except a. reducing taxes b. expanding geographically c. diversifying services d. complying with federal regulations.

(c) 16. Bank holding companies were first regulated in a major way in a. 1933 b. 1935 c. 1956 d. 1980

(a) 17. Bank holding companies are regulated by the a. Fed b. FDIC c. OCC d. FTC

(d) 18. Commercial banks are a. often subsidiaries of bank holding companies b. the largest category of financial institution c. the main transmitters of monetary policy d. all of the above

(d) 19. All but one of the following advantages of the bank holding company: a. economies of scale b. geographic diversification c. service diversification d. largely unregulated

(a) 20. All but one of the following are off-balance sheet activities of banks? a. repurchase agreements b. standby letters of credit c. loan brokerage d. securitization

(d) 21. Which of the following is not a borrowed fund account? a. Fed Funds purchased b. Eurodollars c. Banker's acceptances d. SLC

(c) 22. Repurchase agreements used for all following except a. corporate cash management. b. a source of funds for banks. c. to support loan brokerage activities. d. a method of paying interest to demand depositors.

(a) 23. Banker's acceptances are not a. foreign deposits accepted overseas by branches of American banks. b. drafts drawn on a bank by a corporation to pay for merchandise. c. used in international trade. d. a source of funds for large banks.

(c) 24. In general, which of the following bank investments has the least liquidity? a. T-bills b. Fed Funds sold c. municipal bonds d. T-bonds

(b) 24. Banks generate revenue from credit cards from all the following except a. merchant discount fees b. sale of credit cards c. annual fees from credit card customers d. interest from credit card balances

(d) 25. Which of the following describes bank trust operations? a. Trust operations involve banks acting in a fiduciary capacity b. Smaller banks tend to offer trust services through correspondent relationships c. A large portion of bank trust assets are managed for pension funds d. all of the above

(a) 26. Banks hold municipal bonds primarily for a. high after-tax yields. b. low default risk. c. high marketability. d. service to local communities.

(d) 27. While time deposits are banks' major source of funds, their major use is a. investments b. consumer loans c. demand deposits d. commercial loans

(d) 28. The Financial Services Modernization Act of 1999 permits a. Formation of financial holding companies b. Commercial banking and insurance in the same holding company c. Insurance and investment banking in the same holding company d. Any or all of the above

(b) 29. In a standby letter of credit, a. the bank establishes a liability. b. the bank substitutes its creditworthiness for that of its customer. c. the bank assures a loan applicant that credit will soon be granted. d. the bank pays a customer to guarantee the bank's obligations.

(d) 30. A bank expecting interest rates to rise in the future would prefer to make a. fixed-rate loans b. long-term, fixed rate loans c. floating-rate loans adjusted infrequently d. floating-rate loans adjusted frequently

(a) 31. All of the following are characteristic of bank borrowed funds except a. They are insured by FDIC. b. They are short-term money market sources of funds. c. They are an important source of bank liquidity. d. Some entail pledging collateral; others do not.

(c) 32. All of the following are sources of common equity capital for banks except a. capital stock b. undivided profits c. capital notes d. special reserve accounts

(c) 33. Using matched-funding pricing, the major factor determining the loan rate is a. competitive return to the bank's shareholders b. administrative costs of making the loan c. the interest rate on the funding source d. adjustment for default risk

(a) 34. In loan brokerage, the bank's spread is a. the difference between the rate earned by the bank and the rate paid by the bank b. the rate differential between the cost of funds and the loan rate. c. the discount of the loan at the Window d. the fee collected at the maturity of the loan

(c) 35. Banks invest in treasuries for all the following reasons except a. they are marketable b. they are liquid c. they provide capital d. they provide income

(d) 36. When a bank increases its fed funds sold, its deposit balance in the Fed will ; when a bank's deposit balance in the Fed increases, the bank has increased its fed funds . a. increase; sold b. decrease; sold c. increase; purchased d. decrease; purchased

(d) 37. A form of secured borrowing by banks is a. Eurodollars b. fed funds c. certificate of deposit d. repurchase agreement

(c) 38. Commercial banks borrow from their Federal Reserve Bank at the a. fed funds rate b. eurodollar rate c. discount rate d. repo rate

(a) 39. Which of the following is not a money market source of bank funds? a. common stock b. repurchase agreements c. commercial paper d. treasury bonds

(b) 40. The largest loan category for commercial banks is a. commercial loans b. real estate loans c. consumer loans d. agricultural loans.

(a) 41. All but one of the following is a balance sheet account associated with check clearing? a. Fed funds sold b. reserves at Federal Reserve banks c. balances at other banks d. cash items in the process of collection

(d) 42. Investment in Treasuries provides a. liquidity b. low default risk c. income d. all of the preceding

(c) 43. When Bank A buys fed funds from Bank B, a. the Fed increases one of their asset accounts and decreases the other b. Bank A posts an increase in its asset account, federal funds sold c. Bank B posts an increase in its asset account, federal funds sold d. the Fed increases the deposit accounts of both Bank A and Bank B

(b) 44. All but one of the following is associated with bank loan agreements longer than one year? a. term loans b. line of credit c. revolving credit d. mortgage loan

(c) 45. A bank loan manager who is expecting declining interest rate levels over the next several years would encourage loan originators to make a. variable rate loans. b. loans closely tied to the prime rate. c. fixed-rate loans. d. very short-term loans.

(d) 46. All but one of the following is more associated with the level of a bank's base lending rate: a. bank cost of funds b. the commercial paper rate c. competitor prime rates d. the federal reserve discount rate

(a) 47. Which of the following is least affected by an individual customer’s profile? a. base rate b. default risk premium c. term premium d. nonprice adjustments

(d) 48. A standby letter of credit (SLC) offers the bank a. a source of fee income b. a nondeposit source of funds c. a contingent liability d. “a” and “c”

(a) 49. When a bank is involved in loan brokerage, the bank is a. selling loan participations to investors. b. bringing loan customers together to share funds. c. originating loans, but not funding the complete loan. d. assisting customers in selling their real estate.

(b) 50. All but one of the following is associated with bank loan securitization activity? a. the bank provides credit enhancements. b. the bank provides the source of funds for the loan securitization. c. the bank originates the loans. d. the value of the securities sold to investors exceeds that of the securitized loans.

ESSAY QUESTIONS

1. Why has the bank holding company form of organization been so popular?

Answer: For many years the holding company form provided a way around restrictive branching laws and provided a means of operating non-bank financial subsidiaries. The BHC form also lowered the tax liability of banking organizations.

2. What are the major economic differences between bank loans and investments? Aren’t both intended to generate profits?

Answer: Investment securities provide some income at low risk and can be bought or sold at will. Loans provide higher income at higher risk and can be originated only upon application and qualification of a borrower.

3. What are the major economic differences between deposits and borrowed funds? Aren’t both intended to finance loans and investments cost-effectively?

Answer: Deposits are insured up to certain limits by the federal government, and increase or decrease as a function of a number of factors not controlled by the bank. Borrowed funds are borrowed at times and in amounts chosen by the bank, and are not insured.

4. How does regulation “tax” bank assets and liabilities?

Answer: Banks pay a “regulatory tax” in the form of federal deposit insurance premiums, foregone interest holding required reserves, and mandatory capital requirements exceeding what would be otherwise maintained.

5. Why can banks operate with so much more leverage (so much less equity capital) than ordinary businesses?

Answer: Banks are closely monitored by regulators for safety and soundness. The main operating liabilities of banks—deposits—are government-insured. The Federal Reserve System essentially guarantees the liquidity of banks. Ordinary businesses have none of these “credit enhancements”.

CHAPTER 14
TRUE/FALSE QUESTIONS

(F) 1. Banks need more liquidity than other businesses because of their large proportion of short-term assets.

(T) 2. Banks have lower capital ratios than industrial firms because bank assets are less risky.

(F) 3. Liability liquidity management suggests that banks hold Treasuries for liquidity.

(T) 4. Concentration ratios are utilized in managing the credit risk of an institution.

(T) 5. Liability management theory assumes certain types of highly rate-sensitive funding sources are always available if the bank pays the market rate or better.

(F) 6. Monitoring customer credit ratings is a commonly used loan workout technique.

(T) 7. A key performance ratio used to evaluate a bank's management is the ratio of net income to total average assets, often called ROAA.

(T) 8. Bank returns on average assets are normally lower than returns to average equity.

(T) 9. A bank that has increased its ROAA by increasing its risk-taking may find its stock price declining.

(T) 10. Banks with high capital ratios tend to have more stable returns to average equity (ROAE) than banks with low capital ratios.

(T) 11. Banks need liquidity for both deposit withdrawals and loan demand.

(T) 12. Banks face a liquidity/profitability trade-off in financial decisions.

(F) 13. A bank with a GAP will see its stock price fall if the Fed tightens monetary policy.

(T) 14. A zero duration gap immunizes a bank against interest rate risk.

(F) 15. Adequate liability liquidity has replaced the need for asset liquidity.

(F) 16. A high positive maturity GAP position is less risky than a high negative GAP position.

(T) 17. A bank with a negative maturity GAP will see a decline in earnings if interest rates fall.

(F) 18. Interest rate risk can reduce the earnings of the bank, but not its cash flow.

(T) 19. A bank with a high positive duration GAP will see a decline in value if interest rates rise.

(F) 20. A bank with a negative duration GAP can “macrohedge” by selling futures.

MULTIPLE-CHOICE QUESTIONS

(c) 1. Banks have greater liquidity needs than other types of businesses because banks have a. a high proportion of short-term assets. b. a low proportion of capital. c. a high proportion of short-term liabilities and outstanding lines of credit. d. large amounts of financial assets.

(b) 2. Banks are more subject to liquidity failures because they have a. low capital-to-asset ratios. b. a large proportion of short-term liabilities. c. a large proportion of short term loans. d. extensive short term investments.

(d) 3. Managing a bank’s maturity GAP is concerned with a. managing a bank's assets. b. managing a bank's liabilities. c. managing Federal funds. d. managing the relative levels of rate-sensitive assets and liabilities.

(b) 4. A bank with a high negative duration GAP can macrohedge its balance sheet by a. selling financial futures. b. buying call options on financial futures. c. reducing its rate-sensitive liabilities. d. swapping fixed-rate interest income for variable- rate interest income.

(d) 5. A bank with a high negative maturity GAP can hedge its interest rate risk by a. increasing its rate-sensitive assets. b. reducing the maturity GAP to zero. c. making more long-term, fixed-rate loans. d. both a and

(c) 6. Which of the following liabilities are not appropriate for liability liquidity management? a. negotiable CDS b. Federal funds c. demand deposits d. Eurodollar deposits

(b) 7. The bank will hedge the impact of changing interest rates on its equity value when: a. the duration of assets equals the duration of liabilities. b. the duration GAP of the bank is zero. c. the maturity GAP of the bank is zero. d. the duration of the loans matches than of the deposit sources.

(c) 8. Risk-based capital ratios measures are associated with which of the following bank risks? a. interest rate risk b. liquidity risk c. credit risk d. reinvestment risk

(b) 9. A match funding of a commercial loan with a large CD is an example of a. a macrohedge b. a microhedge c. increased interest rate risk d. short position

(a) 10. A bank would participate in a interest rate swap macrohedge in order to: a. widen the difference between cash-flow timing and repricing of assets and liabilities b. remove the difference between cash-flow timing and the repricing of assets and liabilities c. take advantage of an opportunity to maximize profits d. make up the profits lost by a deteriorating credit portfolio.

(d) 11. A bank can fail two ways: inadequate liquidity and a. inadequate reserves. b. inadequate liabilities to fund loans. c. inadequate loans. d. inadequate capital to absorb losses.

(a) 12. A major factor effecting changes in bank industry earnings is (are) a. changes in loan interest rates. b. competition from savings and loan associations. c. credit losses. d. variation in salaries paid.

(c) 13. The major sources of bank liquidity are and ; the major uses are and . a. loans and deposits; borrowed funds and selling assets b. borrowed funds and loans; deposits and selling assets c. selling assets and borrowed funds; loans and deposit withdrawals d. borrowed funds and loans; securities and deposit withdrawals.

(b) 14. Important characteristics of secondary reserves include a. low cost and immediate availability. b. excellent liquidity and interest earning. c. nonearning asset with immediate liquidity. d. high income with low risk.

(c) 15. Liability liquidity management assumes a. asset management has been utilized to the fullest extent possible. b. the bank is adequately capitalized. c. the bank can finance in money markets at will. d. primary and secondary reserves are sufficient for any liquidity needs.

(c) 16. A bank with a high positive maturity GAP position that has probably forecasted a. falling interest rates b. variable interest rates c. rising interest rates d. none of the above

(d) 17. Maturity GAP is defined as a. rate-sensitive assets divided by rate-sensitive liabilities. b. fixed-rate assets minus rate-sensitive liabilities. c. rate-sensitive liabilities plus rate-sensitive assets. d. rate-sensitive assets minus rate-sensitive liabilities.

(c) 18. A bank forecasting a recession is likely to: a. Increase its concentration ratios. b. expand its loans to new customers. c. decrease its concentration ratios. d. decrease its loan loss reserves.

(c) 19. All of the following are functions of bank capital except: a. to absorb losses. b. to provide a source of funds. c. to protect insured depositors. d. to maintain public confidence.

(b) 20. The adequate level of bank capital is related mostly to a. the level of deposits. b. the total level of risk, including asset risk. c. the types of assets held. d. the profitability objectives of the bank.

(b) 21. An important "finance" concept is the risk/return tradeoff. A similar tradeoff in banking is a. growth versus stability. b. profitability versus safety. c. regulation versus deregulation. d. federal versus state chartering.

(c) 22. The major source of bank revenue is _______ ; the major expense is ________. a. loan interest revenue; salary expense b. security interest revenue; deposit interest expense c. loan interest revenue; deposit interest expense d. Noninterest revenue; provision for loan losses

(d) 23. The management of bank capital refers to a. the ability to raise funds in the capital market. b. the extent to which a bank can lend to its customers. c. the human capital value of its employees. d. the amount of equity capital relative to the amount of risky assets.

(a) 24. A bank regulator reviewing a bank's risk asset level relative to equity capital is assessing a. bank solvency. b. bank liquidity. c. the quality of the loan portfolio. d. the GAP position of the bank.

(d) 25. A bank that is extremely liquid and solvent is likely to have a. a large proportion of short-term, marketable securities. b. a return on assets and equity well above average. c. a high capital to asset ratio. d. "a" and "c" above.

(d) 26. Which of the following is likely to adversely affect bank shareholder value? a. an increase in the required rate of return of shareholders. b. a decreasing ROAA over time. c. an increase in the variability in ROAA over time. d. all of the above.

(b) 27. Bank managers are likely to finance a consistent but continuing deposit withdrawal with a. purchase of federal funds. b. funds from maturing assets. c. borrowing from the Fed. d. new deposits.

(d) 28. All but one of the following may be classified as bank primary reserves? a. vault cash b. deposits at correspondent banks c. deposits at the Federal Reserve Bank d. Treasury bills

(d) 29. Which of the following may be classified as part of a bank's secondary reserve? a. deposits at correspondent banks b. short-term government agency securities c. Treasury bills d. "b" and "c" above

(b) 30. What is the major difference between securities held as secondary reserves and those held for investment? a. taxable versus tax-free b. risk, liquidity and maturity c. default risk d. issuer of the securities

(c) 31. A bank that emphasizes liquidity and safety is likely to have a. deposit outflows. b. frequent regulator examinations. c. a lower than average ROA. d. a high proportion of assets in loans.

(a) 32. Using liquidity sources from financing in financial markets is called a. liability liquidity management. b. asset liquidity management. c. demand deposit liability management. d. equity liquidity management.

(c) 33. Bank liability liquidity management is most likely carried out in the _________ market. a. capital b. mortgage c. money d. equity

(d) 34. When a bank lowers its interest rates it is likely to attract a. more demand deposits. b. more large, negotiable certificates of deposits. c. more securities. d. more loans.

(d) 35. Which answer below best describes why banks keep liquidity reserves against deposits? a. It is required by bank regulators. b. It is prudent banking business to keep liquidity reserves. c. The equity capital in a typical bank does not provide sufficient liquidity. d. "a" and "b" above.

(c) 36. A small bank in a rural area would spend a material percentage of its revenue on all of the following except a. interest paid on savings accounts b. salaries and benefits c. interest paid on “jumbo” negotiable CDs d. occupancy

(a) 37. With reference to the question above, the bank, if well-managed, probably has a. a higher net interest margin than a large money-center bank. b. a lower net interest margin than a large money-center bank. c. a lower proportion of secondary reserves than a large money-center bank. d. more “off-balance-sheet” activity than a large money-center bank.

(c) 38. Which of the following best describes the trend in bank total capital to total assets? a. Capital ratios have trended downward since the early 1960's. b. Capital ratios have increased steadily since the 1960's. c. After a lengthy decline since the 1960's, bank capital ratios have been increasing since the late 1980's. d. After a steady decline through the 1960's, bank capital ratios have been increasing since the early 1970's.

(d) 39. Which of the following best describes the reason for the recent increase in bank capital to asset ratios? a. Bankers realized that their decreasing off-balance sheet risk required more capital. b. Bank regulators increased the minimum capital requirements for banks. c. Financial markets and rating agencies demanded more capital for the increase in risk observed in banks. d. "b" and "c" together explain the reasons for increased capital ratios.

(b) 40. Which of the following best describes the current risk-weighted asset minimum capital policy of bank regulators? a. The amount of capital required is inversely related to the level of asset risk. b. The amount of capital required is directly related to the level of asset risk. c. The amount of capital required is directly related to the market value of equity capital. d. The amount of capital required is inversely related to the amount of off-balance sheet risk of the bank.

(c) 41. Bank regulators require minimum capital levels in banks because a. they are interested in maximizing the value of bank shareholders' equity. b. they are concerned about the failure of a bank. c. they are concerned about the failure of one bank undermining the confidence in all banks. d. bank regulatory agencies receive a proportion of bank capital each year to fund their operations.

(b) 42. Critically undercapitalized banks, according the asset risk-weighted minimum capital standards, a. are likely to be warned to increase their capital by FDIC. b. may be seized by the FDIC. c. must begin filing capital improvement plans with the FDIC. d. will begin to have asset growth restricted by FDIC.

(b) 43. The management of bank interest rate risk has become more important because a. regulators are concerned about interest rate risk. b. of increased interest rate variability in financial markets. c. the banks are deriving a greater proportion of their revenue from interest revenue. d. the proportion of interest-bearing liabilities has been decreasing over time.

(d) 44. GAP analysis of future cash flows and their repricing is an attempt to measure a. price risk. b. default risk. c. purchasing power risk. d. reinvestment risk.

(d) 45. Maturity GAP is defined as a. RSA + RSL b. RSA divided by RSL c. RSL - RSA d. RSA - RSL

(d) 46. Which of following will not be repriced in the next 180 days? a. a 90 day Treasury bill b. the interest received next month from a five-year Treasury note c. the principal and interest on a three-year auto loan received over the next five months d. the interest received in eight months from federal funds sold.

(c) 47. A bank with a cumulative maturity GAP to 90 days of +100 must have a _________ GAP of _______ in the next 30 days to have its funding GAP hedged at 120 days? a. positive; 100 b. negative; 200 c. negative; 100 d. positive; 30

(c) 48. Small banks tend to have a greater proportion of operating income from _________, and a greater proportion of __________ expense. a. provision for loan losses; securities b. loan revenue; interest c. securities; salaries and wages d. other noninterest income; provision for loan loss

(c) 49. A speculating bank, which is estimating increases in interest rates, would position itself with a ______ maturity GAP. a. negative b. zero c. positive d. secured

(c) 50. Increased bank profitability in the late 1990's was the result of a. increased provisions for loan losses. b. declining salary and wage levels. c. declining interest rates, negative maturity GAPS and reduced loan loss provisions. d. decreased noninterest revenue costs.

ESSAY QUESTIONS

1. Banks are more apt to fail than other forms of business. Do you agree? Discuss.

Answer: The banks’ role of providing credit and liquidity to local customers can spell trouble for the single bank if the local economy deteriorates or if its customers demand liquidity (cash) immediately. Loan diversification, the presence of a lender of last resort to aid in liquidity crises, and deposit insurance to prevent bank runs are all factors in reducing bank failures.

2. Discuss the concern regarding bank profitability, solvency, and liquidity from the shareholder, depositor, and regulator perspective. How are these similar? Dissimilar?

Answer: All stakeholders are interested in a going concern with adequate capital, liquidity and profitability. When one leg of the “profitability-solvency-liquidity” stool is broken, or if one stakeholder group is favored over another, problems result. Shareholders and managers, interested in high returns, may take more than reasonable risk, threatening solvency and depositor and the public’s interest. Over-regulated, highly capitalized banks will please depositors, but not shareholders.

3. Discuss the major sources and use (needs) of bank liquidity. Why do liquidity and profitability often involve a trade-off?

Answer: The major use or need for liquidity comes from loan demand or deposit withdrawal, while the major source of liquidity derives from the ready convertibility of certain assets to cash (asset management) or access to money markets (liability liquidity). Liquidity compromises profit maximization in that the most liquid assets typically yield well below the required rate of return to shareholders. Risk-taking in pursuit of return compromises liquidity in that the highest-yielding assets typically embody less liquidity. Thus liquidity management is essentially a constraint-optimization exercise in which the bank seeks the minimum liquidity consistent with operational stability and regulatory compliance.

4. Explain the role that bank secondary reserves play in liquidity management.

Answer: Secondary reserves provide high liquidity and some income, offsetting some of the opportunity cost of maintaining liquid assets against loan demand or deposit withdrawal occurs.

5. Define maturity GAP. If interest rates are expected to rise in the future, how should bank management adjust the GAP between its assets and liabilities?

Answer: Maturity GAP is the difference in the amount of rate-sensitive assets and rate-sensitive liabilities. If interest rates are expected to rise in the future, and if the bank wishes to gamble on its interest rate forecast, a positive maturity GAP of more rate-sensitive assets than liabilities will provide for increased margins on the GAP if interest rates increase. For the GAP amount interest rate yields will increase while the fixed financing cost remains the same.

CHAPTER 15
TRUE-FALSE QUESTIONS

(T) 1. IBFs may be established by a U. S chartered depository institution, a U. S. branch or agency of a foreign bank or the U. S. office of an Edge Act Corporation.

(F) 2. The Edge Act of 1919 permitted U.S. banks to create international banking facilities.

(F) 3. U.S. bank regulators allow U.S. banks overseas to engage in all banking activities allowed by the host country.

(F) 4. Representative offices can accept deposits and make loans in the host country.

(F) 5. Foreign branches of U. S. banks are subject to both the host nation’s regulations and the regulations in the U. S.
(F) 6. International banking facilities (IBFs) operate as subsidiaries of bank holding companies.

(T) 7. Edge Act corporations can engage in some types of equity investments.

(T) 8. An international loan syndicate is a risk reduction technique.

(F) 9. Expropriation and nationalization are two methods of guaranteeing payment of U.S. bank loans to developing countries.

(T) 10. Until the passage of the International Bank Act of 1978, foreign banks enjoyed substantial operating advantages over domestic banks.

(T) 11. Pooling risk entails lending by several banks to a foreign borrower.

(T) 12. Foreign branches of U.S. banks evolved in the 1960s as a reaction to capital flow regulations in the U.S.
(T) 13. Shell branches pay no local taxes and generally operate in relatively stable political environment.

(T) 14. U.S. banks have been permitted to engage in a wider range of business activities in foreign countries than at home in order to be competitive with foreign banks.

(F) 15. Representative offices are usually established to coordinate business between domestic and foreign banks.

(T) 16. Shell branches are developed for international money market transactions without contact with the public of the host country.

(F) 18. IBFs collect small domestic deposits and make foreign loans.

(T) 19. Sovereign loans to LDCs are usually rescheduled rather than foreclosed.

(F) 20. Pooling and third-party guarantees are two methods of reducing international currency risk.

MULTIPLE-CHOICE QUESTIONS

(d) 1. Which of the following is not a reason for the rapid expansion of U.S. banks overseas? a. the establishment of the Edge Act b. overall expansion of U.S. world trade c. the growth of multinational corporations d. the International Bank Act of 1978

(d) 2. All but one of the following is a reason why American banks expanded their international activities. a. the growth of U.S. based multinational corporations b. the expansion of U.S. world trade c. regulatory restrictions in U.S. banking markets d. the World Bank provided assistance to expand globally.

(c) 3. The major area of lending by the foreign branches of U.S. banks is associated with a. Japan. b. United Kingdom. c. Bahamas and British West Indies. d. Canada.

(a) 4. Unlike the United States, many countries grant their banks the authority for a. full merchant banking. b. deposit banking. c. forming bank holding companies. d. lending to foreign companies and countries.

(c) 5. While country central banks have pursued their own country interests, recently under the framework of the Bank for International Settlements, central banks from leading economies have agreed to a. allow international banks to branch throughout every country involved. b. stabilize interest rates. c. establish minimum capital ratios for international banks. d. maintain fixed exchange rates.

(c) 6. All but one of the following is associated with U.S. regulation of international banking? a. Federal Reserve Act of 1913 b. Edge Act of 1919 c. National Banking Act of 1863 d. International Banking Act of 1978

(b) 7. Which of the following forms of international banking organization is associated with interbank money market transactions? a. representative office b. shell branch c. Edge Act corporation d. international banking facility

(c) 8. Which of the following forms of international banking organization is associated with providing a complete range of international banking services associated with foreign trade to domestic banks. a. international banking facility b. shell branch c. correspondent bank d. Edge Act bank

(a) 9. Which of the following forms of international banking organization is an extension of a domestic bank but is located in a foreign country? a. foreign branch b. shell branch c. representative office d. international banking facility

(d) 10. Which of the following forms of international banking organization is a separate federal corporate charter to operate international banking business including equity investments? a. international banking facility b. foreign branch c. correspondent bank d. Edge Act bank

(a) 11. Which of the following forms of international banking organization is a separately incorporated bank owned entirely or in part by a U.S. bank or bank holding company? a. foreign subsidiary bank b. international banking facility c. Edge Act bank d. shell branch

(c) 12. Which of the following forms of international banking organization was intended to bring offshore, shell banking back to the U. S.? a. Edge Act banks b. correspondent bank c. international banking facility d. foreign subsidiary bank

(c) 13. International bank lending is characterized by all of the following except that loans a. are unsecured. b. have floating rates. c. are made for relatively small amounts. d. are priced relative to the LIBOR.

(d) 14. Most of the largest banks in the world are based in a. the United States. b. France. c. Germany. d. Japan.

(a) 15. Among the largest banks in the world, the banks from _________ have the lowest risk-based capital ratios. a. Japan b. the United States c. Germany d. Netherlands

(b) 16. International lending based from the LIBOR rate with a rollover-pricing feature protects the bank from a. liquidity risk. b. interest rate risk. c. default risk. d. solvency risk.

(b) 17. A loan syndication is similar to a. loan securitization. b. investment banking underwriting syndicates. c. defaulting on a loan. d. having a mortgage on specific asset to support the loan.

(b) 18. An international lender's concern about the changing tax rate on interest income from an international loan is an example of a. credit risk. b. country risk. c. foreign exchange risk. d. reinvestment risk.

(b) 19. All but one of the following is an example of country or sovereign risk in international lending? a. profit controls b. loan default by borrower c. nationalization of borrower d. a new political party now controls the government

(c) 20. Which of the following is associated with the currency risk of international lending by a U.S. bank? a. The Spanish borrower is slow to pay the U.S. bank. b. The U.S. bank is paid dollars by its foreign borrowers. c. A U.S. bank expects to receive an interest payment from a French borrower paid in French Francs. d. A U.S. bank holds a mortgage on property in a country in the middle of a civil war.

(d) 21. The LIBOR is: a. an interbank lending rate. b. an index rate used to price many international loans. c. the highest yield available on time deposits in international banks. d. both a and b

(d) 22. Which of the following factors is an important consideration in international lending? a. credit risk b. country risk c. currency risk d. all of the above

(c) 23. International floating rate bank loans are funded by a. relatively long-term time deposits because the loans have long maturities. b. syndicated demand deposits. c. short-term time deposits. d. cash flows from loan interest and principal.

(d) 24. A U.S. bank loan to a Mexican manufacturer payable in pesos accepts which risks? a. country risk b. credit risk c. currency risk d. all of the above

(a) 25. The rescheduling of troubled international loans involves all of the following except a. the separation of larger loans into several more, smaller loans that are easier to repay. b. the extension of governmental guarantees to private sector debts. c. the granting of grace periods, which defers payment for a time. d. the extension of the payment date.

(d) 26. The 1978 International Bank Act a. prohibited foreign banks from establishing any new U.S. banking operations. b. allowed U.S. banks to engage in a wider range of non-banking activities overseas. c. allowed U.S. banks to take equity positions in overseas business ventures. d. reduced the competitive advantage of foreign banks over U.S. banks.

(c) 27. All of the following are risk reduction techniques which reduces the impact of risk-taking except a. foreign government guarantees of loans to private corporations. b. pooling risk through syndication with other banks. c. loan sales, which removes the troubled loans from the balance sheet. d. diversification.

(a) 28. A representative office a. can assist the parent bank's customer only in that country and cannot accept deposits or make loans. b. can only accept deposits and cannot make loans. c. can both accept deposits and make loans. d. can engage only in money market transactions.

(b) 29. The development of foreign banking activities in the 1960s was prompted by all of the following U.S. regulations that restricted U.S. capital flows abroad except: a. Foreign Direct Investment Program (FDIP) b. Agricultural Export Restraint Program (AERP) c. Interest Equalization Tax (IET) d. Voluntary Foreign Credit Restraint program (VFCR)

(d) 30. All but one of the following is true about International Banking Facilities (IBFs) a. may be established by a U. S chartered depository institution, a U. S. branch or agency of a foreign bank or the U. S. office of an Edge Act Corporation. b. represent the balance sheet of the aggregated foreign assets and liabilities by the IBF. c. Deposits over $100,000 can be accepted from non U. S. residents or other IBFs. d. Deposits generated can be used to make domestic loans only.

(c) 31. Most U.S. foreign bank operations have been limited by regulation to lending and not controlling equity investments because of a concern for a. bank safety. b. promoting competition. c. keeping banking and other business activity separate. d. protecting bank depositors.

(a) 32. An initial foothold entry into international banking is a(n) a. representative office. b. branch bank. c. Edge Act corporation. d. IBF.

(b) 33. The international banking market, in terms of size, is dominated by banks from a. the United States. b. Japan. c. West Germany. d. Great Britain.

(d) 34. A foreign branch office of a U.S. bank is regulated by: a. U.S. bank regulations b. the host country bank regulation. c. the FDIC. d. both a and b

(d) 35. An Edge Act bank may a. be located in the United States outside a parent's own state. b. own foreign banking subsidiaries. c. engage only in international banking activities. d. all of the above

(e) 36. A loan made by a U.S. bank to a foreign private corporation guaranteed by the host government and payable in dollars has what risks associated with it? a. bank risk b. country risk c. foreign exchange risk d. all of the above. e. both a and (c) above.

(c) 37. U.S. banks reduce their risk in foreign operations by a. seeking guarantees from borrowers. b. FDIC insurance. c. portfolio diversification. d. insurance through the International Monetary Fund

(b) 38. The purpose of the International Banking Act of 1978 was to a. return the competitive edge to U.S. banks. b. return competitive equality between domestic and foreign banks. c. slow down the competitiveness of foreign banks. d. none of the above

(d) 39. A U.S. bank with a loan to a Japanese manufacturer can reduce its currency risk associated with the loan by a. requiring that the payments be made in yen. b. speculating in yen futures. c. having the borrower seek third-party assistance. d. hedging the risk in yen futures.

(c) 40. Default or credit risk on international receivables is reduced when the receivables are guaranteed by an organization of insurance companies called the a. Overseas Private Investment Corporation. b. World Bank. c. Foreign Credit Insurance Association. d. Receivables Assurance Association.

(a) 41. International participation loans is a method of reducing the _________ risk of a international lender? a. credit b. currency c. interest rate d. country

(c) 42. International loan diversification is enhanced if the historic realized rates of return on loans from loan applicant, Country A, a. have a high positive correlation with prior loans from Country A. b. have a high positive correlation with the historic country returns of the international loan portfolio. c. have a low negative correlation with the historic loan returns from the international loan portfolio. d. have a very low negative correlation to the returns on U.S. Treasury bonds.

(c) 43. A U.S. bank is owed $10 million in interest from the Mexican government organization in 90 days. What is the more likely action taken by a currency risk manager? a. The Mexican manager will sell U.S. dollars in a 90-day forward contract. b. The U.S. bank will buy peso in a 90-day forward contract. c. The Mexican manager will buy U.S. dollars in a 90-day forward contract. d. The Mexican manager will buy a peso 90-day forward contract.

(a) 44. With reference to the question above, if the Mexican manager thought that the value of the peso would fall in the next 90 days, he would choose which of the following to hedge his foreign currency risk? a. Buy U.S. dollars in a forward contract. b. Wait 90 days and buy U.S. dollars in the spot market. c. Buy a U.S. dollar T-bill now. d. "b" and "c" above.

(b) 45. A U.S. bank has just extended a U.S. $10 million to a Canadian firm at the rate of U.S. prime plus 2 percent, payable in U.S. dollars, one year from now. The current Canadian dollar/U.S. dollar is 1.367. With a prime rate of 7 percent, what is the amount of interest paid in a year? a. C$ 1,230,300 b. $ 900,000 c. $ 700,000 d. C$ 658,376

(c) 46. A multinational firm can borrow 5 million Canadian dollars from a Canadian bank at 9 percent for one year and the same in U.S. dollars at a Detroit bank at 8 percent. With a current C$/$ exchange rate of $1.345, what forward contract rate would make the borrower indifferent between the two loans? a. 1.345 b. 1.324 c. 1.357 d. 1.362

(a) 47. With reference to the question above, if the C$/U.S.$ one year forward rate contract was priced at 1.344, which loan was more favorable to the borrower? a. The cost of the loan from the U.S. bank is lower. b. The cost of the loan from the Canadian bank is lower. c. The borrower is indifferent between the two at the forward rate of 1.344. d. The solution cannot be calculated from the information above.

(c) 48. All but one of the following is directly related to the level of loan rate charged on an international loan? a. The cost of gathering information about the borrower. b. The level of country risk. c. The size of the borrowing business. d. The credit risk of the borrower.

(a) 49. All but one of the following relates to rescheduling activities of a troubled sovereign loan? a. Shortening the repayment schedule. b. The consolidation of several loans into one. c. The extension of governmental guarantees to private business debt. d. The granting of a grace period, during which no payment is expected.

(b) 50. Which of the following is related to currency risk in an international lending situation? a. late interest payments on a loan by a foreign borrower. b. increased exchange controls limiting the payment of interest on a loan. c. the government officials have been voted out of office by a party that may impose exchange controls. d. the LIBOR rate is increasing, increasing the odds that the borrower will be unable to meet their obligations.

(a) 51. The Foreign Credit Insurance Association (FCIA) is an organization of U.S. insurance companies which a. insures the foreign lending (trade credit) risk of exporters. b. insures the foreign lending (trade credit) risk of importers. c. insures bank loans made to developing nations. d. assures that foreign exporters will pay their trade credit.

(c) 52. All but one of the following is true about shell branches set by U.S. banks: a. they conduct limited inter-bank money market transaction rather than retail public branches. b. they do foreign exchange transactions and limited loan participation in Eurocurrency markets. c. they pay local taxes. d. all of the above are true

(d) 53. All but one of the following is true about The International Banking Act of 1978. a. permitted federal chartering of foreign banking facilities. b. limited ability of foreign banks of accepting interstate deposits. c. Allowed the Fed to impose reserve requirements on foreign banks. d. gave the Federal Reserve Bank the authority to oversee the activities of foreign institutions in the U.S.

(d) 54. Risk evaluation in international lending involves which of the following a. an analysis of both the borrower and borrower's country b. a statistical analysis of the country’s political and economic risks. c. a financial analysis of the borrower is also conducted. d. all of the above

(c) 55 All but one of the following causes country risk to increase. a. expropriation b. nationalization c. elimination of currency controls. d. Change of government

ESSAY QUESTIONS

1. What risks are involved in international lending? What methods do banks have to reduce these risks? Explain.

Answer: In addition to credit risk, international lending involves possibly foreign exchange risk and country or political risk, which includes regulations, taxation, and other legal restrictions that may cause the actual return on a loan to be different than expected.

2. List the various organizational forms to deliver international banking services?

Answer: representative offices, shell branches, correspondent banks, foreign branches, Edge Act corporations, foreign subsidiaries and affiliates, bank consortia and international banking facilities.

3. Explain the “rollover pricing” feature of LIBOR lending?

Answer: The LIBOR or London Interbank Offered Rate is the interbank lending rate between banks in London. A bank customer will usually pay a premium, based on credit risk for a period of time. At the end of the period, the loan may be “rolled over,” and be re-priced for the new period. With frequent reprising banks can make intermediate term loans with exposure to interest rate risk.

4. List several ways that banks reduce the risks of international lending.

Answer: Banks may use third-party help, which may provide loan guarantees from governments or the Foreign Credit Insurance Association. Political risks are reinsured through the U.S. Export-Import Bank. The Overseas Private Investment Corporation offers insurance against risk of war, expropriation and currency inconvertibility. Banks may pool risks through loan participations and other diversification efforts to spread credit risks geographically, by country, and type of industry.

5. What was the primary reason US banks began to develop overseas operations after World War II?

Answer: U.S. banks followed U.S. corporations as trade began to develop after World War II. The businesses required financial services, credit and assistance with international trade.

CHAPTER 16
TRUE/FALSE QUESTIONS

(F) 1. Bank failures are now treated as a remote contingency at best.

(T) 2. Regional and industry recessions were and still are a major cause of bank failures.

(T) 3. The Comptroller of the Currency is the oldest bank regulatory agency.

(T) 4. Traditional level-premium deposit insurance encouraged excessive risk-taking.

(T) 5. Federal deposit insurance has prevented widespread bank panics.

(F) 6. The FDIC charters many state banks.

(T) 7. All state banking authorities have the power to charter banks.

(F) 8. The FDIC generally prefers to just pay off depositors of a failed bank.

(F) 9. A "too big to fail" policy encourages small banks to take higher risks.

(T) 10. Private deposit insurance has not proven effective in preventing depositor panic.

(F) 11. In a clean bank purchase and assumption, the FDIC retains a "put" option to return bad loans to the acquiring bank.

(F) 12. The American public has determined that the market is an adequate regulator of banks.

(T) 13. Banks are regulated in part to protect the nation's money supply, much of which is a liability of the banking industry.

(T) 14. A role of the central bank is to provide liquidity and prevent panic.

(F) 15. Bailout of large banks by federal regulators is an example of market discipline.

(F) 16. The Federal Reserve System controls the money supply and is not a bank regulator.

(F) 17. Regulators have eliminated moral hazard in large bank and thrift firms.

(T) 18. The Glass Steagall restrictions separating investment and commercial banking were finally repealed in 1999.

(T) 19. In a purchase and assumption, the acquiring bank assumes all deposits in the failed bank.

(F) 20. Safety and soundness regulations promote price competition among banks.

MULTIPLE-CHOICE QUESTIONS

(d) 1. Which of the following has influenced U.S. banking structure? a. concern for concentrated financial power b. historical experience with bank failures and panics c. states vs. federal authority d. all of the above

(c) 2. Innovation around regulation followed by new regulation to offset the innovation is a. moral hazard. b. the innovation cycle. c. the regulatory dialectic. d. securitization.

(a) 3. Regulations provide financial institutions certain benefits such as a. reducing the chance of failure. b. increasing the cost of funds. c. increased labor cost to comply with regulations. d. increased profit from the added compliance costs.

(d) 4. Insurance or a guarantee to cover losses may create a moral hazard a. which is an increase in the chance that a random accident will occur. b. which is an incentive to decreased risk-taking by the insured. c. which is an incentive to increase risk-taking by the insurance authority. d. which is an incentive to increase risk-taking by the insured.

(b) 5. Deposit insurance with constant proportional premiums has a. prevented bank failures. b. created a moral hazard associated with increased risk assumption. c. helped large banks at the expense of small banks. d. charged increased premiums for increased risk.

(c) 6. All but one of the following is a purpose of regulating financial institutions: a. to provide stability of the money supply b. to serve certain social objectives c. to reduce barriers to entry d. to offset the moral hazard incentives to protect the deposit insurance fund

(c) 7. While an individual bank's illiquidity may cause a bank ______, a general loss of faith in banks' ability to pay is called a _______. a. loss; run b. panic; run c. run; panic d. payoff; regulatory dialectic

(a) 8. An individual bank ______ may produce a general bank _______. a. run; panic b. panic; run c. sale; merger d. regulation; legislation

(c) 9. Regulations limiting risk taking of financial institutions are imposed because a. the costs of regulation exceeds the benefits. b. the private costs of failure exceed the social costs of failure. c. the social costs of a general bank failure exceed the private costs to shareholders. d. risk is harmful.

(b) 10. All but one of the following is associated with bank failure: a. banks hold illiquid assets and reserves that are but a fraction of total deposits. b. assets may rise in value more quickly than liabilities when interest rates change. c. excessive loan losses may erode net worth. d. asset values fall below the value of liabilities.

(c) 11. Which of the following is not a regulatory offset to the moral hazard of deposit insurance? a. risk-based capital standards. b. risk-based deposit insurance premiums. c. truth-in-lending regulations. d. safety and soundness examinations.

(c) 12. The maximum amount of FDIC deposit insurance per eligible deposit account is a. $25,000 b $50,000 c. $100,000 d. $150,000

(d) 13. The original purpose of deposit insurance was to a. prevent bank runs by large depositors. b. increase the regulatory monitoring of banks. c. force the banks to invest in less risky investments. d. prevent bank panics by insuring the small deposits of many people.

(a) 14. All but one of the following has deposit insurance for its customers: a. bank holding companies b. credit unions c. commercial banks d. savings and loan associations

(c) 15. Most of the banks in the U.S. are _________ chartered, __________ of the Federal Reserve System and are insured by the _________. a. state; members; OTS-SAIF b. national; members; OCC-BIF c. state; nonmember; FDIC-BIF d. national; member; FRB-BIF

(d) 16. In a purchase and assumption of a failed bank, the ________ purchases the ________ of the failed bank and assumes its ________? a. FDIC; charter; deposit liabilities b. FDIC; assets; loan payments c. assuming bank; deposits; assets d. assuming bank; assets; deposit liabilities

(b) 17. The FDIC's use of purchase and assumption resolution of failed banks has resulted in de facto 100 percent deposit insurance because a. all accounts up to $100,000 have been paid off by the FDIC. b. the assuming bank assumes all deposits of the failed banks. c. the assuming bank assumes all deposits up to $100,000. d. the large accounts above $100,000 are assumed by the FDIC.

(b) 18. The FDIC pays off on a failed bank. Assets are worth $100 million. Deposits of $100,000 or less total $60 million. Uninsured deposits and other unsecured liabilities total $80 million. What proportion of uninsured deposits will be recovered by depositors? a. 60% b. 50% c. 40% d. 100%

(a) 19. With reference to the question above, what proportion of the stockholders' claim of $10 million will be realized in the FDIC payoff? a. 0% b. 10% c. 50% d. 100%

(b) 20. In a purchase and assumption of a failed bank, an assuming bank may be required to invest funds for all but one of the following reasons: a. acquire the sound assets of the failed bank b. acquire the deposit liabilities c. pay a premium for the intangible value of the bank d. infuse sufficient cash to provide adequate capitalization.

(c) 21. Nonfederal deposit insurance arrangements have failed primarily because a. not all banks participated. b. the amount of the deposit funds were not adequate. c. there was never a "deep pocket" backing such as the Federal Reserve System to prevent bank panics in the first place. d. the FDIC worked hard to undermine the confidence in the nonfederal insurance arrangements.

(d) 22. Bank failures are considered to be more important to the economy because a. failure of a single bank induces fear about the solvency of other banks. b. they reduce the money supply in the economy. c. a large number of people in a community lose their liquid wealth. d. all of the above

(b) 23. Which bank regulatory agency regulates bank holding companies? a. the Comptroller of the Currency b. the Federal Reserve System c. the FDIC d. individual state agencies

(b) 24. The moral hazard problem of federal deposit insurance is most associated with: a. the competitiveness of financial services markets. b. the incentives of managers. c. the high salaries paid to managers. d. the fear of loss by most depositors.

(a) 25. Which bank regulatory agency charters national banks? a. the Comptroller of the Currency b. the Federal Reserve c. the FDIC d. individual state agencies

(a) 26. Federal deposit insurance has a. prevented bank depositor panics, but not bank failures. b. prevented bank panic and bank failures. c. prevented bank failures, but not bank depositor panic. d. not prevented bank depositor panics, but has eliminated bank failures.

(d) 27. Financial institutions are regulated for the following reason(s): a. they provide essential financial services to consumers and businesses. b. there is a need to control the money supply. c. government has promised to insure deposits. d. all of the above

(d) 28. Moral hazard incentives for undesirable manager behavior may have been created by a. a "too big to fail" policy. b. a flat proportional premium charge to banks and thrifts for deposit insurance. c. regulatory accounting practices, which inflated capital ratios. d. all of the above

(c) 29. Private or state deposit insurance funds have not successfully prevented panic because a. the size of the funds was more than enough to pay all depositors. b. they overcharged the institutions on their premiums. c. they did not have a "deep pocket" with unlimited borrowing power like Congress behind them. d. the regulation of the depositors was not as restrictive as it should have been.

(d) 30. The most significant cause of bank failure today is: a. bank depositor panics. b. economic recession. c. insufficient bank regulation. d. fraud, embezzlement, and poor management practices.

(c) 31. All of the following are reasons to regulate depository institutions except: a. To promote safety and soundness. b. To affect the structure of banking. c. To make sure bank capital ratios are competitive. d. To protect the interest of consumers.

(c) 32. Regulatory balance sheet restrictions are designed to a. encourage high risk-taking by proper diversification. b. limit proper diversification. c. limit risk-taking and encourage diversification. d. limit the size of depository institutions.

(c) 33. The experiences of the early 1930s taught bank regulators to respond to widespread economic panic with a. restricted bank liquidity and increased bank capital requirements. b. increased availability of liquidity and interbank guarantees of deposits. c. increased availability of liquidity and federal guarantees for bank deposits. d. restricted money supply and lowered interest rates.

(c) 34. Most U.S. banking regulation focuses on a. price control b. consumer protection c. safety and soundness d. workplace safety

(c) 35. The purpose of a bank examination is to a. verify the bank's financial statements according to generally accepted accounting principles. b. maintain proper control of the bank by FDIC. c. promote and safety, soundness, and compliance with regulations. d. make sure the bank is not taking any risk.

(b) 36. The presence of moral hazard incentives a. reduces the need for close regulatory supervision. b. increases the need for more regulations, examinations, and regulators. c. reduces the church attendance rate of bank managers. d. increases the role of markets in disciplining excessive risk-taking.

(d) 37. If the cost of an FDIC insurance payoff is $20 million and the cost of the financial assistance for a purchase and assumption is $15 million, the FDIC is likely to: a. pay off depositors of the failed bank. b. establish a Deposit Insurance National Bank. c. ask Congress for assistance. d. encourage a purchase and assumption of the failed bank by a healthy bank.

(a) 38. If bank managers lobby to maintain America's traditional "dual banking" structure, they: a. want an option of either federal or state bank chartering. b. want to maintain the right to make loans and take deposits. c. want the right to fight competition. d. want the option of remaining a bank or a bank holding company.

(d) 39. A bank holding company may, under the Financial Services Modernization Act, purchase an insurance underwriting subsidiary if: a. the state insurance commissioner approves of the merger. b. the bank holding company is well capitalized. c. the bank holding company does business in the states where the insurance company is licensed. d. the holding company applies to the Fed and becomes a financial holding company.

(b) 40. Bank structure might be more competitive if: a. bank charters were more difficult to obtain. b. banks could establish branches in response to customer demographics rather than to political boundaries. c. large bank mergers were encouraged. d. bank holding companies were prohibited from entering nonbanking businesses.

(d) 41. In a bank examination, the most important area of the CAMEL analysis is a. bank capital. b. liquidity. c. asset quality. d. management competency.

(c) 42. The "market" disciplines banks for assuming excessive risk levels by a. driving up deposit insurance premiums b. denying job opportunities to managers who take risks c. pricing nondeposit financial claims accordingly d. refusing to demand loanable funds from risky banks

(c) 43. If FDIC tends to charge depository institutions less than the full cost of deposit insurance in its risk-based deposit premium system, a. the banks will be upset with FDIC. b. the risk-based premium system will adequately "tax" the excess risk returns of banks that have made risky investments. c. the moral hazard associated with deposit insurance is still present. d. the regulator will not have to worry about banks taking excessive risk.

(a) 44. If commercial banks in FDIC/BIF are charged less than S&Ls in the FDIC/SAIF, a. S&L's are encouraged to convert their charters to commercial banks. b. commercial banks will be at a competitive disadvantage to S&L's. c. for fairness to all, the BIF and SAIF should be merged. d. all parties should be satisfied.

(a) 45. Deposit insurance has a moral hazard associated with it because it offers an incentive by which of the following groups not to be concerned with how the bank is managed? a. insured depositors b. uninsured depositors c. stockholders d. subordinated creditors

(c) 46. State chartered depository institutions are regulated at least by a. the FDIC-BIF regulators. b. the FDIC-SAIF regulators. c. the states chartering the depository institutions. d. the OCC.

(b) 47. If the regulated financial institutions are able to encourage their regulator to serve the industry's interest over the public's interest, what has occurred? a. regulatory representation b. regulatory capture c. regulatory acquisition d. regulator-regulated negotiation

(a) 48. All but one of the following is an example of safety and soundness regulation: a. Consumer Credit Protection Act of 1968 b. Banking Act of 1933 (Glass-Steagall) c. FDIC Improvement Act of 1991 d. FIRRE Act of 1989

(d) 49. Which of the following regulators is also the lender of last resort? a. FDIC b. Office of Comptroller of Currency c. Office of Thrift Supervision d. Federal Reserve System

(c) 50. Although the FDIC does not charter depository financial institutions, it is said to have considerable influence in an institution's application for chartering because a. the FDIC establishes the types of deposit accounts that financial institutions can offer. b. the FDIC reviews all bank charter applications. c. chartering criteria include eligibility for deposit insurance. d. the FDIC advises the Fed as to which banks it should charter.

(c) 51. A state-chartered bank which is not a member of the Federal Reserve System will never be examined by the a. state banking authority b. FDIC c. OCC d. Fed

(d) 52. A national bank is regulated in some way or to some extent by a. the Fed b. the OCC c. the FDIC d. all of the above

(c) 53. Most depository institutions are regulated in some way or to some extent by a. the Fed b. the FDIC c. both of the above d. none of the above

ESSAY QUESTIONS

1. Explain why depository institutions are today the most regulated firms in the financial services industry.

Answer: Depository institutions are heavily regulated because society heavily depends on them. Their deposit liabilities represent most of the money supply and their operations are critical to the payments system. Their power to allocate credit is an important social and economic power.

2. Describe three methods by which the FDIC may handle a failed bank. Which method do you believe is of most benefit to depositors? Which of these methods causes a moral hazard? Explain.

Answer: The FDIC may pay off the depositors of a failed bank, arrange a purchase and assumption “merger” with another bank, or operate the failed bank until it can be sold. The FDIC will select the least costly alternative. A payoff hurts large depositors who have balances beyond insurance limits. Allowing the bank to continue operating under the “too big to fail” doctrine creates a moral hazard, encouraging aggressive managers to increase the risk of their operation when they know the FDIC will bail them out if they fail.

CHAPTER 17
TRUE/FALSE QUESTIONS

(T) 1. “Mutual” institutions are owned by their depositors.

(F) 2. S&Ls were originally established to take advantage of a tax loophole.

(F) 3. Federal Home Loan Banks are among the regulators of savings institutions.

(T) 4. “Negative maturity GAP” S&Ls may actually profit in a recession.

(F) 5. Federal Home Loan Banks were disbanded year s ago.

(T) 6. Thrifts assume interest rate risk because maturities of their liabilities and assets are typically unmatched.

(F) 7. The Federal Savings and Loan Insurance Corporation insures deposits of S&Ls.

(T) 8. The Office of Thrift Supervision is the principal federal regulator of S&Ls.

(T) 9. Congress gave thrifts the right to make consumer loans so they could diversify their assets and shorten their asset durations.
(F) 10. Adjustable rate mortgages insulate thrifts against risk.

(T) 11. Mortgages remain the most important asset of savings institutions.

(F) 12. Securitization has not “caught on” in the thrift industry.

(T) 13. Noninterest income has become an important source of revenue for thrifts.

F) 14. Noninterest expenses of thrifts have declined significantly.

T) 15. Thrifts assume less interest rate risk and manage it better than they did 25 years ago.

(T) 16. Credit unions were originally organized with the idea that members could pool their funds together and make low-cost loans to themselves as a group.

(F) 17. Credit risk may be reduced by selling credit life insurance to credit union members.

(T) 18. Liquidity risk is reduced by deposit insurance and the presence of credit union “centrals”.

(F) 19. Credit unions have shortened the duration of their loan portfolios by making mortgage loans.

(F) 20. Credit unions have higher loan losses than commercial banks.

(T) 21. Credit unions are exempt from federal income tax on income from financial assets.

(T) 22. A finance company in a recession would worry more about credit risk than interest rate risk.

(T) 23. Consumer lending is subject to more regulations than business lending.

(T) 24. Consumer protection legislation has had an impact on the strategy of finance companies.

(F) 25. The fixed cost of loan origination and servicing explains why finance companies prefer small shorter-term loans over large longer-term loans.

(T) 26. Finance companies borrow in large amounts, lend in small amounts.

(F) 27. Most business credit extended by finance companies is unsecured.

(F) 28. The major expenses of a finance company are salaries and loan losses.

(F) 29. Deregulation has made all lending institutions more alike than different.

(T) 30. The thrift crisis of the 1980s was caused by a combination of unsound lending practices and inadequate interest rate risk management.

(F) 31. The U.S. Central Credit Union is a principal regulator of credit unions.

(T) 32. Industrial banks may arguably be likened to finance companies that issue savings deposits.

MULTIPLE-CHOICE QUESTIONS

(a) 1. The Office of Thrift Supervision, the FDIC-SAIF, and the Resolution Trust Corporation were created by the a. FIRRE Act of 1989. b. FDIC Improvement Act of 1991. c. Garn-St. Germain Act of 1982. d. DIDMCA Act of 1980.

(b) 2. The regulatory agency most directly concerned with supervising thrifts is the a. FHLBB. b. OTS. c. OCC. d. Fed.

(c) 3. Acquisition of a greater proportion of which following asset would help a thrift alleviate a high negative GAP position? a. NOW accounts b. high yield bonds c. adjustable rate mortgages d. fixed rate mortgage-backed securities

(d) 4. Thrifts invest in mortgages for which of the following reasons? a. Tax incentives provided by Congress. b. To reduce interest rate risk. c. They have the management expertise to specialize in mortgages. d. Both a and c.

(c) 5. All of the following are important sources of liquidity for thrifts except: a. purchasing federal funds. b. issuing commercial paper. c. buying mortgage-backed bonds. d. advances from Federal Home Loan Banks.

(c) 6. The expense categories for thrifts, from largest to smallest, are a. non-interest expense, interest expense, provision for loan losses. b. provision for loan losses, non-interest expense, and interest expense. c. interest expense, non-interest expense, and provision for loan losses. d. tax expense, interest expense, and provision for loan losses.

(a) 7. The takeover of weakly but still positively capitalized thrifts was an important part of the a. FDIC Improvement Act of 1991. b. FIRRE Act of 1989. c. Garn-St. Germain Act of 1982. d. DIDMCA Act of 1980.

(d) 8. When comparing high performing with low-performing thrifts, low-performing thrifts tend to have fewer: a. intangible assets. b. repossessed properties. c. high-yield securities. d. residential mortgages.

(d) 9. Which of the following has contributed to the very low capital levels of thrifts? a. the use of the mutual form of organization. b. loan losses. c. high operating expenses. d. all of the above

(b) 10. A manager/owner agency problem for thrifts when capital ratios were low was a. managers would inflate salaries and perks for themselves. b. managers were encouraged to assume excessive credit risk. c. managers were encouraged to sell low-yielding mortgages, book the loss, and reinvest in higher yielding 1-4 family residential mortgages. d. managers were encouraged to reduce risk to dangerously low levels.

(a) 11. Earnings of the S&L industry suffered in the 1980s from both maturity imbalances and a. loan losses related to new asset powers granted in 1980. b. high, sustained interest rates. c. the high rates paid on NOW accounts. d. higher yields from consumer credit card loans.

(d) 12. While thrifts are federally insured, are federally chartered. a. few; most. b. most, few. c. very few; half. d. most; half.

(c) 13. The major assets of savings and loans are: a. mortgage-backed securities. b. construction loans. c. residential mortgages. d. cash and investment accounts.

(c) 14. Though most thrift institutions have had expanded asset/service privileges for several years, few have expanded very far beyond mortgage related activities for all but one of the following reasons: a. unfamiliarity with new, competitive markets. b. lack of experienced employees trained in the new areas. c. reluctance to challenge the banking industry. d. concern over possible loss of federal income tax advantages

(b) 15. Which of the following would reduce the high negative GAP position of an S&L? a. increased fixed rate mortgages b. increased long-term CDs c. increased money market deposit accounts d. increased federal funds purchased

(b) 16. The sale of mortgages would offer the thrift institution all of the following except: a. a source of liquidity from the mortgage portfolio. b. a source of interest income. c. an opportunity to reduce a high negative GAP position. d. an opportunity to make additional mortgage loans.

(c) 17. Which of the following will definitely increase an S&L’s net worth, all else equal? a. a reduced GAP position b. conversion from stock to mutual charter c. sale of preferred stock d. increased reserve for loan losses

(b) 18. The Office of Thrift Supervision does all the following except a. examines federally chartered S&L's. b. administers the Savings Association Insurance Fund (SAIF). c. charters federal S&Ls. d. supervises S&L holding companies.

(a) 19. A purpose of the FSLIC today is to: a. give financial historians something to study. b. insure federal S&Ls. c. regulate the capital position of S&Ls. d. monitor the activities of the 12 FHLBs.

(a) 20. The Resolution Trust Corporation was disbanded because a. its work was complete b. its mission proved ultimately impossible c. it failed d. of political infighting

(a) 21. All but one of the following is classified to some extent as a “thrift”: a. commercial bank b. savings and loan association c. savings bank d. credit union

(c) 22. Thrift institutions are chartered by a. states only. b. the federal government only. c. both states and the federal government d. none of the above.

(b) 23. All but one of the following is defunct: a. FHLBB b. OTS c. RTC d. FSLIC

(b) 24. Almost all thrift financial institutions are insured by _________ deposit insurance. a. state b. federal c. private d. group

(a) 25. All but one of the following is a reason mutual thrifts have converted to stock institutions: a. to obtain federal deposit insurance b. to sell stock and increase their net worth c. to acquire subsidiaries more easily d. to merge with other institutions more easily

(d) 26. The number of OTS-regulated thrift institutions has_______ in the last five years, while the amount of assets of those institutions has _______? a. increased, increased b. increased, decreased c. decreased, increased d. decreased, decreased

(a) 27. Most thrift institutions were originally organized as: a. mutuals b. corporations c. proprietorships d. partnerships

(b) 28. Mutual thrift institutions are owned by: a. managers b. depositors c. stockholders d. the general public

(c) 29. Today thrift institutions’ deposits are primarily insured by: a. large insurance companies b. Federal Deposit Insurance Corporation c. Federal Savings and Loan Insurance Corporation d. FDIC-BIF

(c) 30. The primary function of the Resolution Trust Corporation (RTC) was to: a. insure the deposits of problem thrift institutions. b. charter and regulate savings and loan associations. c. liquidate and sell problem savings and loans. d. resolve the interest rate risk problems of thrifts.

(c) 31. The Office of Thrift Supervision (OTS) replaced the _______ as the primary federal thrift regulator in 1989. a. Federal Savings and Loan Insurance Corporation b. Federal Deposit Insurance Corporation c. Federal Home Loan Bank Board d. Federal National Mortgage Corporation

(b) 32. The major asset of thrift institutions is ______ ; ______ are the primary source of funds. a. home mortgages; small denomination deposits b. commercial mortgages; large denominations deposits c. home mortgages; large denomination deposits d. multifamily home mortgages; small denomination deposits

(d) 33. The account, other real estate owned (OREO), found as an asset on a savings and loan balance sheet is associated with: a. the real estate associated with the home office and branches. b. the real estate financed by home mortgages c. the real estate of managers and employees financed by the institution. d. repossessed real estate associated with foreclosed mortgage loans not yet resold.

(d) 34. Thrift capital ratios increased in the last few years primarily because of a. industry consolidation b. stock sales and earnings retention c. declining problem loans d. all of the above

(c) 35. Thrifts’ return on average assets (ROAA) has increased in recent years primarily due to a. increased net interest income per average assets. b. decreased noninterest expenses per average assets. c. increased noninterest income per average assets. d. the decline in average assets in the period.

(b) 36. A thrift institution can reduce interest rate risk by a. making more mortgages financed by six month CD’s. b. performing more mortgage banking activities. c. buying Treasury bond futures to reduce the thrift’s negative maturity GAP. d. making more thirty-year mortgages.

(a) 37. Which of the following is an effective way to reduce a thrift’s negative maturity GAP? a. making more adjustable rate mortgage loans b. buying related futures contracts. c. borrowing less long-term funds from the FHLB. d. raising the rates on short-term CD’s.

(a) 38. Which of the following statements is not true? a. Credit unions pay federal income taxes. b. To use the services of a credit union one must be a member. c. Credit unions have been exempt from antitrust laws. d. The total number of credit unions is declining in the United States.

(d) 39. Credit unions are chartered by a. state governments. b. the National Credit Union Administration. c. the Comptroller of the Currency. d. either a or b

(d) 40. Credit union large certificates of indebtedness, $100,000 and above, are insured by a. NCUSIF. b. FDIC. c. SAIF. d. none of the above

(a) 41. Which of the following statements is not true? a. Credit unions, most of which are very small, cannot match the extent of services offered by a commercial bank. b. Credit union share accounts are the functional equivalent to passbook accounts. c. Credit unions may arguably be more comparable to “clubs” than to businesses. d. Credit unions have a common-bond requirement.

(a) 42. All of the following serve as an advantage for credit unions except a. small size. b. sponsor support. c. federal income tax exemption. d. payroll deduction.

(d) 43. Finance companies have increasingly made second mortgage loans because of a. higher average balances. b. profit potential of such loans. c. the Federal Bankruptcy law. d. all of the above

(a) 44. In contrast to depository institutions, finance companies tend to a. obtain their funds in large amounts, lend in small amounts. b. obtain their funds in small amounts, lend in large amounts. c. have a greater proportion of deposit sources of funds d. be less flexible in their ability to branch.

(c) 45. The major assets of large finance companies are a. certificates of deposit. b. cash, ready to be loaned out. c. loan receivables. d. commercial paper.

(c) 46. Investment securities are owned by finance companies to provide a. income and financing. b. liquidity and cash. c. liquidity and income. d. collateral and income.

(c) 47. Major finance companies place their commercial paper "directly," which is a. directly from the bank. b. through direct contact with dealers. c. through direct contact with suppliers of funds. d. directly through the mail.

(d) 48. Much of the flexibility and variety associated with finance companies is associated with a. the wide variety of financial services allowed by the Federal Reserve System. b. little constraining regulation at the commercial finance level. c. the opportunistic culture of finance company managers. d. "b" and "c" above.

(b) 49. Finance companies can issue demand deposits if they a. qualify for deposit insurance b. somehow obtain repeal of the laws now prohibiting them from doing so c. affirmatively disclose that such deposits are uninsured d. obtain “industrial bank” charters

(c) 50. The profitability of consumer loans tends to ___________ as loans get ___________. a. decrease; larger b. increase; larger c. stay the same; larger d. increase; smaller

ESSAY QUESTIONS

1. Explain how unexpected increases in interest rates hurt savings institutions. How would they alter their maturity GAP if they expected interest rates to rise?

Answer: Traditional thrifts, taking relatively short-term fixed-rate deposits to fund relatively long-term fixed-rate mortgages, ran a constant and unhedged negative maturity GAP. Thus rising interest rates would erode both their net worth and their net interest margin. A thrift expecting an increase in interest rates today might promote variable-rate loans more aggressively, or shift more loanable funds to less interest-sensitive securities, or promote longer-term deposits, or seek longer-term nondeposit sources of funds. It might also go “off balance sheet” to sell financial futures, buy “puts” on futures, or swap fixed interest streams for variable interest streams.

2. The issue of defining the common bond among members of credit unions has been in the courts and Congress. Why is this issue important to competing bankers? To credit unions? Does it have any relationship to the risks faced by credit unions?

Answer: As credit unions have sought growth opportunities, they have sought to have the definition of "common bond" expanded. The closer credit unions get to serving the general public, the more of a problem their tax exemption is for commercial banks, who must compete on pricing while still paying taxes. Thus commercial banks have lobbied with some success to keep common bond definitions within traditional limits. Wider membership would help credit unions achieve economies of scale and diversification of assets, but might also oblige them to argue more creatively for their traditional tax exemption.

3. Explain how finance companies and depository institutions might differ in managing credit risk.

Answer: Credit risk is an unsystematic risk which can be managed through underwriting standards and portfolio diversification. Depository institutions receive a lot of “help” from regulators in managing credit risk, and cannot assume too much of it without predictable and significant consequences. Finance companies are left alone to make their own philosophical choices about credit risk, subject to such policing as creditors, shareholders, and the markets may care to do.

CHAPTER 18
TRUE/FALSE QUESTIONS

(F) 1. Life insurance companies provide protection against death.

(T) 2. Life insurance companies are the oldest financial intermediary in the United States.

(T) 3. The assets of life insurance companies are not as marketable as those of casualty/property insurance companies because life companies have greater certainty of claims.

(F) 4. An annuity provides both insurance against premature death and savings features.

(F) 5. Property/liability insurance companies pay little federal income tax, thus explaining their large portfolio of state and municipal, tax-exempt securities.

(F) 6. Social Security is a fully funded pension program.

(T) 7. Health insurance includes protection against the risk of large, unexpected medical expenses and/or the loss of income from illness or disability.

(T) 8. Objective risk is the deviation of actual from expected.

(T) 9. Universal life became popular in the inflationary, high interest periods of the 1980s because interest rates on universal life policies vary with market rates.

(T) 10. Pension funds, which count on current contributions to make payments to retirees, are under funded.

(F) 11. The nature of the assets of life insurance companies influence the type of liabilities they may issue.

(F) 12. The sale of term life insurance was an important factor explaining the growth and large size of life insurance companies.

(T) 13. Pure risk and objective risk are both assumed by life insurance companies.

(T) 14. Insurance premiums are directly related to expected dollar losses.

(T) 15. The liability of Lloyds of London members on assumed risks are unlimited.
(T) 16. Though stock companies dominated the number of life insurance companies, mutuals are dominant in terms of assets and insurance in force.

(T) 17. A deductible is a form of loss-sharing.

(T) 18. Term life policies provide maximum life insurance dollar protection for consumers for a given amount of premium.

(F) 19. Life insurance and pension reserves are liquid asset balances held by life insurance companies to pay losses and pension benefits.

(F) 20. Investment income tends to offset premium income, thus reducing premiums for the insured.

(T) 21. Business interruption is an example of an indirect loss.

(F) 22. Any risk is insurable for a high enough premium.

(T) 23. Property/casualty insurers have a tax incentive to hold preferred stock.

(F) 24. Municipal bonds are a logical investment for “qualified” pension plans.

(F) 25. Liability risk is much easier to gauge than property risk.

(F) 26. The law of large numbers practically guarantees that an insurer will be profitable if it has enough policy holders.

(T) 27. “Fully contributory plans” are funded with employee contributions only.

(T) 28. All insurers must deal with the problem of adverse selection.

(T) 29. “Superannuation” is an unwelcome development to the underwriter of a life annuty.

(T) 30. Insurance is almost entirely regulated by state, not federal law.

MULTIPLE-CHOICE QUESTIONS

(a) 1. Of the following, which type of life insurance policy would probably accumulate the least amount of funds for investment in capital market securities? a. term insurance b. whole life insurance c. annuity d. universal life insurance

(c) 2. Which statement is not true about life insurance companies? a. they have relatively predictable inflows and outflows. b. their liabilities are long-term in nature. c. they invest heavily in short-term highly marketable securities. d. they sell contracts that offer financial protection against premature death and against living too long.

(c) 3. Which statement is not true about casualty insurance companies? a. they are subject to federal income tax. b. they invest heavily in municipal bonds. c. they have more predictable cash flows related to claims than life insurance companies. d. they invest in corporate stock.

(b) 4. Which one of the following types of casualty insurance policy would a bank purchase if it wants to protect itself against economic loss from bank tellers who might embezzle cash? a. liability insurance b. fidelity bond c. surety bond d. marine insurance

(d) 5. Which one of the following statements best describes the insurance industry? a. major insurance company liabilities are called reserves. b. most life insurance companies are stock companies. c. mutual insurance accounts for about half of all the life insurance in force. d. all of the above are true.

(d) 6. Traditionally, pension funds were: a. government-insured b. defined contribution c. fully contributory d. defined benefit

(c) 7. Pension funds whose contributions are not large enough to actually cover the benefits to be paid out when all employees retires are termed: a. unvested. b. vested. c. under funded. d. funded.

(b) 8. A pension plan feature that provides employees with the right to future retirement income, even if the employee terminates employment, is called: a. unvested. b. vested. c. under funded. d. funded.

(c) 9. All of the following are methods used by insurance companies to reduce objective risk except: a. safety education programs. b. selective underwriting of insureds. c. investment in investment grade securities only. d. use of deductibles.

(c) 10. Keogh plans and IRAs are a. government sponsored retirement programs. b. noninsured retirement plans. c. individual retirement programs. d. pay-as-you-go programs.

(b) 11. A "stock" life insurance company is owned by a. its policyholders. b. its shareholders. c. its managers. d. both a and b above.

(a) 12. Life insurance companies may best be called a. a capital market intermediary. b. a depository intermediary. c. an investment company. d. a money market intermediary.

(d) 13. Life insurance companies tend to be larger than casualty insurance companies because of a. their special income tax exclusions. b. the characteristics of their term policies. c. the inability to accumulate policyholders. d. the long-term, accumulative nature of whole life policies.

(a) 14. Which contract provision below is not likely to be associated with a term life policy? a. loan provision b. participating c. convertible d. renewable

(d) 15. A life insurance company needs more liquidity when selling a high proportion of: a. whole life policies. b. annuities. c. thirty-year term policies. d. one-year renewable term policies.

(c) 16. A person who saves money for the future by buying a whole life policy a. probably earns a rate of return on cash values greater than in an equivalent universal life policy. b. pays the same premium for the same amount of term coverage. c. is able to accumulate tax-free interest earnings on cash values. d. buys more insurance for a given premium compared to term.

(c) 17. Which one of the following economic conditions is best suited for the sale of whole life contracts? a. moderate inflation (5%) and high economic growth (6%) b. high inflation (10%) and cyclical instability c. low inflation (3%) with stable economic growth (4%) d. none of the above.

(c) 18. Which one of the following statements about universal life insurance is not true? a. Cash contributions, net of term premiums, are invested at market rates. b. The policyholder may vary the level of insurance coverage. c. The policy does not qualify for the special federal tax exclusion of income built up inside the contract. d. The amount of policyholder contribution each year is the difference between the contributions and the price of a one-year term policy.

(c) 19. The major investment area of life insurance companies is , while casualty insurance companies hold more of their investments in . a. corporate stock; corporate stock b. corporate stock; government securities c. corporate bonds; municipal bonds d. mortgages, municipal bonds

(b) 20. Which one of the following combinations of pension terms offers the greatest protection for the future retiree? a. under funded, vested, uninsured b. insured, fully funded, vested c. unfunded, private, company managed d. trustee managed, under funded, and vested

(c) 21. Insurance companies manage all but which financial risk? a. default risk b. interest rate risk c. pure risk d. liquidity risk

(d) 22. ________ risk is the chance of loss, a one-tailed risk, while _________ risk, a two-tailed risk offers returns above and below an average? a. speculative; pure b. objective; pure c. default risk; pure d. pure; speculative

(c) 23. The major areas of business for a life insurance company are a. insuring against death and pension fund management. b. providing life insurance and wealth accumulation for retirement such as a term policy provides. c. providing life insurance and wealth accumulation for retirement such as a whole life or universal life policy provides. d. reinsurance

(d) 24. In the last few years, which noninsurance financial institution has been able to offer insurance services to the concern of the insurance industry? a. finance companies b. credit unions c. investment banks d. commercial banks

(a) 25. The National Association of Insurance Commissioners is an organization of _______ regulators interested in the ________ of insurance regulation. a. state; consistency b. state; federalization c. federal; effectiveness d. state and federal; efficiency

(b) 26. Life insurance protects the insured from a. premature death. b. the economic consequences of death. c. beneficiaries. d. pure risks faced by the insured.

(c) 27. Purchasing insurance may alter the behavior of the insured and is known as a. default risk and adverse selection. b. pure risk and speculative risk c. moral hazard and adverse selection. d. moral hazard and speculative risk

(b) 28. Insurance companies have to deal with the concept of adverse selection, which is a. the practice of low-risk insured seeking low premiums. b. high-risk persons are more likely to purchase insurance. c. insureds are likely to increase their risky behavior. d. Insurance salespersons try to sell their most profitable policies.

(c) 29. A level-premium, whole life policy is a combination of a. an annuity and a pension. b. universal life and an annuity. c. decreasing term insurance and building a future sum of savings. d. life and casualty insurance on the insured life and property.

(c) 30. A convertibility option added to a term policy gives the insured the option of a. converting the term insurance to common stock of the insurance company. b. converting the term policy into cash. c. converting the term policy to a whole life, level premium policy. d. canceling the policy at any time.

(a) 31. While life insurance protects the insured against the economic consequences of premature death, annuities protects against a. the economic consequences of living too long. b. varying interest rates. c. aggressive beneficiaries. d. default by life insurance companies.

(b) 32. To protect against moral hazard, disability income policies a. do not cover disabilities from moral problems. b. do not provide a high percentage of pre-disability income and require a waiting period. c. usually pay more than 100 per cent of an insured's income. d. usually require a five-year waiting period before benefits begin.

(b) 33. Life insurance companies have a portion of their assets invested in common stocks most likely because a. there’s no other way to finance whole life insurance policies. b. the company probably offers variable-life insurance policies. c. it reduces the risk of the corporate bond portfolio. d. common stockholders desire a small amount of their return in life insurance.

(b) 34. Insurance regulation is concerned with all but one of the following: a. capital adequacy of insurance companies b. making sure that the perils covered under insurance do not occur too frequently c. protecting and informing consumers d. keeping insurance available and affordable

(c) 35. All but one of the following are important areas of insurance regulation: a. licensing of insurance companies and agents. b. review of the financial condition of insurance companies. c. annual safety inspection of insurance offices in each state. d. the orderly liquidation of insolvent insurers.

(a) 36. While life insurance provides economic protection in case of premature death, pensions provide coverage against a. superannuation b. working too long. c. disability. d. unemployment.

(c) 37. Private pension plans are a. available only to people who work. b. illegal. c. pensions provided by and to non-governmental, private sector businesses, organizations, and their workers. d. a personal financial plan provided for a fee by a financial planner.

(c) 38. A noninsured pension plan will a. not be covered under the Pension Benefit Guaranty Corporation. b. always be underfunded. c. be managed by an appointed trustee to invest funds contributed for the benefit of future pensioners. d. will be covered by term insurance, not whole life.

(a) 39. The largest amount of pension assets are associated with a. trusteed, private pension funds. b. social security. c. government-administered pension funds. d. insured pension plans with life insurance companies.

(c) 40. Social security, formally called OASDHI, stands for a. Office of Aging Survivors, Disabled and Health Insurance b. Office of Active Standards for the Disabled, Healthy and Infirmed c. Old Age, Survivors, Disability, and Health Insurance System d. Old Age Standards for Disability Health Insurance

(c) 41. Social security is a _________ pension plan. a. fully funded b. private c. pay-as-you go d. noncontributory

(c) 42. All but one of the following was an important result of the ERISA Act of 1974: a. strengthen the fiduciary responsibilities of pension fund trustees. b. increased the number of pension funds at small businesses c. established reporting and disclosure requirements d. provided insurance for failed pension funds.

(c) 43. The difference between an insured versus a noninsured pension plan is a. the insured plan is insured under the Pension Benefit Guaranty Corporation, while the noninsured is not. b. the insured plan is a government pension fund; the noninsured is in the private sector. c. the insured plan obligations are issued by a life insurance company with promises to pay specific amounts in the future, while the noninsured are managed by a trustee with no guarantee of amounts distributed in the future. d. the employer of the insured guarantees payments, but not so in the case of the uninsured.

ESSAY QUESTIONS

1. Discuss a way in which contractual financial institutions contribute to society.

Answer: Contractual financial institutions promote order and prosperity by freeing their customers of certain worries about the future so that they can be happier, more productive, and more able to manage risk today. People who are anxious about the future are distracted from performing at their best, and are reluctant to take the risks on which economic growth and social progress depend. A society full of such people would not reach its full economic potential, and declining standards of living would provoke even more anxiety about the future.

2. What is a “Lloyd’s association”?

Answer: Lloyd’s associations are organizations that do not directly write insurance, but instead provide a marketplace and services to members of an association who write insurance as individuals. In this respect, Lloyd’s is similar to the New York Stock Exchange, which does not buy or sell securities but provides a trading floor and services to stock traders. The most famous Lloyd’s association is Lloyd’s of London, where the members (called “names”) have unlimited liability for the risks they underwrite.

CHAPTER 19
TRUE/FALSE QUESTIONS

(T) 1. Investment banking operations occur in the direct financial market.

(F) 2. The Glass-Steagall Act of 1933 has eliminated banks from any underwriting activities.

(T) 3. Commercial banks may underwrite low-risk securities in the direct financial markets.

(T) 4. A security underwriting takes place in the primary market; subsequent trading in the security takes place in the secondary market.

(F) 5. A dealer earns a commission for bringing buyers and sellers together.

(F) 6. An underwriter's selling group assumes underwriter risk.

(F) 7. Discount brokers offer investment advice at prices below full-service security brokerage houses.

(T) 8. Venture capital financing usually entails some managerial involvement and equity ownership.

(F) 9. The Banking Act of 1933, known as the Glass-Steagall Act, has effectively kept commercial banks out of the commercial lending area.

(T) 10. Investment banking firms provide both financing and investment services for borrowers and lenders, respectively.

(F) 11. The 40% margin rule requires the buyer/seller of a security to provide at least 60% of the funds necessary to cover the transaction, borrowing 40%.

(F) 12. Venture capital firms compete with commercial banks for new business loans.

(F) 13. Discount brokers offer investment advice at prices below full service security brokerage houses.

(T) 14. Security brokers and dealers obtain most of their funds from customers and banks.

(F) 15. Venture capital recipients are often called angels.

(T) 16. Seed financing is the first stage of venture capital financing.

(T) 17. Under the Glass-Steagall Act commercial banks were permitted to underwrite and trade Federal government securities and general obligation bonds of states and municipalities.

(T) 18. Before the Financial Services Modernization Act of 1999, the Supreme Court (1988) of the U.S. provided commercial banks permission to underwrite commercial paper and municipal revenue bonds, but not equities.

(F) 19. SEC Rule 144A permitted borrowers in private placements the opportunity to trade their obligations.

(F) 20. A best efforts sale of securities is likely to generate more revenue for the investment banker than an equivalent underwriting of securities.

(T) 21. Mezzanine or bridge financing is the interim financing before public offerings of securities.

T 22. In an underwritten offer, the risk of selling the issue at a price higher than that promised to the issuer is borne by the investment bank.

F 23. In an underwritten offering, the investment bank is compensated based on the number of securities sold.

F 24. Universal banks are financial institutions that are allowed to do only commercial banking activities.

F 25. The Banking Act of 1933, known as the Glass-Steagall Act, has effectively kept commercial banks out of the commercial lending area.

MULTIPLE-CHOICE QUESTIONS

(b) 1. All of the following were the objective of the Glass-Steagall Act except: a. discourage speculation in financial markets. b. promote a safe and sound investment banking environment. c. prevention of conflict of interest and self-dealing. d. restore confidence in the commercial banking system.

(a) 2. All of the following are the major services of an investment banking firm except: a. make commercial loans. b. bring new security issues to market. c. trading and brokerage. d. arrangement of the selling group.

(c) 3. Full-service brokerage service includes a. origination, underwriting, and sales. b. registration of securities, storage of securities, and execution of trades. c. execution of trades, investment advice, and margin credit. d. cash management service, private placements, and security distribution.

(d) 4. All of the following can be associated with a private placement except: a. financing includes debt or equity securities. b. the direct financial market. c. used by both lesser-known firms and large, well-known firms in need of funds. d. the underwriting spread is usually lower.

(b) 5. The commercial banking services that investment banking/full service brokerage firms and commercial banks now compete intensely for are: a. consumer loans and deposits. b. commercial loans and deposits. c. investment securities and check clearing operations. d. private placements and corporate underwriting.

(d) 8. All of the following is associated with the origination function of investment banking except: a. design of the security to fit the needs of the market and the issuing firms. b. filing of the required registration statements. c. obtain a credit rating on a debt issue. d. commit to a specific price to the issuing firm and attempt to sell the security in the market.

(d) 9. SEC Rule144A may lower the cost of private placement financing for corporations for it: a. places an interest rate ceiling on private placement financing. b. it now permits trading in private placement securities after a two-year wait, enhancing the liquidity of the investment. c. permitted sophisticated institutional investors to invest in private placement securities. d. permits the trading of private placement trading before the traditional two-year holding period, enhancing the liquidity of the investment.

(a) 10. Early investment banks, unlike commercial banks with limited "money- related” services and loans, could perform many financial services and were known as: a. private banks. b. universal banks. c. Jay Cooke banks. d. industrial banks

(c) 11. The Glass-Steagall Act of 1933 separated a. insurance from credit. b. investment banking from mutual funds. c. investment banking from commercial banking. d. commercial banking from insurance.

(d) 12. All but one of the following is associated with financial reform legislation of the post Great Depression era? a. Securities Act b. Securities Exchange Act c. Glass-Steagall Act d. Bank Holding Company Act

(a) 13. All but one of the following is associated with the objectives of the Glass-Steagall Act? a. to limit bank mergers when the merger might adversely affect competition. b. to discourage speculation in financial markets. c. to prevent conflict of interest and self-dealing. d. to restore confidence in the safety and soundness of the banking system.

(c) 14. If a company has never offered securities to the public, the investment banking will offer the securities in the primary market as a. a seasoned offering. b. a rights offering. c. an IPO. d. a best efforts offering.

(c) 15. The optimum offering price of an underwritten security is called the market equilibrium price, which is a. the highest price offered to the issuing firm. b. the lowest price paid by the investment banker. c. the highest price which allows the entire issue to be sold quickly at the offering price. d. the price that will maximize the amount obtained by the issuing firm.

(c) 16. The preliminary and final prospectus provided prospective investors in a new security issue is a summary of the a. registration statement filed with Federal Reserve. b. public announcement of price and number of securities issued by the SEC. c. registration statement filed with the SEC. d. duties of the investment banker in the primary offering.

(b) 17. All but one of the following is associated with the activities performed around the time of new debt security issue? a. securing a credit rating from a rating service provider. b. Obtain the security certificates printed by the Federal Reserve Banks. c. selecting a transfer agent. d. selecting a trustee.

(b) 18. Venture capital investments are characterized by all of the following except: a. Substantial control over management decisions. b. No protection against downside risk c. A share of capital appreciation. d. serves as intermediate financing between founders' capital and the IPO.

(b) 19. The best example of an effort to manage the inventory risk is a. the formation of a selling group. b. the formation of an underwriting syndicate. c. allotting shares of the issue to participating brokers. d. paying a high price to the issuing firm.

(b) 20. When an investment banker holds a security inventory to make market in a security it has just underwritten, it is performing the ________ function in the market. a. registration b. dealer c. broker d. advisory

(a) 21. The Federal Reserve System has authority over what area of securities trading? a. margin trading b. insider trading c. exchange market trading d. registration of the issue

(b) 22. The major source of funds for brokers and dealers is a. customer accounts balances. b. call loans from commercial banks. c. their net worth. d. loans from the SEC.

(c) 23. All but one of the following is associated with the services provided by full-service brokerage firms? a. execution of trades b. storage of securities c. making a market in the customers' securities d. investment advice

(d) 24. In a private placement a. The underwriting function is avoided. b. The extremes of high credit quality firms and low or unknown credit quality firms use private placements. c The terms may be negotiated between the issuer and the investors. d. all of the above

(b) 25. Investment bankers tend to reduce their risk of underwriting by a. using futures contracts to hedge their price risk. b. underpricing a new issue. c. reducing the size of the selling group in the underwriting. d. reducing the number of investment banking firms in the underwriting.

(c) 26. A _________ is a “market-maker” in securities and trades on a bid/ask basis? a. broker b arbitrager c. dealer d. investment banker

(a) 27. A venture capitalist provides seed financing: a. at the "idea" stage of a new business b. at the product development stage. c. at the time of the IPO. d. in the year prior to the public offering.

(c) 28. Mezzanine or bridge financing is provided by a venture capital firm for the purpose of: a. financing seasonal inventory needs. b. financing long-term capital needs. c. financing before the IPO. d. financing for the railroad connection to the plant.

(c) 29. The adoption of SEC Rule 144A provided private placement borrowers: a. higher costs of financing because of increased regulation. b. lower cost financing because the reduction in default risk provided by the regulation. c. lower cost financing because private placement investors can now trade private placement securities instead of holding them for a two-year period. d. greater liquidity of their private placement investments.

(a) 30. All but one of the following is a merger-related service provided by investment bankers to acquiring firms? a. Investment advice to target companies. b. Identify merger target companies for the acquirer. c. Analysis and pricing of the deal. d. Merger negotiation assistance.

(b) 31. Universal banks were/are: a. commercial banks operating in the U.S. prior to 1980. b. financial institutions outside of the U.S. that can engage in deposit taking, making loans, brokerage activities, securities underwriting, and offering insurance services. c. investment banks operating in the U.S. prior to 1980. d. none of the above.

(d) 32. The objectives of the Glass-Steagall Act were to: a. discourage speculation in financial markets. b. prevent conflict of interest and self-dealing. c. restore confidence in the safety and soundness of the commercial banks system. d. all of the above.

(d) 33. It is called an underwritten offer if: a. the risk of selling the issue at a price higher than that promised to the issuer is borne by the investment bank. b. the difference between the price at which the issue is sold and that promised to the issuer represents the underwriting spread or the profit earned by the investment bank. c. When the investment bank guarantees the issuing firm a certain price. d. all of the above

(d) 34. In a best efforts underwriting offer, a. the investment bank is compensated based on the number of securities sold. b. the risk of the securities not selling or not selling at a desired price is borne by the issuing firm, not the investment bank. c. typically, the smaller and more riskier issues are forced to use this type of offering. d. all of the above are true

(b) 35. All but one of the following is true in a private placement, a The sale of securities directly to the ultimate investor and not through a public offering. b. The underwriting function cannot be avoided. c. A fee is earned for the origination/selling or uniting the supplier and user of funds. d. A private placement may reduce the total flotation costs for a business or government.

ESSAY QUESTIONS

1. Discuss the intense competitive battle between commercial and investment banks for corporate client business. Why have investment banks and commercial banks sought to step into each other’s business?

Answer: Before the 1930s Glass-Steagall Act separated investment banking from commercial banking, both services were provided to businesses by larger banking organizations. The “tie-in” relationship between financing and lending and other businesses, along with the concern for the stability of commercial banks (protect the money supply) prompted Congress to separate the two services. Since both serviced the same type of customers, commercial banks and investment banks quickly sought ways to avoid the restrictive legislation and provide full service to their corporate clients. Over the years, such an approach led them to step on each other’s business of deposit taking (bank monopoly) and underwriting (securities business monopoly). Competition, technology, and gradual deregulation have provided the means for offering services in each other’s traditional business. The Financial Services Modernization Act finally legitimized what had been contested in the courts by regulators and state governments over several decades, and allowed commercial banking, investment banking and insurance to run under one holding company roof.

2. Name and discuss the important procedures involved in bringing a new security issue to market by an investment banking firm.

Answer: The investment banker will consult with the financing firm and provide assistance with the correct type of financing for the times, the registration process, pricing the issue, arranging for an underwriting syndicate, and finally, the underwriting itself. Often a member of the IB firm will sit on the board of directors, providing a close tie to IB services.

3. What are the major services of a full-service investment banking/brokerage firm? What does each provide for financial investors and funds-seeking firms and governments?

Answer: The services of investment bankers are focused to 1) the financing company or government and 2) the investors who will provide the financing. Registration, pricing, and underwriting are services for the financing company; information, competitiveness, integrity, and follow up advice are services provided the investors. Recently, a few security analysts (sell side), who derived much of their compensation from the level of financing and investment banking business, were hesitant to tell investors when companies’ stock prospects dimmed or “tanked.”

4. How might SEC Rule 144A enhance the liquidity and lower the financing costs in private placements?

Answer: SEC Rule 144A enables private placement institutional investor to trade (sell) their private placement securities before the classic two-year holding period, enhancing the liquidity of the investment and lowering the liquidity risk premium for borrowers.

5. Venture capitalists provide a unique service to developing businesses. Discuss their services and the organizational structures used by venture capital firms.

Answer: Venture capitalists are usually institutional investors who provide upstart financing for young companies with risky prospects. They may be private individuals or institutional investors seeking diversification with their portfolios, corporate subsidiaries, or publicly traded small-business investment companies who take an equity stake in an upstart business in exchange for the opportunity for returns when the company is taken public or sold to a larger company. Venture capitalists may provide all or one of the stages of financing, including seed financing, start-up financing, first-stage financing for upstarts and second, third and mezzanine or bridge financing for later-stage development.

CHAPTER 20
TRUE/FALSE QUESTIONS

(T) 1. Balanced funds generate higher proportion of income than growth and income funds and are less volatile.

(T) 2. Market arbitrage by hedge funds is the simultaneous buying and selling of a security or derivative of the security to exploit market pricing differentials.

(F) 3. When purchasing load mutual fund, the NAV includes the load charge for purchasing the mutual funds.

(T) 4. Money market mutual funds invest in commercial paper, large bank CDs, and short-term government securities.

(F) 5. Unit investment trusts have a high security turnover rate, increasing their costs over equivalent mutual funds.

(F) 6. Income funds are made up of a portfolio of mortgage-backed securities only.

(T) 7. Mutual funds offer diversification and professional investment management for the fees charged.

(F) 8. Closed-end investment companies stand ready to redeem their shares at their present asset value.

(T) 9. Money market mutual funds invest in commercial paper, large bank CDs, and short-term government securities.

(T) 10. Money market mutual funds are not subject to reserve requirements.

(F) 11. When purchasing load mutual fund, the NAV includes the load charge for purchasing the mutual funds..

(F) 12. Closed-end investment companies provide shareholders with maturity intermediation.

(F) 13. An underwriting of General Motor's common stock is an IPO.

(T) 14. Security brokers and dealers obtain most of their funds from customers and banks.

(F) 15. No-load mutual funds are commonly sold by security brokers and dealers.

(T) 16. Load mutual fund shares may be sold back to the fund.

(T) 17. Closed-end investment companies= securities often sell at a discount of their NAV.

(T) 18. If interest rates are expected to fall very soon, the bond mutual fund manager is likely to have a high cash position.

(F) 19. Unit investment trusts have a high security turnover rate, increasing their costs over equivalent mutual funds.
(T) 20. The major investment of mutual funds is common stock.

(T) 21. Hedge funds are typically organized as limited partnerships with the fund manager as the general partner.

(T) 22. Hedge funds have been popular diversification investments for high wealth investors.

(T) 23. Arbitrage activities of hedge funds tend to increase capital market efficiency.

(F) 24. Short-selling activities of hedge fund look for high growth companies.

MULTIPLE-CHOICE QUESTIONS

(c) 1. An investor in a mutual fund family who anticipates a tightening of monetary policy in the near future a. is likely to shift from money funds to stock funds. b. is likely to shift from bond funds to utility stock funds. c. is likely to shift from longer-term bond funds to shorter-term bond funds or money market mutual funds. d. is likely to shift from a S&P 500 index fund to a Mid-cap fund with smaller company stocks.

(d) 2. Owning mutual funds from a large "family of funds" mutual fund company enables an investor to transfer from one fund to another by a. making a 1-800 telephone call. b. directing an order via a personal computer. c. sitting down in a "telephone" booth arrangement in a public place and telephoning your request via direct lines. d. all of the above.

(d) 3. Mutual fund companies provide all but one of the following to their customers? a. diversification b. payment services c. discount brokerage d. insurance

(c) 4. The key feature of a "family of mutual funds" is a. to be able to diversify an investment portfolio. b. to be able to add funds on a regular basis such as with a 401K retirement plan. c. the ability to shift quickly from one type of mutual funds to another with little or no cost and without rolling over 401K monies. d. the ability to shift from one mutual funds management company to another.

(b) 5. Mutual fund management companies offering "families of funds" are attractive to pension-oriented investors because a. they provide high return, low risk funds. b. they provide an opportunity to alter the investment portfolio without the paperwork of rolling over the pension monies. c. they provide significant "load" fees for customers. d. they are not regulated like most mutual funds are.

(c) 6. Which one of the following services is not provided by closed-end investment companies? a. transaction cost economies b. risk diversification c. maturity intermediation d. shared costs of investment management

(b) 7. Which type of investment company allows shareholders to cash in their shares at their present asset value? a. unit investment trusts b. open-end investment companies c. closed-end investment companies d. none of the above

(b) 8. The commercial bankers' response to the growth of retirement-oriented mutual funds was to seek authority to a. offer money market mutual funds. b. market a complete variety of mutual funds. c. enter investment banking. d. seek insurance services authority in several states.

(d) 9. "Load" mutual funds are sold at a. the best price an underwriter can get. b. their present asset value. c. their present asset value less a discount. d. none of the above

(d) 10. One may find the shares of which of the following traded on the national exchanges? a. MMMF. b. open-ended investment company. c. no-load mutual fund. d. closed-end investment company.

(c) 11. No-load mutual funds compensate investment managers and sales people by a. charging a small fee for each purchase/sale. b. charging a fee based on the performance of the fund. c. charging a fee based on the value of the fund's assets. d. charging brokers a fee to sell the shares.

(b) 12. Unit investment trusts are associated with a. actively managed, short-life, liquidity provided by market. b. not actively managed, long-life, liquidity provided by originator. c. not actively managed, long-life, very little liquidity. d. none of the above

(c) 13. Money market mutual funds compete most with bank: a. DDAs. b. time deposits. c. MMDAs. d. regular savings accounts.

(a) 14. The major investment of money market mutual funds is: a. commercial paper and banker's acceptances. b. bank CDs. c. U.S. government securities. d. cash.

(c) 15. The majority of securities owned by open-ended mutual funds are: a. real, physical assets. b. money market securities. c. capital market securities. d. safe, low-risk government securities.

(d) 16. Open-end investment companies are also called ________ and are called "open-end" because a. high risk funds; they are able to assume high levels of risk. b. venture capitalists; they invest in the stock of firms. c. mutual funds; they can buy an unlimited number of corporate shares. d. mutual funds; they can issue an unlimited number of shares to investors.

(c) 17. The price of a mutual fund share is a. the sum of the value of mutual fund shares divided by the number of corporate shares held. b. the net asset value or the number of shares issued divided by the number of corporate shares owned. c. the net asset value or the value of assets divided by shares issued. d. the net asset value or the number of shares of corporate stock held divided into the total value of the stock portfolio.

(d) 18. The market value per share of closed-end investment companies a. usually exceed the net asset value per share. b. is determined by the market. c. usually is less than the net asset value per share. d. "b" and "c" above are correct answers.

(b) 19. A mutual fund "load" refers to a. the operating expenses charged against the assets. b. the sales commissions. c. the sum of the commissions paid for buying and selling the assets of the fund. d. the fees for the investment manager.

(b) 20. The major investment of mutual funds is a. municipal bonds. b. common stock. c. corporate bonds. d. mutual fund shares

(a) 21. As interest rates _________, stock mutual funds tend to hold more _________ assets. a. increase; liquid b. increase; common stock c. decrease; liquid d. fluctuate; common stock

(c) 22. The capital gains and earnings of mutual funds a. are taxed at a lower rate than individuals, a major aspect of their popularity. b. are taxed only on the interest income, not the capital gains, a major aspect of their popularity. c. are not taxed as long as they distribute a very high proportion of earnings to shareholders who pays taxes on gains and income. d. are not taxed as long as they invest in tax-free municipal securities.

(c) 23. Money market funds are included in definitions of the money supply because a. they are invested in high quality assets. b. they are invested in short-term assets. c. they provide investors opportunities to access their MMMF accounts very quickly via wire transfers and debit cards. d. of all of the above.

(c) 24. Real estate investment trusts are ________ investment companies that tend to prosper when a. open-end; when interest rates are low. b. open-end; when interest rates are high. c. closed-end; when interest rates are low. d. closed-end; when interest rates are high

(d) 25. The rapid growth of real estate investment trusts seem to be associated with a. low interest rates. b. favorable tax sheltering. c. an expanding economy. d. all of the above

(c) 26. Money market funds are included in definitions of the money supply because a. they are invested in high quality assets. b. they are invested in short-term assets. c. they provide investors opportunities to access their MMMF accounts very quickly via wire transfers and debit cards. d. of all of the above.

(d) 27. Which one of the following is true about Money Market Mutual Funds (MMMF)? a. Short-term money market investments b. Provide excellent liquidity for investors c. High quality and high yield when yield curve is inverse d. all of the above are true.

(b) 28. Mutual fund _______ promote asset gathering by providing a variety of mutual funds for their investing clients. a. managers b. families c. salesmen d. societies

(c) 29. Mutual fund managers are able to keep their cash balances low by all but one of the following. a. maintaining lines of credit at commercial banks b. increasing redemption fees. c. working to maintain low NAV=s d. redeeming shares with stock.

(b) 30. The growth of mutual funds in recent years is associated with all but one of the following statements? a. increasing number of retiring baby boomers. b. wide spread shift from defined contribution to defined benefit retirement plans. c. the increased variety of mutual funds offered. d. the attractive rates of return on common stock.

(b) 31. The major investments of mutual funds are _______, followed by______? a. bonds; common stock b. common stock; bonds c. common stock; preferred stock d. cash; common stock

(a) 32. Which of the following mutual fund types is likely to have the lowest expense ratios? a. indexed funds b. aggressive growth funds c. growth and income funds d. international and global equity funds

(d) 33. A back-end load fund will likely have an initial cost of a. the NAV less the load. b. the NAV plus the 12b-1 fees. c. the NAV plus the back-end load d. the NAV.

(b) 34. Which of the following is a rule of mutual fund investing? a. high fund managers fees insures higher than average returns. b. buy index funds with low expense ratios. c. past performance is a good predictor of future performance. d. there is little risk associated with investing pension funds in money market mutual funds.

(a) 35. The major regulatory body representing investors= interest is the a. Securities and Exchange Commission b. Security Investors Protection Commission c. Federal Reserve System d. Federal Trade Commission

(c) 36. An investment in a 3% front-end load mutual fund with a $20 NAV would cost the investor: a. $20.00 b. $19.40 c. $20.60 d. $23.00
(c) 37. Which of the following is best associated with hedge fund investors? a. employees in a 401k pension plan. b. commercial banks c. high net worth individuals and institutions. d. investors seeking to hedge their business price risk.

(a) 38. Hedge funds are typically organized as: a. limited partnerships b. corporations c. proprietorships d. partnerships

(c) 39. Hedge funds would provide investor portfolio diversification benefits if: a. the correlation of returns from the hedge fund and the investor=s portfolio are approaching +1. b. the hedge fund and the portfolio are investing in the same things. c. the correlation of returns from the hedge fund and the investor=s portfolio are less than +1. d. the hedge fund portfolio includes none of the investments of the investor portfolio.

(d) 40. Hedge funds are unlike mutual funds in all but one of following? a. registered with the SEC. b. borrow significant amounts of their capital. c. concentrate their investment in very few areas. d. are managed by professional fund managers.

(d) 41. If a hedge fund manager focused on short-selling of stocks, he/she would be: a. investing in company stock for short-term profits. b. investing in companies with high future growth prospects. c. borrowing money to invest in stocks. d. selecting companies where the future supply of securities might exceed demand.

(b) 42. The arbitrage activities of hedge funds seeks to: a. estimate what stocks will appreciate in the near future. b. capitalize on capital market inefficiencies. c. estimate the future price of derivative securities. d. make significant gains from underwriting securities.

(b) 43. Investment funds provide investors all of the following except: a. diversification. b. contractual rate of return. c. professional advice. d. small minimum investment.

(d) 44. Unit investment trusts provide all of the following advantages to investors except: a. diversification b. professional organization and investment selection c. no-load mutual fund d. all of the above

(b) 45. Hedge funds often seek to take advantage of market inefficiencies such as: a. high transaction costs. b. pricing differentials between derivative contracts and the underlying security. c. technological developments aiding informational efficiencies. d. similar prices in different geographic locations.

(b) 46. All but one of the following are advantages of exchange-traded funds? a. tax advantages b. high return; low risk c. low expense ratio d. ease of buying and selling

(a) 47. All but one of the following is true of REITs a. REITs total assets started growing in 1974 and peaked in 1984. b. REITs are financed by short (commercial paper) and they invested long in rising rate environment. c. A real estate recession caused many REIT failures. d. REITs rebounded with low interest rates and real estate revival of 1984 and low interest rate periods.

(d) 48. Which one of the following is true about marketing expenses or “12b-1” fees? a. Are subtracted from funds assets each year. b. Can be a maximum of one per cent of average net assets per year. c, Increases with higher portfolio turnover (commissions) d. all of the above are true.

(d) 49. Which one of the following is not a Federal law regulating mutual funds? a. Securities Act of 1933 b. SEC Act of 1934 c. Investment Company Act of 1940 and 1970 d. Garn-St. Germain Act of 1982

(d) 50. Closed-end mutual funds sell at a discount off the NAV for which one of the following reasons a. poor management b. tax considerations c. market demand d. all of the above

(d) 51. Which one of the following is true about Income Funds? a. Income funds consist of bonds that provide steady coupon cash flows and are quite varied in their risk level. Income funds could be made up of a portfolio of entirely corporate bonds (risky) or a portfolio of entirely Treasury issues (no default risk) or of mortgage-backed securities. b. Income funds are exposed to not only default risk, but also to interest rate risk. c. Income funds are attractive to investors close to retirement age as the income stream of fund’s instruments provides them with necessary income. d. all of the above are true.

(a) 52. Which one of the following is not true about Balanced Funds? a. Such funds are a portfolio of mortgage securities and preferred stock b. The proportion of each determines the level of return for each fund. c. They generate a higher proportion of income than growth and income funds and are less volatile. d. Investors who have a few more years to retirement and are typically in their early 50s are attracted to such funds.

(d) 53. Which one of the following is true about Growth Funds? a. The objective of growth funds is to invest in industries and companies that are not mature and are still experiencing sizable growth. b. Investors looking for a higher return and a moderate risk are attracted to such funds. c. Focus is on capital appreciation rather than steady income so investors’ outlook needs to be long-term. d. all of the above are true.

() 54. Which one of the following is true about Growth & Income Funds? a. They seek a balance between capital gains and current income. b. Mostly invest in highly rated companies’ stock. c. Ideal for investors who are looking for some income, but would also want to invest in growth stocks. d. all of the above are true.

(d) 55. One may find the shares of which of the following traded on the national exchanges? a. MMMF. b. open-ended investment company. c. no-load mutual fund. d. Exchange-Traded Funds(ETF)

ESSAY QUESTIONS

1. Compare and contrast an open-end (mutual fund) investment fund with a closed-end investment company.

Answer: Closed-ed investment companies start with a set number of shares of various companies and are usually listed on an exchange. The number of shares in a mutual fund is open-ended, and is dependent upon new shares issued (at NAV) and redeemed. Closed-end funds often trade at a discount from net asset value, the estimated market value of the fund securities.

2. How is the marketing channel of distribution different for load mutual funds vs. no load funds?

Answer: Load funds, paying an up-front sales commission, are more likely to be offered by commission security representatives (brokers), whereas no loads are likely to be sold via an "1-800" number or via the Internet, not by brokers. 3. Why are there so many different mutual funds offered for sale?

Answer: First of all, there has been a tremendous flow of funds into mutual funds over the last twenty years with each investor having a different risk profile and expectations. Fund families and fund managers have entered the business as it grew, offering opportunity for many fund managers and fund families. Stock index funds, recognizing the inability to outperform the market over time, and incurring lower expense ratios, have been popular with investors in recent years, especially when equity markets were appreciating.

4. Why have exchange-traded funds become popular in the last few years? Name one and what does it track?

Answer: First introduced in 1989 at the Toronto Stock Exchange, exchange-traded funds, are investment companies whose shares are traded on organized exchanges, similar to closed-end funds. Buyers deposit a specific portfolio of stocks, usually a stock index portfolio, and redeem their ETF shares for stock as well. Arbitrage keeps the NAV of the underlying and the ETF shares the same. American Stock Exchange's Standard & Poor's Depository Receipts (SPDRS) is one of the more popular ETF's.

5. How do hedge funds take advantage of capital market inefficiencies and end up making the markets more efficient?

Answer: Hedge funds often arbitrage derivative securities and their underlying assets, such as stock index funds and the associated portfolio of stocks. This activity increases market efficiency.