Financial Markets and Institutions
Study Guide Questions
Course Introduction
This course provides a comprehensive exploration of financial markets and institutions, examining their roles within the global economy. Students will learn about the structure and functions of various financial markets including money, capital, and foreign exchange markets and the key institutions that operate within them, such as central banks, commercial banks, investment firms, and insurance companies. The course covers regulatory frameworks, the management of risk, and the impact of monetary and fiscal policy on financial systems. Emphasis is placed on understanding how these markets and institutions facilitate the allocation of resources, influence economic stability, and respond to financial innovations and crises.
Recommended Textbook Money Banking and Financial Markets 4th Edition by
Stephen G. Cecchetti
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Chapter 1: An Introduction to Money and the Financial System
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Q1) Which core principle(s) could you use to explain why credit card issuers charge such high rates of interest?
Answer: You could explain the high rates of interest from three principles.First, risk requires compensation, and certainly the credit card issuers are taking a risk when they let people use the cards.There is a risk that some users may not repay the credit card company.Second, you can also justify it from the principle that time has value.The borrowers are using the issuer's funds, and the issuer needs to be compensated for letting the borrower use these funds.Some borrowers do not repay for considerable periods of time.Third, you could also invoke the principle that people use information in making their decisions.Credit card issuers need to acquire information on each applicant before a card is issued and this process is costly.Unfortunately, the applicants who are denied do not get the card, but those who are approved must help cover the information costs.
Q2) In the United States, control of the quantity of money is given to the:
A)President.
B)Federal Reserve System.
C)Bureau of Printing and Engraving.
D)Department of the Treasury.
Answer: B
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Chapter 2: Money and the Payments System
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Q1) M1 has decreased in its usefulness in understanding inflation due to:
A)the increased use of checks in the economy.
B)the introduction of money market mutual fund shares and similar checking substitutes.
C)more reliance on the use of currency.
D)the increased use of electronic payments.
Answer: B
Q2) What is included in M2 that is not included in M1?
Answer: Small denomination time deposits, plus Savings Deposits and Money Market Deposit Accounts and Retail Money Market Mutual Fund Shares.
Q3) Economists study the link between money and inflation because:
A)they want to understand how to keep inflation low and stable.
B)economists believe that inflation in the 3-6% range is healthy for an economy.
C)as prices increase money becomes more valuable.
D)the Fed needs to increase the money supply as prices increase.
Answer: A
Q4) What does it mean to say that an asset is "liquid"?
Answer: An asset is liquid when it can be converted into a means of payment, quickly without suffering a loss in value.
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Chapter 3: Financial Instruments, Financial Markets, and Financial Institutions
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Q1) Equity markets are markets:
A)of U.S.Treasury bonds.
B)for AAA rated bonds.
C)for stocks.
D)for either stocks or bonds.
Answer: C
Q2) Money markets are where trades occur for:
A)stocks.
B)bonds of all maturities.
C)derivatives.
D)short-term bonds issued by both governments and private companies.
Answer: D
Q3) A primary financial market is:
A)a market just for corporate stocks.
B)a market only for AAA rated Securities.
C)the New York Stock Exchange.
D)one in which newly issued securities are sold.
Answer: D
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Chapter 4: Future Value, Present Value, and Interest Rates
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Q1) A credit card that charges a monthly interest rate of 1.5% has an effective annual interest rate of:
A)18.0%
B)19.6%
C)15.0%
D)17.50%
Q2) Tom deposits funds in his savings account at the bank which is paying 3.5% interest.If he keeps his funds in the bank for one year he will have $155.25.What amount is Tom depositing?
A)$151.75
B)$150.00
C)$148.75
D)$147.50
Q3) A bond offers a $40 coupon, has a face value of $1000, and 10 years to maturity.If the interest rate is 5.0%, what is the value of this bond?
Q4) Suppose a two-year coupon bond has payments of $40 and a face value of $800.The interest rate is 8%.Compute the present value of the coupon payments and the principal payment of the bond.What is the price of this bond?
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Chapter 5: Understanding Risk
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Q1) The risk premium for an investment:
A)is negative for U.S.treasury securities.
B)is a fixed amount added to the risk-free return, regardless of the level of risk.
C)increases with risk.
D)is zero (0) for risk-averse investors.
Q2) Which of the following individuals is least likely to use value at risk as an important factor in his/her investment decision?
A)An individual considering a mortgage to buy his first home.
B)A family considering purchasing health insurance.
C)A policy maker considering regulation of depository institutions.
D)A mutual fund manager choosing the allocation of investments in the fund's portfolio.
Q3) Uncertainties that are not quantifiable:
A)are what we define as risk.
B)are factored into the price of an asset.
C)cannot be priced.
D)are benchmarks against which quantifiable risks can be assessed.
Q4) Explain the following: Risk results from the fact that more outcomes could happen than will happen.
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Chapter 6: Bonds, Bond Prices, and the Determination of Interest Rates
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Q1) A zero-coupon bond refers to a bond which:
A)does not pay any coupon payments because the issuer is in default.
B)promises a single future payment.
C)pays coupons only once a year.
D)pays coupons only if the bond price is above face value.
Q2) Suppose that the interest rate on a conventional 30-year mortgage is currently 8%.You receive a call from a mortgage broker who offers you a 30-year adjustable rate mortgage at 2% that is adjusted once each year.Evaluate each mortgage in terms of the following: risk that the monthly payment will change over the next 30 years and interest-rate risk.
Q3) The current yield of a bond:
A)is another term for the coupon rate.
B)is another term for the yield to maturity.
C)equals zero for a zero-coupon bond since these bonds have no coupon payments. D)is the difference between its future value and its present value.
Q4) When expected inflation increases, for any given nominal interest rate the:
A)bond demand curve shifts right.
B)bond supply curve shifts right.
C)price of bonds increases.
D)yield on bonds will increase.
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Chapter 7: The Risk and Term Structure of Interest Rates
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Q1) The reason for the increase in inflation risk over time is due to the fact that:
A)the inflation rate always increases over time.
B)we always have inflation.
C)it is more difficult to forecast inflation over longer periods of time.
D)investors are more focused on nominal returns than real returns.
Q2) Bonds rated as "highly speculative" are:
A)rated so because they guarantee high returns for the buyer.
B)commonly referred to as junk bonds.
C)ranked just above investment grade by Standard & Poor's.
D)rated so because they do not have any default risk.
Q3) When the Russian government defaulted on its bonds in August 1998:
A)risk spreads decreased significantly.
B)yields on U.S.Treasury securities fell while yields on corporate bonds rose.
C)yields on U.S.Treasury securities rose while prices of corporate bonds rose.
D)risk spreads did not change.
Q4) When the yield curve is downward sloping:
A)people are expecting an economic slowdown.
B)short-term yields are lower than long term yields.
C)people are expecting higher inflation in the future.
D)people could be expecting a tightening in monetary policy.
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Chapter 8: Stocks, Stock Markets, and Market Efficiency
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Q1) Considering the S&P 500 Index, if each company's stock price increased by 10%:
A)the weights in the index would remain the same.
B)the companies with the most shares outstanding would have even greater weight after the increase.
C)the companies with fewer shares would gain more weight at the expense of the companies with greater shares.
D)the weights in the index would change to reflect the percentage changes in the prices of the various stocks.
Q2) XYZ Inc.announces plans to finance the expansion of the firm by issuing hundreds of millions of dollars of bonds.Discuss how the current stockholders of XYZ Inc.will feel about this plan.
Q3) Why does the theory of efficient markets imply that stock price movements are unpredictable?
Q4) From the perspective of the theory of efficient markets, explain why it may be difficult for professional portfolio managers who have an exceptional year to continuously outperform the market average.
Q5) What possibilities exist to explain the claim made by many professional portfolio managers that they can exceed the average stock market return year after year?
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Chapter 9: Derivatives: Futures, Options, and Swaps
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Q1) Forward contracts are:
A)an agreement between more than two parties.
B)contracts usually involving the exchange of a commodity or financial instrument.
C)always standardized.
D)easily resold.
Q2) The time value of the option can best be defined as (excluding its intrinsic value):
A)the commission earned by a broker.
B)the fee earned for the potential benefits from buying the option.
C)the service fee charged by the SEC for regulating the option market.
D)the fee paid for the potential benefits from buying an option.
Q3) Consider a call option; in terms of the option writer and option holder, who is the buyer? Who is the seller? Finally, who has the option? Explain.
Q4) Explain the concept of notional principal used in swaps.
Q5) Identify four factors that will cause the value of call options to increase.
Q6) What is the process that makes sure the market price of an underlying asset equals the price of a futures contract at the settlement date? Provide an example.
Q7) How did CDS' contribute to the financial crisis of 2007-2009?
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Chapter 10: Foreign Exchange
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Q1) Considering the law of one price, evidence in the foreign exchange markets over brief intervals shows:
A)the law works most of the time.
B)this is the closest thing to a perfect law in economics.
C)that the law fails most of the time.
D)the law only works in the very short run.
Q2) In theory, the law of one price makes a lot of sense.So why do we see it fail so often?
Q3) Large, advanced economies like the United States, Japan, and the euro area generally:
A)use fixed exchange rates to promote stability.
B)allow their respective Treasuries to determine the exchange rates.
C)allow supply and demand to determine exchange rates.
D)give exclusive control of exchange rates to their respective central banks.
Q4) The strong appreciation of the dollar for the last part of the 1990s:
A)was a benefit to all U.S.residents but costly to most foreign producers.
B)was a benefit to U.S.exporters, but put a severe strain on U.S.Importers.
C)was welcomed by all U.S.manufacturers.
D)played a key role in keeping inflation in check even though the economy was growing rapidly.
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Chapter 11: The Economics of Financial Intermediation
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Q1) One of the conclusions from Akerlof's paper titled "The Market for Lemons" was:
A)high quality goods will drive low quality goods out of the market.
B)lacking the ability to distinguish high from low quality, the quality the market will end up offering will be the average quality.
C)lacking the ability to distinguish high from low quality, low quality may drive high quality out of the market.
D)high quality is always demanded by consumers over low quality.
Q2) Two problems that arise from asymmetric information are:
A)adverse selection and diseconomies of scale.
B)moral hazard and the free-rider problem.
C)moral hazard and adverse selection.
D)the free-rider problem and adverse selection.
Q3) The publication, Consumer's Reports, is one tool designed to address:
A)adverse selection.
B)moral hazard.
C)the free-rider problem.
D)symmetric information.
Q4) Explain how the threat of a leveraged buyout or a takeover can actually address the problem of moral hazard.
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Chapter 12: Depository Institutions: Banks and Bank Management
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Q1) Mergers resulting from the financial crisis of 2007-2009 have left what percentage of deposits in the hands of 4 banks?
A)10%
B)30%
C)40%
D)60%
Q2) If bank with leverage of 8 to 1 increases its assets by adding $1 to capital for every $1 added to assets:
A)leverage increases.
B)leverage decreases.
C)leverage stays constant.
D)the answer cannot be determined from the information in the question.
Q3) A bank that cannot meet its loan commitments is experiencing the results of:
A)interest rate risk.
B)credit risk.
C)trading risk.
D)liquidity risk.
Q4) What are the securities that U.S.banks own and why are they often referred to as secondary reserves?
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Chapter 13: Financial Industry Structure
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Q1) A business needs a loan to help keep its shelves stocked.This is an example of:
A)an inventory loan.
B)sales finance.
C)equipment leasing.
D)consumer finance.
Q2) The U.S.has many banks because:
A)small banks are more profitable than large banks.
B)many states outlawed bank branching.
C)the Great Depression caused the failure of the large banks, leaving many small banks.
D)the Glass-Steagall Act forced the splitting up of large banks.
Q3) In many cases, life insurance companies will require applicants to take a physical.This is done to avoid the problem of:
A)adverse selection.
B)moral hazard.
C)free riding.
D)transaction costs.
Q4) There are two current trends in the financial industry which run in opposite directions.What are they?
Q5) What is the basic difference(s) between term and whole life insurance?
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Chapter 14: Regulating the Financial System
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Q1) Financial regulators set capital requirements for banks.One characteristic about these requirements is:
A)every bank will have to hold the same level.
B)the riskier the asset holdings of a bank, the more capital it will be required to have.
C)the more branches a bank has, the more capital it must have.
D)the amount of capital required is inversely related to the amount of assets the bank owns.
Q2) The payoff method used by the FDIC to address the insolvency of a bank is when the FDIC:
A)pays the owners of the bank for the losses they would otherwise face.
B)pays off all depositors the balances in their accounts so no depositor suffers a loss, though the owners of the bank may suffer losses.
C)pays off the depositors up to the current $250,000 limit, so it is possible that some depositors will suffer losses.
D)takes all of the assets of the bank, sells them, pays off the liabilities of the bank, in full and then replenishes their fund with any remaining balance.
Q3) What was the primary motivation behind the creation of the 1988 Basel Accord?
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Chapter 15: Central Banks in the World Today
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Q1) Over very long periods, U.S.real economic growth averaged around:
A)3 percent per year.
B)1 percent per year.
C)5 percent per year.
D)7 percent per year.
Q2) The means for assuring accountability and transparency:
A)may differ across the central banks of different countries.
B)are the same for all successful central banks.
C)involve setting specific numerical targets so there is no confusion as to what the goal is.
D)are opposite to each other; increasing one means decreasing the other.
Q3) If a government were to find that it cannot raise taxes any further, and that it cannot borrow any further from financial markets, the government:
A)cannot increase its spending any further.
B)can increase spending by having the central banks purchase its bonds.
C)is in default.
D)can decrease the amount of money in circulation.
Q4) Explain why inflation is a way for governments to default on a portion of the debts they owe.
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Chapter 16: The Structure of Central Banks: The Federal
Reserve and the European Central Bank
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Q1) Discuss whether a large private organization could function in the role of a lender of last resort, and if it could, what potential problem(s) might arise.
Q2) The method used by the ECB to measure inflation for meeting its objectives:
A)gives equal weight to each member country.
B)gives greater relative weight to smaller countries.
C)can result in a contractionary monetary policy being used in a country where inflation is already very low.
D)is based on wholesale rather than retail prices.
Q3) Buying and selling U.S.Treasury Securities for the Fed's own portfolio is called:
A)managing the float.
B)discount buying.
C)open market operations.
D)reserve adjustment.
Q4) The Governors of the Federal Reserve System serve terms of:
A)four years that can be renewed.
B)fourteen years.
C)four years, the same as the U.S.President, and the terms are not renewable.
D)seven years.
Page 18
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Chapter 17: The Central Bank Balance Sheet and the Money
Supply Process
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Q1) The collapse of the Thai currency, the baht, was partially due to:
A)inaction by the Federal Reserve.
B)the European Central Bank.
C)information provided by the central bank of Thailand.
D)information not provided by the central bank of Thailand.
Q2) As a portion of total assets measured in billions of dollars, the most important asset on the Fed's balance sheet is:
A)gold.
B)securities.
C)foreign exchange reserves.
D)loans.
Q3) To obtain a discount loan from the Fed, a commercial bank must:
A)prove that it will fail if it does not obtain the loan.
B)prove that the loan will be used to make loans.
C)provide collateral.
D)agree to more frequent examinations.
Q4) What would be the amount of deposits D, given that the monetary base MB = $750 billion, the required reserve rate (r<sub>D</sub>) = 0.1, the excess reserve rate (ER/D) = 0.005, and non-bank currency to deposits (C/D) equaled 1.2?
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Chapter 18: Monetary Policy: Stabilizing the Domestic Economy
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Q1) The measure for the actual rate of inflation used in the Taylor rule is the:
A)Personal Consumption Expenditure Index.
B)GDP deflator.
C)Consumer Price Index.
D)Producer Price Index.
Q2) The European Central Bank's equivalent of the Fed's open market operations (OMO) is:
A)very similar to the Fed's OMO in that they are highly centralized.
B)dissimilar to the Fed's OMO in that the operations are conducted at all 18 of the National Central Banks simultaneously.
C)similar to the Fed's OMO in that they accept only U.S.Treasury securities in their refinancing operations.
D)dissimilar to the Fed's OMO because fewer banks participate in the auctions of the securities.
Q3) Consider the desirable features of monetary policy operating instruments and the use of intermediate targets.What missing feature makes a target intermediate rather than operating? Why did the Fed abandon the use of most intermediate targets?
Q4) Is the Taylor rule the specific formula followed by the FOMC? Explain.
Page 20
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Chapter 19: Exchange-Rate Policy and the Central Bank
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Q1) What is the relationship between a nation's monetary and fiscal policy and its exchange rate?
Q2) A country announces capital outflow controls that will take effect in three months.This announcement will likely:
A)stabilize the country's exchange rate.
B)attract significant amounts of foreign investors.
C)result in a significant appreciation of the country's currency.
D)result in a significant depreciation in the country's currency.
Q3) Using demand and supply analysis, explain why the euro/dollar exchange rate rises (the dollar appreciates) if the Fed intervenes in the foreign exchange market and sells euros.
Q4) When a country operates with a currency board, the central bank's sole objective is to:
A)focus on domestic monetary policy.
B)maintain the domestic interest rate.
C)maintain the exchange rate.
D)maintain the target inflation rate.
Q5) Are foreign exchange market interventions the only tool available to a central bank to change the exchange rate? Explain.
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Chapter 20: Money Growth, Money Demand, and Modern Monetary Policy
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Q1) Crises that occasionally hit financial markets will increase the demand for money since:
A)the return on money increases.
B)the return on financial assets increases.
C)there is no risk with holding money.
D)the risk of holding money relative to other financial assets decreases.
Q2) For many of the countries that made up the Soviet Union, the period immediately following the collapse of the Soviet Union in 1990 found these countries experiencing:
A)rapid economic growth.
B)severe deflation.
C)rapid development of financial intermediaries.
D)extremely high rates of inflation.
Q3) If on average, a dollar is spent 4 times each year to purchase real output, the velocity of money is:
A)one-fourth.
B)four.
C)the money supply divided by 4.
D)nominal GDP divided by four.
Q4) What factors can cause the portfolio demand for money to increase?
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Chapter 21: Output, Inflation, and Monetary Policy
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Q1) Evidence points out that since the mid-1950's just about every recession was preceded by rising interest rates.This suggests that the recessions were:
A)caused in part by the actions of the Federal Reserve.
B)the result of changes in consumer confidence.
C)due to increases in oil prices and other production costs.
D)caused by simultaneous shifts in aggregate demand and aggregate supply.
Q2) If policymakers are not aggressive about keeping inflation close to the target rate, the slope of the monetary policy reaction curve would be:
A)steep.
B)relatively flat.
C)horizontal.
D)negative.
Q3) The dynamic aggregate demand curve illustrates that the relationship between inflation and real output is:
A)direct.
B)inverse.
C)independent.
D)undefined.
Q4) What are the conditions for long-run equilibrium?
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Chapter 22: Understanding Business Cycle Fluctuations
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Q1) A reduction in the central bank's inflation target will result in:
A)an increase in potential output.
B)no change in potential output.
C)a decrease in potential output.
D)the long-run aggregate supply curve having an upward slope.
Q2) Without a change in target inflation, anything that shifts the aggregate demand curve to the right will cause:
A)a temporary increase in output.
B)a permanent reduction in inflation.
C)a temporary decrease in inflation.
D)an increase in output in the long run.
Q3) The period 1974-1975 is somewhat unique in U.S.economic history due to the fact that:
A)the output was growing rapidly and the inflation rate was falling.
B)both the output and the inflation rate were falling.
C)output was falling yet the inflation rate rose dramatically.
D)output and the inflation rate were both rising.
Q4) What is opportunistic disinflation and what provides the opportunity? Explain how the process works.
Q5) What is meant by saying that automatic fiscal policy is countercyclical?
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Chapter 23: Modern Monetary Policy and the Challenges
Facing Central Bankers
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Q1) If central bankers raise the interest rate, the asset-price channel of monetary policy implies:
A)stock prices will decrease.
B)stock prices will remain the same but bond prices will increase.
C)bond prices will remain flat.
D)stock prices will increase and bond prices will remain flat.
Q2) The importance of the bank-lending channel of monetary policy transmission:
A)becomes more important the more important banks are as a source of funds for firms and individuals.
B)is likely to become more important with the growth of loan brokers and asset-backed securities.
C)has become more important as technology has solved the problems of information and moral hazard.
D)none of the answers given is correct.
Q3) Monetary policymakers could keep equity and property price bubbles from developing by:
A)raising their interest rate target when they suspect a bubble.
B)lowering their interest rate target when they suspect a bubble.
C)expanding the money supply in the economy.
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D)purchasing U.S.treasury securities to drive up their prices.
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