Principles of Finance Practice Questions
Course Introduction
Principles of Finance introduces students to the fundamental concepts and tools essential for understanding financial management and decision-making within organizations. The course covers key topics such as time value of money, risk and return, capital budgeting, financial markets and institutions, and the analysis of financial statements. Students will learn how organizations raise capital, allocate resources, and manage financial risks, providing a solid foundation for further study in finance and related disciplines. Through case studies and practical examples, the course aims to develop critical thinking skills and equip students with the knowledge needed to analyze financial decisions in real-world scenarios.
Recommended Textbook
Financial Markets and Institutions Global 7th Edition by Frederic S Mishkin
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Chapter 1: Why Study Financial Markets and Institutions
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Sample Questions
Q1) Financial markets and institutions
A)involve the movement of huge quantities of money.
B)affect the profits of businesses.
C)affect the types of goods and services produced in an economy.
D)do all of the above.
E)do only A and B of the above.
Answer: D
Q2) In recent years
A)interest rates have remained constant.
B)the success of financial institutions has reached levels unprecedented since the Great Depression.
C)stock markets have crashed.
D)all of the above.
Answer: C
Q3) Money is anything accepted by anyone as payment for services or goods.
A)True
B)False
Answer: True
Q4) What is monetary policy and who is responsible for its implementation?
Answer: not answered
Page 3
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Chapter 2: Overview of the Financial System
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Sample Questions
Q1) Which of the following statements about the characteristics of debt and equity are true?
A)They both can be long-term financial instruments.
B)They both involve a claim on the issuer's income.
C)They both enable a corporation to raise funds.
D)All of the above.
E)Only A and B of the above.
Answer: D
Q2) Why is it so important for an economy to have fully developed financial markets?
Answer: not answered
Q3) Financial markets have the basic function of
A)bringing together people with funds to lend and people who want to borrow funds.
B)assuring that the swings in the business cycle are less pronounced.
C)assuring that governments need never resort to printing money.
D)both A and B of the above.
E)both B and C of the above.
Answer: A
Q4) Distinguish between direct financing and indirect financing.
Answer: not answered
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Chapter 3: What Do Interest Rates Mean and What Is Their
Role in Valuation
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Sample Questions
Q1) Which of the following are true of coupon bonds?
A)The owner of a coupon bond receives a fixed interest payment every year until the maturity date, when the face or par value is repaid.
B)U)S. Treasury bonds and notes are examples of coupon bonds.
C)Corporate bonds are examples of coupon bonds.
D)All of the above.
E)Only A and B of the above.
Answer: D
Q2) With an interest rate of 5 percent, the present value of $100 received one year from now is approximately
A)$100.
B)$105.
C)$95.
D)$90.
Answer: C
Q3) Increasing duration implies that interest-rate risk has increased.
A)True
B)False
Answer: True
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Chapter 4: Why Do Interest Rates Change
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Q1) During business cycle expansions when income and wealth are rising, the demand for bonds ________ and the demand curve shifts to the ________.
A)falls; right
B)falls; left
C)rises; right
D)rises; left
Q2) When the quantity of bonds demanded equals the quantity of bonds supplied, there is
A)excess supply.
B)excess demand.
C)a market equilibrium.
D)an asset market approach.
Q3) The economist Irving Fisher, after whom the Fisher effect is named, explained why interest rates ________ as the expected rate of inflation ________.
A)rise; increases
B)rise; stabilizes
C)rise; decreases
D)fall; increases
E)fall; stabilizes
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Chapter 5: How Do Risk and Term Structure Affect Interest
Rates
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Q1) According to the market segmentation theory of the term structure,
A)the interest rate for bonds of one maturity is determined by the supply and demand for bonds of that maturity.
B)bonds of one maturity are not substitutes for bonds of other maturities; therefore, interest rates on bonds of different maturities do not move together over time.
C)investors' strong preference for short-term relative to long-term bonds explains why yield curves typically slope downward.
D)only A and B of the above.
Q2) (I)An increase in default risk on corporate bonds shifts the demand curve for corporate bonds to the right. (II)An increase in default risk on corporate bonds shifts the demand curve for Treasury bonds to the left.
A)(I)is true, (II)false.
B)(I)is false, (II)true.
C)Both are true.
D)Both are false.
Q3) What do credit-rating agencies do and why is this work important?
Q4) Why would an increase in the income tax rate reduce borrowing costs to municipalities?
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Chapter 6: Are Financial Markets Efficient
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Q1) In an efficient market, abnormal returns are not possible, even using inside information.
A)True
B)False
Q2) Evidence in favor of market efficiency does not include
A)random-walk behavior.
B)technical analysis.
C)performance of investment analysts and mutual funds.
D)the January effect.
Q3) The efficient market hypothesis
A)is based on the assumption that prices of securities fully reflect all available information.
B)holds that the expected return on a security equals the equilibrium return.
C)both A and B.
D)neither A nor B.
Q4) How is it possible that a firm can announce a record-breaking loss, yet its stock price rises when the announcement is made?
Q5) Explain what the market reaction will be in an efficient market if a firm announces a fully anticipated filing for bankruptcy.
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Chapter 7: Why Do Financial Institutions Exist
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Sample Questions
Q1) Explain how the "lemons" problem could cause financial markets to fail.
Q2) The concept of adverse selection helps explain why collateral is an important feature of many debt contracts.
A)True
B)False
Q3) What conflicts of interest can arise in investment banking?
Q4) A venture capital firm protects its equity investment from moral hazard through which of the following means?
A)It places people on the board of directors to better monitor the borrowing firm's activities.
B)It writes contracts that prohibit the sale of an equity investment to anyone but the venture capital firm.
C)It prohibits the borrowing firm from replacing its management.
D)It does both A and B of the above.
E)It does both A and C of the above.
Q5) What conflicts of interest can arise in credit-rating agencies?
Q6) What conflicts of interest can arise in accounting firms?
Q7) What facts about financial structure can be explained by adverse selection?
Q8) What facts about financial structure can be explained by moral hazard?
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Chapter 8: Why Do Financial Crises Occur and Why Are
They so Damaging to the Economy
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Q1) Stage Two of a financial crisis in an advanced economy usually involves a ________ crisis.
A)currency
B)stock market
C)banking
D)commodities
Q2) In an advanced economy, a financial crisis can begin in several ways, including:
A)mismanagement of financial liberalization or innovation.
B)asset pricing booms and busts.
C)an increase in uncertainty caused by failure of financial institutions.
D)all of the above.
Q3) Most financial crises in the United States have begun with
A)a steep stock market decline.
B)an increase in uncertainty resulting from the failure of a major firm.
C)a steep decline in interest rates.
D)all of the above.
E)only A and B of the above.
Q4) Contrast the stages of a financial crisis between an advanced economy and an emerging market economy.
Q5) What does the "twin crises" in an emerging economy financial crisis refer to?
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Chapter 9: Central Banks and the Federal Reserve System
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Sample Questions
Q1) Which of the following is an element of the Federal Reserve System?
A)The Federal Reserve banks
B)The Board of Governors
C)The FOMC
D)All of the above
Q2) Critics of Fed independence argue
A)that it is undemocratic to have monetary policy controlled by an elite group responsible to no one.
B)that an independent Fed conducts monetary policy with a consistent inflationary bias.
C)that the Fed, since it does not face a binding budget constraint, spends too much of its earnings.
D)only A and B of the above.
Q3) The Board of Governors of the Federal Reserve System
A)appoint three directors to each Federal Reserve Bank.
B)elect six members to member commercial banks.
C)both of the above.
D)none of the above.
Q4) What factors limit the independence of the Federal Reserve?
Q5) What are the factors that promote the independence of the Federal Reserve?
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Chapter 10: Conduct of Monetary Policy: Tools, Goals, Strategy, and
Tactics
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Q1) If the Fed's strategy for conducting monetary policy is thought of as a game plan that proceeds in stages, then the game plan can be summarized as follows:
A)The Fed selects its policy goals, then the intermediate targets consistent with achieving its policy goals, then the operating targets consistent with its intermediate targets. Finally, it adjusts its policy tools to effect the desired targets and goals.
B)The Fed selects its policy goals, then the operating targets consistent with achieving its policy goals, then the intermediate targets consistent with its operating targets. Finally, it adjusts its policy tools to effect the desired targets and goals.
C)The Fed selects its policy goals, then the intermediate targets consistent with achieving its policy goals, then the policy tools consistent with its intermediate targets. Finally, it adjusts its operating targets to effect the desired targets and tools.
D)The Fed selects its policy tools, then the operating targets consistent with achieving its policy tools, then the intermediate targets consistent with its operating targets. Finally, it adjusts its policy goals to effect the desired targets and tools.
E)None of the above.
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Chapter 11: The Money Markets
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Sample Questions
Q1) Money markets are referred to as retail markets because small individual investors are the primary buyers of money market securities.
A)True
B)False
Q2) The Federal Reserve can influence the federal funds interest rate by buying securities, which ________ reserves, thereby ________ the federal funds rate.
A)adds; raising B)removes; lowering C)adds; lowering D)removes; raising
Q3) Which of the following statements about the money markets are true?
A)Not all commercial banks deal for their customers in the secondary market.
B)Money markets are used extensively by businesses both to warehouse surplus funds and to raise short-term funds.
C)The single most influential participant in the U.S. money market is the U.S. Treasury Department.
D)All of the above are true.
E)Only A and B of the above are true.
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Chapter 12: The Bond Market
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Sample Questions
Q1) Which of the following are true for the current yield?
A)The current yield is defined as the yearly coupon payment divided by the price of the security.
B)The formula for the current yield is identical to the formula describing the yield to maturity for a discount bond.
C)The current yield is always a poor approximation for the yield to maturity.
D)All of the above are true.
E)Only A and B of the above are true.
Q2) Debentures are long-term unsecured bonds that are backed only by the general creditworthiness of the issuer.
A)True
B)False
Q3) The current yield on a bond is a good approximation of the bond's yield to maturity when the bond matures in five years or less and its price differs from its par value by a large amount.
A)True
B)False
Q4) What is a callable bond? How does the callability feature affect the bond's price and interest rate?
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Chapter 13: The Stock Market
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Q1) What are the advantages and disadvantages of exchange traded funds (ETFs)fro trading stocks?
Q2) What are the objectives of the Securities and Exchange Commission?
Q3) (I)The market price of a security at a given time is the highest value any investor puts on the security. (II)Superior information about a security increases its value by reducing its risk.
A)(I)is true, (II)is false.
B)(I)is false, (II)is true.
C)Both are true.
D)Both are false.
Q4) (I)The largest of the organized stock exchanges in the United States is the New York Stock Exchange. (II)To be listed on the NYSE, a firm must have a minimum of $100 million in market value or $10 million in revenues.
A)(I)is true, (II)false.
B)(I)is false, (II)true.
C)Both are true.
D)Both are false.
Q5) How do corporate stocks differ from bonds?
Q6) What are American Depository Receipts (ADRs)?
Page 15
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Chapter 14: The Mortgage Markets
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Sample Questions
Q1) A borrower who qualifies for an FHA or VA loan enjoys the advantage that
A)the mortgage payment is much lower.
B)only a very low or zero down payment is required.
C)the cost of private mortgage insurance is lower.
D)the government holds the lien on the property.
Q2) ________ issues participation certificates, and ________ provides federal insurance for participation certificates.
A)Freddie Mac; Freddie Mac
B)Freddie Mac; Ginnie Mae
C)Ginnie Mae; Freddie Mac
D)Ginnie Mae; Ginnie Mae
E)Freddie Mac; no one
Q3) A loan-servicing agent will
A)package the loan for an investor.
B)hold the loan in their investment portfolio.
C)collect payments from the borrower.
D)do both A and C of the above.
E)do both B and C of the above.
Q4) Discuss the pros and cons of a subprime market for residential mortgages in the U.S.
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Chapter 15: The Foreign Exchange Market
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Sample Questions
Q1) The theory of asset demand suggests that the most important factor affecting the demand for domestic and foreign deposits is
A)the level of trade and capital flows.
B)the expected return on these assets relative to one another.
C)the liquidity of these assets relative to one another.
D)the riskiness of these assets relative to one another.
Q2) If the dollar ________ from 1.2 euros per dollar to 0.8 euros per dollar, the euro ________ from 0.83 dollars to 1.25 dollars per euro.
A)appreciates; appreciates
B)appreciates; depreciates
C)depreciates; depreciates
D)depreciates; appreciates
Q3) Increased demand for a country's ________ causes its currency to appreciate in the long run, while increased demand for ________ causes its currency to depreciate.
A)imports; imports
B)imports; exports
C)exports; imports
D)exports; exports
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Chapter 16: The International Financial System
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Q1) An anchor currency provides the base for a floating exchange rate system.
A)True
B)False
Q2) Describe the pros and cons for controls on capital inflows and outflows.
Q3) Which of the following are true statements about the Bretton Woods system?
A)The Bretton Woods system was a fixed exchange rate regime, in which central banks bought and sold their own currencies to keep their exchange rates fixed.
B)To maintain fixed exchange rates when countries had balance of payments deficits and were losing international reserves, the IMF would loan deficit countries international reserves contributed by other members.
C)The German mark was called a reserve currency because it was used to denominate the securities central banks held as international reserves.
D)All of the above are true.
E)Only A and B of the above are true.
Q4) By the end of 2010, China had accumulated more than $2 trillion of international reserves. How did China accomplish this? Is the policy sustainable?
Q5) What was the European Monetary System? How did its exchange rate mechanism work?
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Chapter 17: Banking and the Management of Financial Institutions
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Q1) Net profit after taxes per dollar of equity capital is a basic measure of bank profitability called
A)return on assets.
B)return after taxes.
C)return on equity.
D)equity multiplier.
Q2) Loan loss reserves are an asset on a bank's balance sheet.
A)True
B)False
Q3) Examples of off-balance-sheet activities include
A)loan sales.
B)foreign exchange market transactions.
C)trading in financial futures.
D)all of the above.
E)only A and B of the above.
Q4) Which of the following are not reported as assets on a bank's balance sheet?
A)cash items in the process of collection
B)deposits with other banks
C)U)S. Treasury securities
D)checkable deposits
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Chapter 18: Financial Regulation
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Sample Questions
Q1) Prior to the 2007-2009 financial crisis, inaccurate ratings provided by credit rating agencies helped promote risk taking throughout the financial system.
A)True
B)False
Q2) The Depository Institutions Deregulation and Monetary Control Act of 1980
A)approved NOW accounts nationwide.
B)restricted the use of ATS accounts.
C)imposed interest rate ceilings on bank loans.
D)did all of the above.
Q3) The increased integration of financial markets across countries and the need to make the playing field equal for banks from different countries led to the Basel Accord agreement to
A)standardize bank capital requirements internationally.
B)reduce, across the board, bank capital requirements in all countries.
C)sever the link between risk and capital requirements.
D)do all of the above.
Q4) Why is international financial regulation becoming more important in recent years?
Q5) Discuss the role of NINJA loans in the 2007-2009 financial crisis.
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Chapter 19: Banking Industry: Structure and Competition
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Q1) Explain the innovations that have been created to lower interest-rate risk.
Q2) Bank failures and mergers have caused the number of commercial banks in the U.S. to decline from around ________ in the 1970s to below ________ today.
A)25,000; 10,000
B)15,000; 10,000
C)25,000; 20,000
D)15,000; 5,000
Q3) Which of the following is not a financial innovation stimulated by information technology?
A)credit card
B)debit card
C)adjustable-rate mortgage
D)electronic banking
Q4) The National Banking Act of 1863, and subsequent amendments to it,
A)created a banking system of federally chartered banks.
B)established the Office of the Comptroller of the Currency.
C)broadened the regulatory powers of the Federal Reserve.
D)did all of the above.
E)did only A and B of the above.
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Chapter 20: The Mutual Fund Industry
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Q1) Mutual funds offer investors all of the following except
A)greater-than-average returns.
B)diversified portfolios.
C)lower transaction costs.
D)professional investment management.
Q2) A deferred-load mutual fund charges a commission
A)when shares are purchased.
B)when shares are sold.
C)both when shares are purchased and when they are sold.
D)when shares are redeemed.
Q3) SEC research suggests that about three-fourths of mutual funds let privileged shareholders engage in market timing.
A)True
B)False
Q4) Equity funds can be placed in which class according to the Investment Company Institute?
A)capital appreciation funds
B)world funds
C)total return funds
D)all of the above
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Chapter 21: Insurance Companies and Pension Funds
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Q1) Health maintenance organizations (HMOs)shift the risk from the provider to the insurance company.
A)True
B)False
Q2) ________ is an insurance product that will help if you live longer than you expect. For an initial fixed sum or stream of payments, the insurance company agrees to pay you a fixed amount for as long as you live.
A)Life insurance proper
B)Disability insurance
C)An annuity
D)Health insurance
Q3) The problem of ________ occurs when those most likely to get large insurance payoffs are the ones who want to purchase insurance the most.
A)asymmetric information
B)moral hazard
C)adverse selection
D)fraudulent behavior
Q4) Describe how insurance companies try to reduce adverse selection and moral hazards.
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Chapter 22: Investment Banks, Security Brokers and Dealers,
and Venture Capital Firms
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Q1) How do best efforts agreements and private placements differ from the usual process of underwriting new securities issues?
Q2) Which is not an activity of investment banks?
A)underwriting new issues of corporate stocks and bonds
B)acting as deal makers in mergers
C)acting as intermediaries in the buying and selling of businesses or parts of businesses
D)underwriting new issues of federal government bonds
Q3) Which of the following is not a step in the process by which an investment bank assists in the sale of a company or corporate division?
A)preparation of a confidential memorandum
B)negotiation of a letter of intent
C)preparation of a definitive agreement
D)forming a syndicate of purchasers
Q4) The largest full-service broker is ________.
A)Bank of America Merrill Lynch
B)Charles Schwab Corp.
C)Ameritrade
D)Smith Barney
Page 24
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Chapter 23: Risk Management in Financial Institutions
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Q1) What is gap analysis and why is it important to a bank?
Q2) Banks' attempts to solve adverse selection and moral hazard problems help explain loan management principles such as
A)screening and monitoring of loan applicants.
B)collateral and compensating balances.
C)credit rationing.
D)all of the above.
E)only A and B of the above.
Q3) Explain how banks benefit from specialization in lending.
Q4) One problem with duration gap analysis is that it
A)is calculated assuming that the yield curve is flat.
B)is calculated assuming that the yield curve does not change.
C)does not measure the sensitivity of net worth to interest rate changes.
D)does not measure the sensitivity of income to interest rate changes.
E)applies only to financial institutions.
Q5) Developing and maintaining long-term customer relationships help to reduce banks' costs of screening and monitoring borrowers.
A)True
B)False
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Chapter 24: Hedging With Financial Derivatives
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Q1) Who would be most likely to buy a long stock index future?
A)a mutual fund manager who believes the market will rise
B)a mutual fund manager who believes the market will fall
C)a mutual fund manager who believes the market will be stable
D)none of the above would be likely to purchase a futures contract
Q2) One advantage of using swaps to eliminate interest-rate risk is that swaps
A)are less costly than futures.
B)are less costly than rearranging balance sheets.
C)are more liquid than futures.
D)have better accounting treatment than options.
Q3) If a firm must pay for goods it has ordered with foreign currency, it can hedge its foreign exchange rate risk by
A)selling foreign exchange futures short.
B)buying foreign exchange futures long.
C)staying out of the exchange futures market.
D)doing none of the above.
Q4) If Friendly Finance Company has more rate-sensitive assets than rate-sensitive liabilities, it may reduce risk with a swap.
A)True
B)False
Page 26
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Chapter 25: Savings Associations and Credit Unions
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Q1) In the early stages of the banking crisis in the 1980s, financial institutions were especially hurt by
A)the sharp increases in interest rates from late 1979 until 1981.
B)the severe recession in 1981-82.
C)the sharp decline in the price level from mid-1980 to early 1983.
D)all of the above.
E)only A and B of the above.
Q2) The policy of regulatory forbearance
A)meant delaying the closing of "zombie S&Ls" as their losses mounted during the 1980s.
B)benefited "zombie S&Ls" at the expense of healthy S&Ls, as healthy institutions lost deposits to insolvent institutions.
C)contributed to declining profitability in the S&L industry and an increase in the number of "zombie S&Ls."
D)did all of the above.
E)did only A and B of the above.
Q3) Explain how the Lincoln Savings and Loan scandal is an application of the principal-agent problem.
Q4) How has the thrift industry been transformed since FIRREA?
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Chapter 26: Finance Companies
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Q1) What are the various types of finance companies?
Q2) In which industry is factoring a common practice?
A)automobile
B)tech services
C)entertainment
D)apparel
Q3) In the early 1900s, banks did not offer loans to purchase automobiles. This is because
A)banks could not make a profit on car loans.
B)only finance companies were permitted to offer car loans.
C)banks could not repossess a car if the loan defaulted.
D)banks did not view a car as a productive asset.
Q4) Discuss the regulatory environment for finance companies relative to commercial banks.
Q5) Factoring refers to purchasing a firm's accounts receivables at a premium.
A)True
B)False
Q6) Describe how floor plans work in the automobile industry. Why can finance companies offer these arrangements at a lower cost than banks?
Q7) Describe the process of factoring? When and why is it used?
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