Kidwell, Blackwell, Whidbee, Sias Financial Institutions, Markets, and Money, 11th Edition Test Bank

Financial Institutions, Markets, and Money, 11th Edition BY Kidwell, Blackwell, Whidbee, Sias

Email: richard@qwconsultancy.com

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 deficit spending units (DSUs).

(T)

3.

A financial claim is an “IOU” from a deficit spending unit.

(T)

4.

Investment bankers help deficit spending units (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 a surplus spending units (SSU) owns a financial claim created by financial intermediation, its residual claim is against a deficit spending units (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 surplus spending units ( 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 deficit spending unit.

(T)

14.

Depository intermediaries issue claims that are for the most part highly liquid.

(T)

15.

A household is a surplus spending units when income for the period exceeds spending.

(F)

16.

A surplus spending units surplus spending unit (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.

Deficit spending units (DSUs) and surplus spending units (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.

1

(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 deficit spending units (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 short-term liquidity; the capital market finances long-term corporate 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.

(F)

37.

Federal funds are the funds provided by the Federal Government for domestic corporations for long-term growth.

(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.

(T)

41.

Primary markets are markets where users of funds raise cash by selling securities to funds suppliers.

(F)

42.

Privately placed securities are usually sold to one or more investment bankers and then resold to the general public.

(T)

43.

Financial institutions such as commercial banks typically have assets that are riskier than their liabilities.

2

MULTIPLE CHOICE QUESTIONS (b)

1.

A surplus spending unit’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. a surplus spending unit (SSU) purchasing a financial claim from a deficit spending unit (SSU) spending unit (DSU) b. a surplus spending unit (SSU) purchasing a financial claim from a dealer c. a surplus spending unit (SSU) purchasing a financial claim from a commercial bank d. a surplus spending unit (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 Surplus spending units (SSUs) to deficit spending units (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”?

3

a. b. c. d.

households businesses governments all of the above

(b)

10.

Which of the following best describes the "two faces of debt" concept? a.

Deficit spending units (DSUs) are sometimes Surplus spending units (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 $116 and sell to investors at $118. The “bid” is a. $116 b. $118 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 surplus spending units (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.

4

(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 (SSUs) 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. deficit spending unit (DSU) b. business c. surplus spending unit (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 surplus spending unit (SSU) and deficit spending unit (DSU) . a. indirect; two b. direct; two c. indirect; one d. direct; one

(d)

26.

In direct financing the lender 5

a. b. c. d.

trades a financial claim for money. trades money for a financial claim issued by a financial institution. trades money with a broker who owns the financial claims of a borrower. 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 6

c. d.

earns return from bid-ask spread 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 Surplus spending units (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.

Deficit spending units (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.

7

(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

(a)

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 8

b. c. d.

convertible bonds commercial paper 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) in

54.

The difference between “capital spending” and “real investment” is chiefly a difference a. b. c. d.

essential nature and purpose of the assets created or acquired relative cost of the assets created or acquired susceptibility of the assets created or acquired to amortization or depreciation 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 9

a. b. c. d.

liquidity; marketability. spot; future. liquidity; economic investment. primary; secondary.

(d)

61.

The deficit spending unit (DSU) receives the funds in the primary market; the surplus spending unit (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 ______ . 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

10

through __ ___

(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)

(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 papers and short-term corporate notes. 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.

(b)

74.

The diagram below is a diagram of the

(c )

Users of Funds (DSU)

Underwriter

a. b. c. d. e.

secondary markets primary markets money markets derivatives markets commodities markets

75.

Suppliers of Funds (SSU)

Match the financial institutions with the characteristic that best describes its function.

I. Pool funds of small savers and invest in either money or capital markets II. Provide economic protection from adverse events III. Provide consumer loans and real estate loans funded by deposits IV. Underwrite and trade securities and provide brokerage services V. Accumulate and transfer wealth from work period to retirement period 1. Credit unions 2. Insurance companies 3. Pension funds 11

4. Securities firms and investment banks 5. Mutual funds a. b. c. d. e. (e )

76.

1, 3, 2, 5, 4 4, 2, 3, 5, 1 5, 2, 1, 4, 3 2, 4, 5, 3, 1 5, 1, 3, 2, 4

Secondary markets help support primary markets because secondary markets a. offer primary market purchasers liquidity for their holdings b. reduce the cost of trading the primary market claims c. help investors diversify portfolios d. update the price or value of the primary market claims e. all above

ESSAY QUESTIONS 1.

Explain financial intermediation and its benefits.

Answer: Financial institutions mediate unmatched preferences of deficit spending units (DSUs) and surplus spending units (SSUs) as to amount, maturity, and risk. Financial intermediaries buy financial claims with one set of characteristics from Deficit spending units (DSUs), then issue their own liabilities with different characteristics to Surplus spending units (SSUs). Thus, financial intermediaries “transform” claims to make them more attractive to both Deficit spending units (DSUs) and Surplus spending units (SSUs). This transformation is the basis for 5 services provided by financial intermediaries: Denomination Divisibility. Deficit spending units (DSUs) prefer to borrow the full funding need all at once. Surplus spending units (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. Deficit spending units (DSUs) generally prefer longer-term financing.

Surplus spending units (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. Surplus spending units (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 Deficit spending units (DSUs).

Without financial intermediation, funds would flow only when preferences of Surplus spending units ( SSUs) and Deficit spending units (DSUs) match closely. Deficit spending units (DSUs) would not always obtain timely financing for attractive projects; Surplus spending units (SSUs) would under-utilize savings. Society’s “production possibilities frontier” 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?

12

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.

4.

Discuss the major functions provided by investment banks and security firms.

Answer: a.

Investing: Investing is managing pools of assets such as mutual funds and trusts. b.

Investment Banking: Investment banking is underwriting and distributing new issues of debt and equity. c.

Market Making: Market making is creating a secondary market for securities or contracts. d.

Trading securities for itself and clients.

13

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.

(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.

19

(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.

(T)

38.

The major asset of the Federal Reserve is the U.S. Treasury securities, and the major liability is currency outside banks.

(T)

39.

The seven members of the Board of Governors of the Federal Reserve System serve 14 year nonrenewable terms. Each Board member is appointed by the President and confirmed by the Senate.

(F)

40.

The current chair of Federal Reserve is Joe Biden.

(F)

41.

If the FOMC wished to slow down economic growth and lower down the price level, they could issue a policy directive to the Federal Reserve Board Trading desk to purchase U.S. government securities.

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

20

(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.

21

(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

22

(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 23

(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

(a)

33.

The major asset of the Federal Reserve is a.

The U.S. Treasury securities b.

Depository institution reserves c.

Currency outside banks d.

Vault cash of commercial banks e.

Gold and foreign exchange

(b)

34.

The Fed changes reserve requirements from 10% to 7%, thereby creating $900 million in excess reserves. The total change in deposits (with no drains) would be a. $3,000 million b. $12,857 million c. $13,652 million d. $15,795 million

(b)

35. Nationally chartered banks receive chartering and merger approval from the a.

Federal Deposit Insurance Corporation b.

Office of Comptroller of the Currency c.

Federal Reserve System d.

Office of Thrift Supervision

(b)

36. The fed funds rate is the rate that a.

Banks charge each other on loans of excess reserves b.

Banks charge to lend foreign exchange to customers c.

The Federal Reserve charges on emergency loans to commercial banks d.

Banks charge for loans to corporate customers

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 24

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?

take

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 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.

7.

What are the bodies of the Federal Reserve System?

Answer: The Federal Reserve System consists of a. Board of Governors; b. Federal Reserve Banks and Branches over the country; c. The Federal Open Market Committee 25

26

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 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.

31

(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.

(F)

36.

The primary policy tool used by the Fed to meet its monetary policy goals are to change reserve requirements, to devaluing the US$, and to change bank regulations.

(F)

37.

If the Fed was instead targeting interest rates and money demand dropped the Fed would likely increase the money supply.

(T)

38.

The expected effect of quantitative easing (QE) in 2010 and 2011 is to lower long-term interest rates to boost the economy.

(T) body

39.

The Federal Open Market Committee (FOMC) is the major monetary policy making of the U.S. Federal Reserve System.

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.

32

b. c. d.

the relationship between the monetary base and the money supply. the relationship between the money supply and economic activity. 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 33

a. b. c. d.

the Fed Funds rate to rise. planned inventory investment to fall. depository institutions to lend more freely. 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 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

34

market,

security prices and

(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.

M2 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 35

c. d.

changes in interest rates drive changes in the money supply 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.

(b)

36.

What items are included in M1?

I. Savings deposits II. Checking deposits III. Non-institutional money market mutual funds IV. Eurodollars V. Currency VI. Time deposits a. b. c. d.

I, II, III, IV II, V I, V, VI III, IV, VI

36

(c )

37.

The discount rate is the rate that a.

Banks charge for loans to corporate customers b.

Banks charge to lend foreign exchange to customers c.

The Federal Reserve charges on loans to commercial banks d.

Banks charge each other on loans of excess reserves

(d)

38.

A decrease in reserve requirements could lead to a(n) a.

Increase in bank lending b.

Increase in the money supply c.

An decrease in the discount rate d.

All above

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 controlling the monetary base, the Fed substantially influences 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 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: Excess increase, pressuring the “benchmark” Fed Funds Rate downward. As depository institutions lend or invest excess reserves, the deposit component of M1 expands. Falling interest rates and increased credit availability 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 Fedsponsored 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 37

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. 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.

6.

In 2010 and 2011, Federal Reserve announced quantitative easing’s, or QEs, which is to create money for buying long-term U.S. Treasury bonds in the market. What is the impact of the QE on security prices? How does the Fed expect the QEs to influence the economy?

Answer: 1. Buying bonds pushes down their yields, and the interest rates across the debt markets that are closely tied to U.S. Treasury rates.

2. Lower borrowing costs should help some homeowners finance and should help businesses to apply for loans through cheaper credit. Larger corporations can access money at cheap rates in financial markets while mid and small businesses can borrow at lower costs from financial institutions.

38

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

43

efficient.

(T)

21.

Nominal rates generally exceed the real rate.

(T)

22.

If a security's realized return is negative, the expected return was smaller than the required return.

(F)

23.

In 2010 and 2011, Federal Reserve announced quantitative easing’s, or QEs, which is to create money. This would lead to interest rates increase.

(T)

24.

For a investment project to be accepted by management, its return must exceed the firm’s cost of capital.

MULTIPLE-CHOICE QUESTIONS (d)

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

44

(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%, according to Fisher equation, 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. According to the Fisher effect, what is the expected rate of inflation? 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.

45

(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.

46

(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%

47

(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.

48

(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.

49

c. d.

will increase interest rates. 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 pre50

tax real realized rate of return on the investment? a.

-.7% b.

8% c.

3% d.

5%

(d )

51.

What is NOT an economic factor that cause a shift in the desired lending curve changes the equilibrium rate of interest? a.

Federal Reserve increases in the money supply b.

Business savings c.

Government budget surpluses d.

Consumer credit purchases

(c )

52.

You go to Finance Yahoo! Website and find that yields on all corporate and Treasury securities have increased. The yield increases may be explained by which one of the following: a.

A decrease in current and expected future returns of real corporate investments b.

Newly expected increase in the value of the dollar c.

An increase in U.S. inflationary expectations d.

Decreases in the U.S. Government budget deficit

(a )

53.

On August 7, 2011, Standard and Poors (S&P) announced a downgrade of the rating of the U.S. long-term government debt from AAA to AA+. If other things are equal, what is the impact on the yields on the Treasury securities? a.

Yields increase b.

Yields decrease c.

Yield unchanged

(b )

54.

If everything is equal, the most likely impact of a decrease in income tax rates on economy would be to a.

Decrease the supply of loanable funds b.

Increase the savings rate c.

Increase interest rates d.

Federal Reserve decreases in the money supply

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 51

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.

6.

You are the Chief Economist of Free Formosan Investment and are conducting research on inflation forecasting by using the information of the Treasury Inflation-Protected Securities (TIPS). The information that you have are as the following: Nominal yield on 10-year nonindexed Treasury bond is 4.5%; Real yield on 10-year TIPS is 2.25%; The market adjustment for inflation and liquidity risk is 45 basis-points. What is the expected annual inflation rate over the next decade?

Answer: 4.5% - 2.25% - 0.45% = 1.80%

7.

In January 2011, a Japanese investor placing money in dollar denominated assets desires a 5% real rate of return. Then international expected inflation rate is about 2.5% and the dollar is expected to decline against Japanese Yen by 10% over the investment period. What is the minimum required rate of return for this Japanese investor?

Answer: This Japanese investor has to earn an additional 2.5% to cover the rising cost of goods and services and an additional 10% to cover the loss in value of his dollars since the dollars he will get back will buy fewer units of his home currency. All this is needed in order to preserve a 5% increase in real purchasing power in his home country. Therefore it is approximately 5% + 2.5% + 10% = 17.5%.

52

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.

1

(F)

23.

A zero-coupon bond bears no interest.

(T)

24.

Expected yield is essentially a forecast.

(F)

25.

A bond with an 9% coupon and a 10% required return will sell at a premium to par.

(F)

26.

Ceteris paribus, the holder of a fairly priced premium bond must expect a capital gain over their holding period.

(T)

27.

The duration of a bond with ten-year maturity and 10% coupon is less than ten years.

(T)

28.

All else equal, the greater a security's coupon, the lower the security's price sensitivity to a change in interest rate.

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

2

(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.

3

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 4

(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.

5

(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.

6

(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.

7

(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

(b)

51.

An 16 year corporate bond pays has a 3.5% coupon rate. What should be the bond’s price if the required return is 3% and the bond pays interest annually? a. $1060.44 b. $1062.81 c. $1065.45 d. $1072.99

A 10-year semiannual payment bond with a par value of $1,000 has a 7% coupon annual rate. Currently this bond is a par bond in market. Use the above information to answer the following three questions. (d)

52.

What is the duration of this par bond? a.

10.00 years b.

8.392 years c.

8.452 years d.

7.355 years

(c)

53. If the Federal Reserve announces a QE and, therefore, pushes interest rates unexpectedly fall.

This bond’s YTM drops by 1%. What is the new duration? a.

10.00 years b.

9.592 years c.

7.461 years 8

d.

6.352 years

(b )

54. According to the above, when increases of market interest rates cause an increase in YTM, ceteris paribus, the interest rate risk of this bond should a.

Increase b.

Decrease c.

Unchange

(d )

55. A semiannual payment bond with a $1,000 par has a 5% coupon rate, a 6% YTM, and 5 years to maturity. What is the bond’s duration? a.

5.00 years b.

4.85 years c.

4.76 years d.

4.47 years

(d )

56. A semiannual payment bond with a $1,000 par has a 7% coupon rate, a 6% YTM, and 5 years to maturity. What is the bond’s duration? a.

4.85 years b.

4.57 years c.

4.46 years d.

4.32 years

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. how

Define and discuss interest rate risk. What are the two risk components of interest rate risk and 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.

9

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.

6.

Formosan Independence Co. issues a 9-year semiannual payment bond with a par value of $1,000 a 10% coupon annual rate. The bond’s credit rating is AA. Currently, this bond is a par bond in market. a. What is the duration of this par bond? b. If Standard and Poors unexpectedly downgrades the U.S. government bond rating. The market interest rates increase. This bond’s annual YTM increases by 2%. What is the impact on bond’s interest rate risk? Please use duration to explain.

Answer: a.

Since this bond is a par bond, its YTM must be 10% annually. Using the duration formula 9 t  CFt D=  / 1000 = 6137.03 / 1000 = 6.137 (year) 2t t =0.5 (1 + YTM / 2) b.

When YTM increases as 12% annually, the new bond price will be 891.72 and its duration will be 5.95 years. This means that the increase in market interest rate will lead a decrease in bond’s interest rate risk.

10

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.

A descending yield curve forecasts higher short-term rates in the future.

(F)

3.

Expected lower rates of inflation will lead to an upward sloping yield curve.

(F)

4.

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)

5.

A downward sloping yield curve forecasts higher future interest rates.

(F)

6.

A downward sloping yield curve is typically seen just before an economic expansion.

(T)

7.

The less marketable a security, the higher its yield.

(T)

8.

Default risk premiums are usually smaller during periods of high economic growth.

(F)

9.

Bonds rated BBB would have lower yields than AAA-rated bonds, and higher prices, everything else the same.

(T)

10.

Callable bonds have higher market yields than otherwise similar noncallable bonds.

(F)

11.

The call price of a bond is usually below the bond's par value.

(T)

12.

Everything else the same, the higher the marginal tax rate of an investor, the more likely the investor is to invest in municipal bonds as opposed to similarly rated corporate bonds.

(F)

13.

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

(F)

14.

Investment-grade bonds are more likely to default than speculative-grade bonds.

(T)

15.

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)

16.

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)

17.

A convertible bond will generally have a higher market yield relative to similar nonconvertible bonds.

(F)

18.

Treasury and corporate security yields may be combined when plotting a yield curve.

(F)

19.

Putable bonds offer higher yields than similar non-putable bonds

1

(T)

20.

The market segmentation theory allows for the possibility of a discontinuous yield curve.

(F)

21.

The market segmentation theory assumes that investors are risk-neutral.

(F)

22.

The preferred habitat theory explains the existence of discontinuities in the yields curve.

(T)

23.

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

(F)

24.

The expectations theory can explain why the yield curve slopes upward most of the time.

(T)

25.

Ceteris paribus, the required interest rate of a callable bond will be higher than the interest rate on a convertible bond.

(T)

26.

The yield curves show the relationship between interest rates on bonds similar in terms except for maturity.

(T)

27.

The shape of the yield curve is determined by expectations of changes in future interest rates.

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 always rise before recessions. 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.

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)

4.

The yield curve is a plot of a. maturity changes as risk changes. b. yields of securities with different levels of default risk. c. yields by maturity of securities with similar default risk. d. interest rates over time.

2

(d)

5.

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.

(a)

6.

An investor is more likely to exercise a put option on a bond after a. an increase in interest rates. b. a decrease in interest rates. c. an increase in the bond’s price. d. an upgrade of the bond’s rating by Moody's. e. tax-free municipals become available.

(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 expectations 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. investors always expect short-term interest rates to increase. e. both a and b

(d)

10.

According to the expectations theory of the term structure of interest rates, if the yield curve slopes _______, the markets expect short-term interest rates to _______ in the future a. upward; increase b. downward; decrease c. upward; decrease d. both a and b e. both a and c

3

(e)

11.

A one-year interest rate is 5.50% and a one-year forward rate two years from now is 6.0%. According to the expectations theory, what is the current two-year rate? a.

The rate cannot be calculated from the information above. b.

5.0% c.

5.5% d.

6.0% e.

6.25%

(c)

12.

According to the expectations theory, what is the one-year forward rate three years from now if three and four-year spot 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% e.

5.8%

(a)

13.

A two-year interest rate is 7% and a one-year forward rate one year from now is 8%.

According to the expectations theory, what is the current one-year rate? a.

6.0% b.

6.5% c.

7.0% d.

8.0% e.

9.0%

(b)

14.

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

(d)

15.

If three-year securities are yielding 6% and two-year securities are yielding 5.5%, what is the expected one-year rate two years from now as implied by the two actual rates above? a.

4.7% b.

5.8% c.

6.5% d.

7.0% e.

7.5%

(d)

16.

The major determinant of the bond ratings assigned by Moody's, Standard and Poor, or Fitch is a. marketability. b. tax treatment. c. term to maturity. d. default risk. e. frequency of interest payments.

4

(a)

17.

Default risk premiums vary _______ with the ________ of the security. a. directly; default risk b. inversely; default risk c. inversely; maturity d. directly; marketability

(d)

18.

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)

19.

a. b. c. d. e.

Which of the following statements is true?

The more marketable a security, the higher its yield.

The longer the security’s term to maturity, the greater its yield.

Putable bonds offer higher yields than similar non-putable bonds Taxable bonds have to offer higher before-tax yields than comparable tax-exempt bonds.

Use the following interest rate data to answer the next seven questions.

90-day Treasury bills 180-day Treasury bills 2-year Treasury notes 3-year Treasury notes 90-day Commercial paper 3-year Corporate bonds (AA) 3-year Municipal (AA) Expected 2-year inflation rate

8.36 percent 8.48 percent 9.10 percent 9.25 percent 9.15 percent 10.10 percent 7.07 percent 3.50 percent

(d)

20.

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.

2-year Treasury securities d.

90-day Commercial paper

(c)

21.

With reference to the data above, what is the expected real rate of return on the 2-year Treasury security? a.

12.6% b.

9.1% c.

5.4% d.

4.2% e.

3.5%

(c)

22.

With reference to the data above, what is the default risk premium on commercial paper? a.

5.65% b.

0.95% c.

0.79% d.

0.55% e.

0% 5

(e)

23.

With reference to the data above, what is the one-year forward rate on Treasury securities two years from now according to the expectations theory? a.

8.80% b.

9.10% c.

9.18% d.

9.40% e.

9.55%

(d)

24.

With reference to the data above, at what tax rate would an investor be indifferent between holding the 3-year municipal or 3-year corporate bond? a.

15% b.

20% c.

25% d.

30% e.

33%

(a)

25.

With reference to the data above, what is the default risk premium on 3-year AA-rated corporate bonds? a.

0.85% b.

0.95% c.

3.03% d.

6.60% e.

There is no default risk on these bonds.

(d)

26.

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 e. flat; stable

(c)

27.

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)

28.

Bond A is not callable; bond B is callable. Investors will require a higher yield on bond __ and will pay ____ for the bond. a.

A; less b.

A; more c.

B; less d.

B; more

6

(d)

29.

Bond A is not putable; bond B is putable. Investors will require a lower yield on bond __ and will pay ____ for the bond. a.

A; less b.

A; more c.

B; less d.

B; more

(d)

30.

Federal Agency securities have higher yields than similar Treasury securities because they a. have greater default risk. b. have shorter maturities. c. are less marketable. d. both a and c

(e)

31

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)

32.

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 e. none of the above

Use the following interest rate data to answer the next five questions: Treasury Bills, 90 days Commercial Paper, 90 days Treasury Bill, 1 year Treasury Note, 2 year Corporate Bond AA, 20 year Municipal Bond AA, 20 year Expected Annual Inflation Rate

4.20% 4.84% 4.67% 5.25% 8.23% 6.42% 3.00%

(d)

33.

With reference to the data above, the default risk premium on the 90-day commercial paper above is a.

3.39% b.

0.17% c.

0.64% d.

1.84%

(b)

34.

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.

5.58% d.

4.09% 7

(c)

35.

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.

18% b.

20% c.

22% d.

28%

(b)

36.

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.

1.62% c.

4.67% d.

0.13%

(c)

37.

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%

(c)

38.

Applying the expectations theory, a bank depositor chooses between purchasing a oneyear CD paying 5 percent and a two-year CD paying 5.5 percent. If indifferent between the two, the depositor must expect one-year CDs one year from now to have a rate of a.

6.5% b.

4.5% c.

6.0% d.

5.0%

(c)

39.

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. a twisted yield curve e. none of the above.

(a)

40.

What actions by bond investors, given their expectations of increasing interest rates, result 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)

41.

A bondholder in the 30 percent tax bracket owns a $1000 Treasury bond with an 8 percent coupon rate. What is the after-tax return on the bond? a.

8 percent b.

2.4 percent c.

5.6 percent d.

5 percent 8

(c)

42.

The yield differentials between an AAA-rated corporate bond and an otherwise similar BBB-rated corporate bond may be explained by a. marketability. b. tax treatment. c. default risk. d. term to maturity.

(c)

43.

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 lower 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)

44.

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)

45.

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 downward slope. c. the yield curve had an upward slope. d. loan losses were increasing.

(a)

46.

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)

47.

Bonds are called speculative grade or junk bonds if their Standard & Poor's rating is a. above BBB. b. below BBB. c.

B and below. d.

A and below

(c)

48.

Which of the following is not 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

9

(b)

49.

An issuer of a bond is more likely to exercise a call option on the bond after an increase in interest rates. a. a decrease in interest rates. b. a decrease in the bond’s price. c. a downgrade of the bond’s rating by Moody's.

(d)

50.

A conversion option gives a valuable right to a bond’s _______; a put option gives a valuable right to a bond’s _______. a. issuer; issuer b. issuer; holder c. holder; issuer d. holder; holder

(c)

51.

Which of the following statements 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. e.

All of the above statements are true.

(c)

52.

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)

53.

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. flat e.

Either c or d can happen.

(b)

54.

According to expectations theory, an investor who believes that interest rates are likely to decrease in the near future would a. invest in short-term securities immediately. b. invest in long-term securities immediately. c. sell long-term securities from her portfolio. d. sell corporate securities and invest in Treasury securities.

10

(a)

55.

According to the expectations theory, if the market believes that interest rates are likely to increase 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.

(e)

56.

According to the expectations theory, if the market believes that interest rates are likely to decrease 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 increase. e. both a and b

(a)

57.

The relationship between maturity and yield to maturity is called the ________________. a. term structure b. loan covenant c. bond indenture d.

Fisher effect

(b)

58.

According to the expectation theory a. markets are segmented and buyers stay in their own segment b. the long term spot rate is an average of the current and expected future short term interest rates c the term structure will most often be upward sloping d liquidity premiums are negative and time varying

(d)

59.

The slope of the yield curve is affected by a. inflationary expectations. b. liquidity preferences. c. the comparative equilibrium of supply and demand in the short-term and long-term market segments. d. all of the above.

(b)

60.

To analyze the economic condition, you collect the following yields: U.S. T-bill = 9%, 5year U.S. T-note = 8%, IBM common stock = 15%, IBM Corporate Bond (Moody’s rating Aaa) = 14%, and 10-year U.S. T-bond = 6.5%. Based on the above information, the shape of the yield curve is a. upward sloping. b. downward sloping. c. flat. d. normal.

(c )

61.

All of the following are examples of restrictive debt covenants EXCEPT a. prohibition on selling accounts receivable. b. constraint on subsequent borrowing. c. supplying the creditor with audited financial statements. d. prohibition on entering certain types of lease arrangements.

11

ESSAY QUESTIONS 1.

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

Answer: The five basic factors which may explain yield differences include term to maturity, default risk, tax treatment of income of security, marketability, and call, put, or conversion options attached to the security.

2.

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

Answer: According to the expectations theory, long-term yields are geometric averages of current and expected short-term rates. Future short-term rates can thus be estimated from the current yield curve. For example, an upward sloping yield curve predicts higher short-term rates in the future.

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

Answer: Since investors are concerned with the after-tax yield earned, they will bid up the prices (lower the yields) of municipal bonds compared to corporate bonds.

The message: lower taxes; lower interest rates.

3.

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 return on a similar term U.S. Treasury security. Default risk premiums narrow with growth and expansion of the economy and widen during recessions because many more borrowers default on their debt during recessions.

4.

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 (i.e., to have a higher yield). A put option gives the holder a valuable right to sell the bond back to the issuer. Investors will therefore accept lower yields (higher prices) on putable bonds than similar non-putable bonds. A conversion option is also a valuable right to the investor who will therefore accept a lower yield (pay a higher price) on a convertible bond.

5.

What shapes of the yield curve can be explained by each of the theories of the term structure of interest rates?

Answer: Different theories of the term structure are not mutually exclusive. Rather, each one adds to the explanations proposed by the other theories. The expectations theory can explain the flat yield curve, as well as upward- and downward-sloping yield curves. The liquidity premium theory can explain why the yield curve slopes upward most of the time. The market segmentation theory explains twists, spikes, and discontinuities in the yield curve, while the preferred habitat theory can explain the absence of spikes and discontinuities in the yield curve.

12

6.

Explain (a.) liquidity problem in bond market, (b.) default risk, and (c.) maturity risk premiums.

Answer: a. Liquidity problems exist in infrequently traded bonds. b. Default risk (also called credit risk) is the likelihood the corporation will default on its bond obligations, which is to pay interest and principle on time. c. The maturity premium reflects the fact that longer-term bonds possess greater interest rate risk and sensitivity than shorter term bonds. If any of these exist, investors will demand to be compensated for the risk by demanding a yield premium to own the bonds.

13

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 liability securities.

(F)

3.

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

(F)

4.

Treasury bills are least marketable among money market securities.

(T)

5.

Commercial banks act as dealers and are major investors in Treasury securities.

(F)

6.

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

(T)

7.

Commercial paper is more likely to be placed directly by large finance companies.

(F)

8.

The Federal Funds market is not available for smaller, regional banks.

(T)

9.

Bankers' acceptances are used primarily for financing international trade.

(F)

10.

Eurodollars are euro-denominated deposits in U.S. banks.

(F)

11.

Individual investors 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 buyers and sellers together; brokers make a market.

(T)

18.

The higher yields of federal agency securities relative to T-bills is attributed mostly to the lower marketability of agency securities.

(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.

(T)

21.

The money market provides liquidity for deficit spending units; the capital market finances economic growth.

1

(F)

22.

Competitive bids in T-bill auctions require the bidder to specify only the quantity of bills desired.

(T)

23.

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

(F)

24.

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.

(F)

25.

The benefits of money market securities are low denomination, low systemic risk investments designed to appeal to individual investors with excess cash.

(F)

26.

Fed funds are short term unsecured loans while repos are short term secured loans from Federal Reserve Banks.

(F)

27.

A short term unsecured promissory note issued by a company is Negotiable CD.

MULTIPLE-CHOICE QUESTIONS (b)

1.

Which of the following is NOT a characteristic of money market instruments? a. short term to maturity b. small denominations c. low default risk d. high marketability e.

All of the above are characteristics of money market securities.

(e)

2.

Investors in the money markets are generally willing to take which of the following risks? a. default risk b. interest rate risk c. liquidity risk d. all of the above e. none of the above

(d)

3.

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

(a)

4.

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.

Money market transactions include more "primary market" trades for a security than secondary market trades. d.

Most money market transactions are conducted by mail. e.

All of the above statements are true.

2

through ____.

(d)

5.

Which statement about Treasury bills is NOT true? a.

They have maturities less than one year. b.

Most are sold by "book-entry" method. c.

They are sold at a discount. d.

Interest on T-bills is tax-deductible for federal income tax purposes.

(a)

6.

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)

7.

Federal Funds are typically a.

Treasury deposits. b.

Federal Reserve assets. c. commercial bank deposits at the Federal Reserve. d. overnight interbank loans settled in immediately available funds

(c)

8.

The most common money market instrument utilized in the Fed's open market operations is a.

Federal Funds. b. commercial paper. c.

Treasury bills. d.

Agency securities.

(d)

9.

Banks can satisfy their short-term borrowing needs by Federal Funds purchased.

Federal Funds sold. issuing negotiable CDs. both a and c

(a)

10.

Which of the following statements is true? a.

Discount yield is always lower than bond equivalent yield on the same security. b.

Discount yield is always higher than bond equivalent yield on the same security. c.

Discount yield is always equal to bond equivalent yield on the same security. d.

Discount yield can be lower or higher than bond equivalent yield on the same security.

(e)

11.

Which of the following statements about federal agency securities is true? a.

All federal agency debt is explicitly guaranteed by the federal government. b.

All federal agencies are owned by the federal government. c.

Federal agency securities usually have yields of 3 to 20 basis points below Treasury bills. d.

All of above statements are true. e.

None of the above statements is true.

(b)

12.

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 3

d.

a negotiable CD

(a)

13.

Which of the following securities is not a money market security? a.

Ba-rated corporate bonds b.

Treasury bills c. certificates of deposit d. banker's acceptance e.

P2-rated commercial paper

(a)

14.

Issuers of commercial paper tend to be a. large financial and nonfinancial firms b. firms with high credit risk c. small banks d. wealthy individuals e. both a and b

(a)

15.

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)

16.

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

(d)

17.

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

(d)

18.

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)

19.

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)

20.

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

4

(b)

21.

Which of the following money market instruments is not sold on a discount basis? a. commercial paper b. negotiable certificates of deposit c.

Treasury bills d. banker's acceptances e.

All of the above instruments are sold on a discount basis.

(e)

22.

A time draft drawn on and accepted by a commercial bank that orders to pay a specified amount of money to the bearer on a given date is called a _______ a. letter of credit b. negotiable certificate of deposit c. banker's certificate of support d. reverse repurchase agreement e. banker’s acceptance

(a)

23.

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)

24.

When a firm issuing commercial paper uses 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

(c)

25.

What is the bank discount rate on a $100,000 face value T-bill priced at $97,500, maturing in 181days? a.

2.50% b.

4.84% c.

4.97% d.

5.10% e.

5.17%

(b)

26.

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)

27.

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% 5

(d)

28.

Calculate the bond equivalent yield 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)

29.

Which of the following yield calculations 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 prime rate.

(a)

30.

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. e. the primary rate

(a)

31.

The smallest denomination of T-bills is a. $1,000 b. $10,000 c. $100,000 d. $1,000,000 e. $5,000,000

(c)

32.

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

(b)

33.

Purchasing T-bill via a computerized account without actually receiving the securities is achieved through a _______ Account. a.

Direct Purchase b.

Treasury Direct c.

Fed Purchase d.

Federal Benefit

(a)

34.

Federal agency securities have higher yields than Treasury securities because a. they 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. e.

Federal agency securities actually have lower yields than Treasury securities.

6

(c)

35.

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)

36.

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)

37.

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.

3.00% b.

2.97% c.

2.91% d.

2.86% e.

2.93%

(a)

38.

A firm buys $1,000,000 of a 30-day commercial paper issue for $995,450. The bond equivalent yield on this commercial paper is: a.

5.56% b.

5.46% c.

5.49% d.

5.54%

(b)

39.

A reverse repurchase agreement calls for a. a firm to sell securities with the agreement to buy them back later at a higher price. b. a firm to buy securities with the agreement to sell them back later at a higher price. c. a firm to sell securities with the agreement to buy them back later at a lower price. d. a firm to buy securities with the agreement to sell them back later at a lower price.

(a)

40.

A repurchase agreement calls for a. a firm to sell securities with the agreement to buy them back later at a higher price. b. a firm to buy securities with the agreement to sell them back later at a higher price. c. a firm to sell securities with the agreement to buy them back later at a lower price. d. a firm to buy securities with the agreement to sell them back later at a lower price.

7

(d)

41.

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 $5,000,000.

(d)

42.

A non-competitive bid in the Treasury securities auction market is characterized by: a. the bidder specifying the quantity of bills desired b. the bid not exceeding a specific dollar amount c. the bidders paying a price equal to the weighted average price of all competitive bids accepted. d. all of the above.

(d)

43.

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

(d)

44.

Which of the following statements about negotiable certificates of deposits (NCDs) is true? a.

NCDs usually have denominations of less than $100,000. b.

NCDs usually have lower yields than regular CDs. c.

NCDs have no secondary market d.

Large banks are usually able to pay lower interest rates on NCDs than smaller regional banks. e.

All of the above statements are true.

(e)

45.

Which of the following do not participate in the money markets? a. commercial banks b. the Federal Reserve c.

U.S. Treasury dealers d. corporations e.

All of the above participate in the money markets.

(c)

46.

A dealer is quoting a 180-day T-Bill with a face value of $10,000 that is quoted at 3.75 bid, 3.60 ask. This bill can be bought at ________ or can be sold at ________. a. $9,879.23; $9,864.36 b. $9,864.36; $9,859.23 c. $9,820.00; $9,812.50 d. $9,802.50; $9,787.50

(a)

47.

A 90 day $3 million jumbo CD has a 5.75% annual rate quote. If you purchase the CD, how much will you collect in 90 days? a. $3,043,125 b. $3,045.678 c. $3,062,877

8

d. (d)

48. a. b. c. d.

$3,063,750

In terms of dollars outstanding, in recent years, what is the largest money market security?

Commercial paper Banker's acceptances T-Bills Federal funds and repos

(a)

49.

You spent $9,675 to buy a Treasury bill with a par of $10,000 and sell it 180 days later for $9,875. What is the effective annual rate? a.

4.24% b.

4.39% c.

4.45% d.

4.52%

(c )

50.

If a $10,000 par T-Bill has a 2.75% discount quote and a 180 day maturity, what is the price of the T-Bill to the nearest dollar? a. $9,625 b. $9,706 c. $9,863 d. $9,927

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: Money markets are markets for liquidity. Liquidity of many of the world’s investors is stored there; liquidity for high quality borrowers is provided there.

3. Explain why most money market interest rates tend to move together over time.

Answer: To the extent that securities with various terms are substitutable (have more or less similar characteristics), investors will rush in and purchase the security that offers a high yield (low security price) relative to other similar securities. As a result, yields on substitutable securities tend to be closely correlated. Because all money market securities share some important characteristics – high credit quality, high marketability, and low default risk – many investors may view them as close substitutes to each other.

9

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 counterparty in a transaction) that has been “accepted” (became a liability of) by a third party with an excellent credit rating, in this case a large commercial bank. With limited knowledge of counterparties in transactions, a third party “accepter” or guarantor is welcome. Banks and competitors that participate in acceptances are “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. However, the major factor was the surge of funds from around the world out of more risky security markets into money market instruments, which led to bidding up their prices and lowering yields.

6.

Describe in what ways commercial banks participate in the money markets.

Answer: Commercial banks have to frequently adjust their liquidity positions. They buy and sell money market securities from their investment portfolios. To raise funds, a bank can borrow in the federal funds market from other banks or through repurchase agreements, as well as issue negotiable CDs and commercial paper. To invest excess funds, a bank can lend in the federal funds market or through reverse repos or buy money market securities of other issuers.

7.

On August 8, 2011, Finance Yahoo! reports a 90-day T-Bill with a face value of $10,000 that is quoted at 3.25 bid, 3.05 ask. Given the above information, what are the selling and purchasing prices of this T-bill?

Answer: This T-bill can be bought at $10,000[1-(0.0305180/360)] = 9,923.75 and should be sold at 10,000 [1-(0.0325180/360)] = 9,918.75.

10

CHAPTER 8 TRUE/FALSE QUESTIONS (T)

1.

Capital market securities are used to finance real capital investments.

(F)

2.

Capital market securities are more liquid than money 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 a given 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.

The volume of mortgages outstanding exceeds the volume of corporate bonds in the U.S.

(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.

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.

1

(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.

(F)

26.

Callable bonds are the bonds that can be redeemed at par at the option of their holders either at specific date after the date of issue and every 1 to 5 years thereafter or when and if the firm takes specified actions such as being acquired, acquiring another company, or issuing a large amount of additional debt are called.

(T)

27.

The length of the maturity on a bond offering affects its cost. In general, the longer the maturity, the higher the cost.

(T)

28.

Bondholders will NOT convert their convertible bonds into shares of stock only when the conversion price is greater than the market price of the stock.

(F)

29.

The conversion feature of a bond is to give the issuer the opportunity to repurchase bonds at a stated price prior to maturity.

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

(d)

2.

The secondary markets for capital market securities have facilitated economic growth in the U.S. 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

(d)

3.

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-profit organizations

2

(a)

4.

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.

(b)

5.

The fastest growing debt sector in the U. S. is a.

Treasury debt b. federal agency debt c. mortgage debt d. corporate debt

(b)

6.

TIPS have less _____ risk than “regular” Treasury securities of the same maturity. a. default b. price c. liquidity d. foreign exchange

(a)

7.

You purchase a Treasury inflation-protected note with an original principal amount of $1,000,000 and a 2.8 percent annual coupon (paid semiannually). What will the first coupon payment be if the semiannual inflation over the first six months is 1.2%? a. $14,168 b. $14,000 c. $28,336 d. $28,000 e. $12,336

(e)

8.

The yield on a three-year Treasury note is 4.5% and the yield on a three-year TIPS is 2.4%. What is the market’s estimate of the annual inflation rate over the next three years? a.

1.1% b.

1.6% c.

4.5% d.

2.4% e.

2.1%

(c)

9.

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

3

(d)

10.

Which of the following statements about STRIPs is true? a.

STRIPs are sold directly by the Treasury Department b.

When a STRIP is created, all interest payments become one security and the principal payment becomes the other. c.

Many small investors prefer STRIPs because they require a lower minimum investment than original Treasury notes and bonds. d.

Treasury securities dealers create STRIPs because they expect to sell the created zero-coupon securities for more than what they paid for the original Treasury security. e.

None of the above statements is true.

(c)

11.

Most general obligation bonds are sold through a. direct placement. b. negotiated bids. c. competitive bids. d. private placement.

(d)

12.

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

(a)

13.

Which of the following terms is not commonly associated with municipal bonds? a. inflation-protected bonds b. serial bonds c. general obligation bonds d. revenue bonds

(c)

14.

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

(b)

15.

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.

18% b.

25% c.

30% d.

33% e.

35%

(a)

16.

If average corporate bond and tax-exempt municipal bond rates were 8.33% and 6.25% respectively, an investor in the 34 percent marginal corporate tax bracket would purchase a. the tax-exempt bond. b. the corporate bond. c. either security (i.e., the investor is indifferent) d. the security with the higher pre-tax yield. e. both a and d 4

(c)

17.

The largest investor in municipal bonds are a. property and casualty insurance companies b. commercial banks c. households d. mutual funds e. pension funds

(c)

18.

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

(a)

19.

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.

(c)

20.

Privately placed securities a. have to be registered with SEC. b. never trade in the secondary market. c. can only be sold to large, sophisticated investors (e.g., financial institutions). d. cannot be originally sold to less than 35 investors. e. both c and d.

(c)

21.

Corporate bonds are less marketable than money market instruments and corporate equities because a. they have special features (e.g., call provisions) that make them difficult to value. b. they are long-term securities, which tend to be riskier and less marketable. c. both a and b d.

Corporate bonds are in fact not less marketable than money market instruments and corporate equities.

(b)

22.

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

(a)

23.

In the primary market, corporate bonds cannot be sold through a. securities exchanges such as NYSE b. competitive sales c. negotiated sales d. private placement

5

(b)

24.

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. investment-grade bond market d. secondary market e. subprime mortgage market

(d)

25.

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

(c)

26.

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)

27.

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 e. exchange rate risk

(c)

28.

Which of the following is not a difference between municipal bonds (munis) and corporate bonds? a.

Interest paid on munis is tax-exempt, while interest paid on corporate bonds is not. b.

Munis often have a range of maturities (are serial issues) but corporate bonds do not. c.

Unlike corporate bonds, munis are rated by bond-rating agencies such as Moody’s. d.

All of the above are differences between munis and corporate bonds.

(a)

29.

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

(a)

30.

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

6

(d)

31

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.

(b)

32.

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 assetbacked securities. b. the financial market will pay more for the issued asset-backed securities than the loan portfolio. c. a financial guarantee is obtained from a commercial bank. d. the borrowers permit their loan to be securitized. e. both a and d

(d)

33.

Which of the following is NOT 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

(e)

34.

The most important regulator in the U.S. capital markets is the a.

Federal Reserve System b.

Treasury Department c.

National Association of Security Dealers (NASD) d.

Federal Deposit Insurance Corporation e.

Securities and Exchange Commission

(c)

35.

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)

36.

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.

(d)

37.

A putable bond gives the bondholders the right a. to sell the bond back to the corporation at the original purchase price. b. to sell the bond back to the corporation at a stated premium. c. to sell the bond back to the corporation at the current market value. d. to sell the bond back to the corporation at par.

7

(c )

38.

A Treasury Bond with a $1000 par is quoted at 97:14 Bid, 97:15 Ask. The clean price for you to buy this bond is a. $974.38 b. $975.42 c. $974.69 d. $975.77

(b)

39.

Which one of the following bonds is likely to have the highest required rate of return, ceteris paribus? a.

AAA rated noncallable corporate bond with a sinking fund. b.

AA rated callable corporate bond without a sinking fund c.

AA rated callable corporate bond with a sinking fund d.

AAA rated callable corporate bond with a sinking fund

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 usually from five to one hundred years. The money market is largely a “primary” market with some secondary market activity. The capital market is a secondary market with some primary market additions. All money market securities are unsecured debt (with the exception of repos, which are collateralized), 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 between corporate bonds and munis. For example, with a 7% yield available on a corporate bond, an individual in the 28% marginal tax bracket would have to find a similar (in terms of maturity and rating) 5.04% municipal or state bond. For individuals’ pension money in a taxdeferred program, one would invest in the taxable securities.

3.

List the risks faced by bond investors.

Answer: Bond investors may face a variety of risk including default risk, price risk, and reinvestment risk (for coupon bonds), foreign exchange risk and/or political risk for international investments, and market risk.

4.

U.S. Treasury STRIPs are of interest to individuals with IRA's or $401k pension plans. Why? Answer: STRIPs are zero-coupon bonds. Such securities are of interest to individuals investing with 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 immediately know the “pile” of cash expected in the plan at the bonds’ maturity.

8

5.

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

Answer: There have been a number of cumulative factors that, over time, have 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.

6.

You check Wall Street Journal and find information regarding a principal STRIP that will mature in 7 years. The price quote per hundred of par for this STRIP is 85.75%. Using semiannual compounding, what is the promised yield to maturity on the STRIP? Answer: The YTM is [(100 / 85.75) (1/(7x2)) – 1] x 2 = 2.208%

9

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 in mortgages.

(T)

3.

Federal National Mortgage Association (FNMA) is a privately owned corporation with a line of credit from the U.S. Treasury.

(F)

4.

Investors in CMO securities are not exposed to prepayment risk.

(T)

5.

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

(T)

6.

A lender with a fixed-rate mortgage bears the risk of future inflation.

(F)

7.

Like corporate and municipal bonds, mortgages are issued in standard denominations.

(F)

8.

Unlike mortgage-backed securities, individual mortgages are issued in standard denominations.

(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.

(T)

13.

Mortgage-backed securities are more liquid than individual mortgages.

(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 obligations that provide tax-free income to investor.

1

(F)

19.

FHMLC buys FHA/VA insured mortgages from loan originators.

(F)

20.

Interest rate caps limit the size of the decrease in the loan rate over the loan’s life.

(T)

21.

A subprime mortgage is a mortgage made to borrower who has a below normal credit rating.

(T)

22.

On a fixed rate mortgage the dollars of interest the homeowner pays falls each year the mortgage is outstanding.

(F)

23.

The process of packaging and/or selling mortgages which are then used to back publicly traded debt securities is collateralization.

(T)

24.

The major regulator for the GNMA (Ginnie Mae), FNMA (Fannie Mae), and Federal Home Loan Banks is Federal Housing Finance Agency.

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 passthroughs (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.

They are 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(n) a. rollover mortgage b. reverse annuity mortgage c. adjustable-rate mortgage d. home equity loan

(b)

4.

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

2

(b)

5.

What is the monthly payment on a $200,000 conventional fixed-rate mortgage, 7 percent, financed for 15 years? a. $1830 b. $1798 c. $1679 d. $1721

(d)

6.

If a 15-years monthly-payment $200,000 mortgage has a 7 percent of annual percentage rate. 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)

7.

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)

8.

If you added $100 to the monthly payment on a 30-year, $100,000 fixed-rate loan with a 6.5% rate, how soon would your loan be paid off? a.

249 months b.

227 months c.

185 months d.

278 months e.

360 months

(c)

9.

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)

10.

What will be the amount of interest paid in the first month of a $50,000, 7 percent, 25 year loan? a. $305 b. $265 c. $257 d. $292 e. $338

(c)

11.

How long does it take to repay one-half of the principal on a $70,000, 7 percent, 15 year mortgage loan? a.

75 months b.

90 months c.

112 months d.

123 months e.

131 months 3

(c)

12.

Which of the following mortgages would you prefer to hold if you were a lender and you expected inflation of uncertain magnitude? a. reverse annuity mortgages b. conventional fixed-rate mortgages c. adjustable-rate mortgage loans d. balloon payment mortgages

(c)

13.

Which of the following hold 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)

14.

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.

Rollover mortgage, two years c. adjustable-rate mortgage, monthly d. fixed-rate mortgage, 15 years

(c)

15.

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 by 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 to the investors.

(d)

16.

Which of the following is not a reasonable expectation 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. e.

All of the above are reasonable expectations for investors in pass-throughs.

(a)

17.

Which of the following is not a mortgage-backed security? a. a jumbo mortgage b. a Ginni Mae pass-through c. a collateralized mortgage obligation d. a real estate mortgage investment conduit (REMIC) e.

All of the above are mortgage-backed securities.

4

(c)

18.

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)

19.

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)

20.

Private mortgage insurance protects the a. seller of the home. b.

FHA. c. borrower. d. lender. e. government.

(d)

21.

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)

22.

A savings and loan with a very low net worth position would most likely 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)

23.

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

(c)

24.

What will be the amount of interest paid in the first month if you put 30 percent down on a home costing $150,000 with a 25-year, 9% loan? a. $881.16 b. $702.32 c. $787.50 d. $726.31 e. $583.33 5

(e)

25.

If you put 30 percent down on a home costing $150,000 with a 25-year, 9% loan, what is the remaining balance on the mortgage after five years? a. $ 81,450 b. $100,666 c. $ 79,097 d. $84,000 e. $ 97,936

(c)

26.

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)

27.

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 index e.

LIBOR

(d)

28.

What is most likely to happen to an ARM in a decreasing rate environment? a.

The borrower's payments will increase. b.

The maturity of the loan will be extended. c.

The principal of the loan will increase. d.

The borrower's payments will decrease.

(a)

29.

Which of the following statements 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.

(a)

30.

Like other capital market segments, mortgage markets a. bring together borrowers and suppliers of long-term funds. b. are always secured by the pledge of real property. c. are characterized by small, risky borrowers. d. issued in standard denominations. e. all of the above

(c)

31.

Amortizing a mortgage loan means that a. a long-term is converted to a short-term loan. b. the equity in the house declines as the loan is paid down. c. the loan is repaid in equal, consecutive payments. d. interest is paid first entirely, and then the principal

6

(b)

32.

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)

33.

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

(d)

34.

Hybrid 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)

35.

The Tax Reform Act of 1986 increased the popularity of home equity lines of credit because a. tax deductibility of interest for homeowners was reduced. b. interest incurred under home equity lines was made tax 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.

(c)

36.

An ARM has a 5/1 cap (i.e., the rate cannot increase more than 1 percent per year and 5 percent over the life of the mortgage). What will the mortgage rate be after three years if the initial rate is 5%, and interest rates increase by 2% in each of the first three years of the contract? a.

6% b.

7% c.

8% d.

9% e.

10%

(b)

37.

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.

7

(b)

38.

Which of the following is not an advantage of investing in mortgage-backed bonds (MBBs) compared to investing in direct mortgages? a.

MBBs are issued in standard denominations. b.

MBBs are issued by individuals with limited credit experience. c.

MBBs are usually insured and highly collateralized. d.

MBBs have cash flow returns similar to corporate bonds.

(e)

39.

Interest rate caps on mortgage loans 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 life of the loan. c. are required on all ARMs. d. both a and b e. all of the above

(b)

40.

Which of the following statements is true? a.

All fixed-rate mortgages have interest rate caps. b.

All adjustable-rate-mortgages have interest rate caps. c.

An interest rate cap on a mortgage reduces the lender’s interest rate risk exposure. d.

Usually, an annual interest rate cap on a mortgage is 5%, and a lifetime cap is 12%. e.

Both a and b are true.

(b)

41.

An investor in a first-level CMO 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. wait until all tranches are paid before receiving a return. d. have lower risk but a much more varied return than lower level tranches.

(a)

42.

As interest rates rise, the value of PO strips _______ and the value of IO strips _______. a. decreases; increases b. increases; decreases c. does not change; decreases d. decreases; decreases e. increases; increases

(c)

43.

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.

(b)

44.

A prepayment option on a mortgage is similar to a _______ option on a bond. a. put b. call c. conversion d. default

8

(c)

45.

Unlike noncallable corporate bonds, mortgages have _______ risk. a. default b. interest rate c. prepayment d. both a and c

(b)

46.

Which of the following is not 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)

47.

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 e.

All of the above

(d)

48.

Which of the following is associated with determining the creditworthiness of a mortgage borrower? a. income stability b. job stability c. prior credit history d. all of the above

(a)

49.

Mortgage bankers usually do not a. permanently fund mortgages b. originate mortgages c. service mortgages d. collect monthly payments from borrowers

(a)

50.

Mortgage bankers are most likely to be involved in the _______ of a mortgage contract. a. origination b. funding c. servicing d. insuring

(d)

51.

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

9

(b)

52.

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.

None of the above is true.

(b)

53.

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 payments 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)

54.

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)

55.

Which of the following statements about balloon payment mortgages is not true? a.

It is a traditional loan where interest is paid until the 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 an FRM of equal maturity. d.

Rate is variable over the contract term. e.

All of the above statements are true.

(d)

56.

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.

(b)

57.

You purchase a house at $255,000 and pay 20% down. You obtain a 30-year fixed rate mortgage in which the annual interest rate is 5.85%. What is your monthly payment? a. $1,215.27 b. $1,203.48 c. $1,194.45 d. $1,367.22

10

(b)

58.

(b)

59.

(d)

60.

You purchase a house at $331,250 and pay 20% down. The 15-year mortgage is fixedrate 6.25% annually. In addition to the principle and interest paid, you must pay 0.1% of the house purchasing price per month into an escrow account for insurance and taxes.

What is the total monthly payment (to the nearest dollar)? a. a $2,272 b. b $2,603 c. c $2,557 d. d $2,707

Formosan Freedom Co. purchased an office at newly built World Trade Center at $2,812,500. The Company obtained a 30 year fixed rate mortgage at a 7.2% annual rate and pay 20% down. After five years, the Company has excess cash and decides to pay off the remaining balance. Due to several QEs in the past years, the Company can obtain a mortgage of annual interest rates at 7%. How much must the Company pay to retire the mortgage (to the nearest dollar)? a. a $2,225,330 b. b $2,122,426 c. c $2,015,678 d. d $1,999,998 Which one of the following entities is an government agency overseeing housing mortgage services? a. a GNMA b. b FNMA c. c FHLMC d. d FHFA

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, 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. Nowadays, lenders combine qualifying mortgages into pools, acquire a Ginnie Mae guarantee on the pool, and sell the securities backed by the pool. MBS, unlike individual mortgages, have characteristics that make secondary market trading easy: standard denominations, well-known borrowers and insurers, and repayment schedules similar to those of other debt securities.

11

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.

List three ways in which a change in the rate of an adjustable-rate mortgage can affect the borrower's mortgage.

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 of mortgages.

6.

In July 2006, Forrest purchased a town house at $325,000 and paid 25% down. The mortgage that he obtained is a 30-year fixed-rate with an annual percentage interest rate of 5.75%. In July 2011, due to the fall of interest rate, he decided to refinance and obtained a mortgage at a 5.1% annual interest rate for 25 years. After he refinanced, how many dollars of cash out-flow per month he could reduce from the new payment schedule?

Answer: The original monthly payment can be solved by the following: 0.0575 1 1 325,000  75% = PMT  [1 − ]; r = = 0.004792 .

3012 r (1 + r ) 12 The payment is 1,422.46.

After 5 years, the balance of the mortgage is 226,107.8, the new monthly payment is 1 1 0.051 226,107.8 = PMT  [1 − ]; r = = 0.00425 .

2512 r (1 + r ) 12 The new payment is 1,335.01. This means Forrest can save about $1422.46 – $1,335.01 = $84.45 per month.

12

CHAPTER 10 TRUE/FALSE QUESTIONS (T)

1.

The Dow Jones Industrial Average is a price-weighted index.

(F)

2.

The NASDAQ is 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 and ask quotes of a security dealer may represent weak operational market efficiency.

(T)

9.

At NYSE, limit orders are usually entered into the specialist’s limit order book.

(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.

Preferred stockholders have the same voting rights as common shareholders.

(T)

14.

A stock which is expected to pay a $4 dividend next year, growing constantly at 6%, and is priced to yield a required return of 18% must be 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.

(F)

16.

A publicly traded company issuing additional shares of common stock does it through an IPO.

(T)

17.

Convertible preferred stock can be exchanged into common stock at a predetermined ratio.

(F)

18.

Shelf registration permits a corporation to register several types of security issues and sell them at once.

1

(T)

19.

Among financial institutions, mutual funds are the largest holders of corporate equity securities.

(F)

20.

Systematic risk can be significantly reduced through diversification.

(F)

21.

Equity capital can be raised through the money market and the NYSE bond market.

(T)

22.

A proxy is an absentee ballot that allows a representative to vote on behalf of the stockholder.

(F)

23.

Preferred stockholders have a claim junior to common stock but senior to bondholders.

(T)

24.

If the stock markets are semi-strong efficient, stock prices reflect all historic and current public information about a firm but prices do not reflect inside information.

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.

Which of the following is not 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

(b)

4.

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.

2

(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 means 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.

Which of the following terms is not 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. e. both a and d

(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 (ADRs)? a.

ADRs are claims issued by 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.

An ADR enhances a company’s visibility, status and profile in the U.S. and internationally among investors. d.

An ADR decreases the foreign firm’s U.S. liquidity (and potentially total global issuer liquidity).

3

(d)

12.

Which of the following statements is not true? a.

Electronically linking equity dealers 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 statements are true.

(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. indirectly through mutual funds and pension funds d. both a and c

(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% b.

100% c.

30% d.

40% e.

12%

(c)

15.

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.

(d)

16.

Which of the following terms is associated with secondary equity markets? a. seasoned equity offering b. initial public offering c. underwriter’s spread d. bid-ask spread e. shelf registration

(c)

17.

Which of the following market participants functions in the primary equity markets? a. broker b. specialist c. underwriter d. dealer e. none of the above

4

(a)

18.

Sampson Corporation, through its investment banker, First Ohio Securities, recently sold 200,000 shares of common 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. How much net financing did Sampson Corporation raise in the deal? a. $6.6 million b. $7.2 million c. $6.4 million d. $7.0 million e. $6.8 million

(b)

19.

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)

20.

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

(a)

21.

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

(b)

22.

Which of the four types of 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)

23.

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

(d)

24.

Which of the four types of 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

5

(b)

25.

The percentage 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)

26.

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)

27.

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)

28.

Which of the following is not a reason 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

(c)

29.

Which of the following is not associated with the over-the-counter market for stocks? a.

NASDAQ b. unlisted c. auction market d. dealer market

(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.

Which of the following is not one of 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.

6

(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.

Which of the following is not a result of advances in technology and competition 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 statements is true about secondary markets? a.

A buyer may incur search costs and find a seller on their own through a direct search. b.

A broker may bring buyers and sellers together, charging a commission. c.

A dealer may sell and buy securities using his inventory, therefore reducing search costs. The dealer's return is the bid/ask spread. d.

An auction market allocates the selling shares to the highest bidder. e.

All of the above statements 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.

(e)

37.

The primary federal regulator of stock markets is a. the Federal Reserve. b. the Federal National Securities Corporation. c. the National Association of Securities Dealers (NASD). d. the Securities Investor Protection Corporation. e. the Securities and Exchange Commission.

(b)

38.

The federal legislation that made the Securities and Exchange Commission responsible for the broad oversight of securities markets was a.

The Securities Act of 1933. b.

The Securities Exchange Act of 1934. c.

The Investment Company Act of 1940. d.

The National Securities Company Act of 1932. e. 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

7

(d)

40.

A stock just paid an annual dividend of $2. The dividends are expected to grow at 20% per year over each of the next three years and 5% per year thereafter. What is the value of the stock if the required rate of return is 12%? a. $34.29 b. $36.49 c. $39.84 d. $43.80 e. $58.74

(c)

41.

Ace Corporation preferred stock pays an 8% dividend on a par value of $50 and is currently selling at $47.50. What is required rate of return on the stock? a.

7.5% b.

8% c.

8.4% d.

12.5% e.

16%

(b)

42.

What is the estimated value of a stock, which paid a $5 dividend this 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 e. $26.50

(b)

43.

What is the required rate of return on a stock if 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.

22.5% d.

29.5% e.

33%

(d)

44.

If the risk-free rate is 7%, the return on the market portfolio is 15%, and the beta is 1.5, what is the value of the stock if the current dividend (D0) is $1.20 and it is expected to grow at a constant rate of 6% per year? a. $6.30 b. $6.70 c. $9.20 d. $9.80 e. $20.00

(a)

45.

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 year for 10 years. What is the expected total return on the stock this year? a.

17% b.

18% c.

20% d.

9% e.

15%

8

(c)

46.

Investors in well diversified stock portfolios are concerned about ________ risk. a. specific stock b. unsystematic c. systematic d. diversifiable

(c)

47.

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 return variability similar to the market. d. has had a constant rate of return. e. both a and b

(b)

48.

The security market line shows a. the amount of risk demanded for each unit of return. b. the return for each level of risk. c. the sum of the systematic and unsystematic risks. d. the risk/return tradeoff over time.

(a)

49.

The slope of the security market line is a. the market risk premium. b. beta c. the risk-free rate d. the return on the market portfolio. e. none of the above

(b)

50.

When constructing a stock market index, which two items 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 dates of the index. d.

1,000 is the base value, combined with the starting date.

(d)

51.

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.

36.3% d.

15.0% e.

14.3%

(c)

52.

Stocks XX, YY, and ZZ, initially 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, respectively. What was the value of the index at the end of year one? a.

88 b.

100 c.

114 d.

124 e.

196

9

(a)

53.

Which of the followings statements is correct? a.

The stock market does a poor job of predicting economic recessions. b.

The stock market does a good job of predicting economic recessions. c.

Economic recessions always precede poor stock market performance. d.

Positive stock market returns are not possible during economic recessions.

(a)

54.

The current dividend yield, which is the recent dividend divided by the current stock price, on common stock of Formosan Freedom Co. is 4.8 %. The company just paid a $2.10 dividend. The dividend will be $2.205 in next year. The dividend growth rate is expected to remain constant at the current level. What is the required rate of return on stock of Formosan Freedom Co.? a.

10.04 percent b.

16.07 percent c.

21.88 percent d.

43.75 percent

(b)

55.

Suppose MBI Co. recently paid $2 annual dividend. The company is projecting that its dividends will grow by 20 percent next year, 12 percent annually for the two years after that, and then at 6 percent annually. Based on this information, how much should the company’s common stock sell for today if the required return is 10.5%? a. $50.90 b. $59.22 c. $66.60 d. $77.50

(d)

56.

The current price of Fukushima Power Co. stock is $32.50 per share. Earnings next year should be $2.5 per share and it should pay a $ 1 dividend. The P/E multiple is 15 times on average in this industry. What price would you expect for the firm’s stock in the future if you believe the P/E multiple approach is correct? a. $13.5 b. $22.50 c. $26.50 d. $37.50

(a )

57.

Paul is examining a common stock of Cino Oil Co. that currently has a beta of 1.3. The risk-free rate, which is 90-day Treasury Bill yield, is an annual rate of 6%, and the market return, which is S&P 500 index change, is an annual rate of 12%. This stock is expected to generate a constant dividend of $5.20. However, a toxic spill of Cino Oil Co. results in an international lawsuit and potential finds, and the beta of the stock jumps to 1.6. What will the new equilibrium price of the stock be? a. $33.33 b. $37.68 c. $43.33 d. $53.68

10

(d)

58.

Since your grandmother supports your tuition at college, she wants to make sure it is worthy to invest in your education. She is wondering if you can tell her the key differences between common stock and bonds. Which of the following is NOT accurate? a. interest paid to bondholder is tax-deductible but dividends paid to stockholders are not. b. bonds have a stated maturity but stock does not. c. bonds are long-term debt instruments, while stock is long-term equity capital. d. common stockholders have a senior claim on assets and income relative to bondholders.

(c )

59.

All of the following features may be characteristics of preferred stock EXCEPT a. convertible b. callable c. tax-deductible dividends d. no maturity date

(d)

60.

Suppose Zina & Co. has an expected dividend next year of $5.6 per share, a growth rate of dividends of 10 percent, and a required return of 20%. The value of a share of common stock is. a. $22.40 b. $28.00 c. $18.67 d. $56.00

ESSAY QUESTIONS 1.

Explain what shelf registration is and how it can help companies to reduce their costs.

Answer: Shelf registration permits an issuer to register a certain quantity of securities with the SEC and sell them over a period of time rather than all at once. Thus, the issuer is able to save money and time through a single registration.

2.

List and briefly describe the four types of secondary equity markets.

Answer: Direct search involves buyers and sellers seeking each other directly. Brokered markets feature brokers, middlemen who bring buyers and sellers together. Dealer markets are characterized by the presence of dealers, market participants who “make market” in certain securities, therefore eliminating the need for time-consuming searches for trading partners.

Auction markets provide centralized locations and procedures for trading securities, which eliminates not only search costs but also bargaining for a favorable price.

3.

Describe how limit orders whose prices are not close to current market prices are handled at NYSE. Answer: When a limit order carries a price that is not close to the current market price, the broker handling the order enters it into the specialist’s limit order book. The order is then executed by the specialist if and when the stock price hits the specified limit.

11

4.

What are the advantages of investing in American Depository Receipts (ADRs) compared to direct investment into foreign equities?

Answer: ADRs make international diversification easier. First, they are dollardenominated claims that pay dividends in dollars. Second, ADR trading is done in accordance with American securities laws. Finally, ADRs are more marketable (i.e., easier to trade) for U.S. investors than direct investments into foreign stocks.

5.

Explain why unsystematic risk is ignored when appropriate levels of return are computed.

Answer: Unsystematic risk is unique to each security. As investors diversify their portfolios, unsystematic risk is reduced and eventually eliminated. Because it is easy to diversify across different stocks, investors take advantage of it. As a consequence, they are not concerned with unsystematic risk and ignore it when computing appropriate returns on securities.

6.

Why have international stock prices fallen as a result of Standard and Poor’s announcement regarding the down grade in the U.S. long-term credit rating in August 2011?

Answer: The U.S. economic growth slowed as a result of the high unemployment rate, high government deficit, high international account deficit, and the resulting credit down grade. Slower U.S. growth often results in poorer economic performance overseas. This is one reason why foreign stock prices have not performed well even though most other countries. As money moved out of equity markets to safer securities, such commodities and gold, stock prices fell. In addition, as the the U.S. government debts’ default risk increased, the risk premia over the world increased, resulting in stock price declines.

12

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 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 Eurodollar 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 savings and loan with interest rate-sensitive liabilities and interest rate insensitive assets (i.e., negative GAP) might swap future fixed rate interest payments for variable rate interest payments.

(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.

Interest rate swap dealers bring together counterparties willing to trade but never take positions in swap contracts themselves.

(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 can protect his/her recent price gains by buying stock index futures contracts.

(F)

18.

The Chicago Board Options Exchange is the primary regulator of options contracts.

(T)

19.

Cross-hedgers have to accept some basis risk.

(F)

20.

A hedger always owns the financial contract or is producing the commodity.

1

(T)

21.

Speculators intentionally assume price risk.

(F)

22.

At least one of two counterparties in a forward contract must be a speculator.

(F)

23.

A non-standardized agreement that is negotiated between a buyer and seller to exchange an asset for cash at some future date, with the price set today is called a future agreement.

(F)

24.

If you forecast that interest rates are likely to decrease over the next several years, you might sell a T-bond futures contract or buy an interest rate cap to take advantage of your expectations.

(T)

25.

The writer of a call option on stock benefits if the underlying stock price decrease or if the volatility of the stock’s price decreases.

(T)

26.

If the exercise price is greater than the current stock price, the call option is out-of-themoney but the put option is in-the-money.

MULTIPLE-CHOICE QUESTIONS (d)

1.

Which one of the following statements is true? 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)

2.

Which of the following is not a derivative security? a. a call option on a stock index b. a futures contract c. an interest rate swap d. a repurchase agreement e.

All of the above are derivative securities.

(d)

3.

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.

2

(c)

4.

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 equal but opposite price risk of the futures position. d. will always short financial futures to create a perfect hedge.

(b)

5.

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)

6.

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)

7.

The purchase of U.S. Treasury bonds for immediate delivery is a _______ market transaction. a. stock b. spot c. futures d. forward e. swap

(d)

8.

A portfolio manager plans to buy three-month T-bills with the total face value of $1,000,000 in one month. The current price for three-month T-bills is $988,520. What is the fair forward price if the current effective annual risk-free rate over one month is 4%? a. $950,500 b. $985,236 c. $988,520 d. $991,815 e. $1,028,061

(c)

9.

The forward price for an asset is a. equal to the face value of the asset. b. always higher than the current price of the asset. c. the price that makes the forward contract have zero net present value. d. adjusted downward to incorporate storage costs. e. both c and d

(d)

10.

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.

3

(c)

11.

In a forward contract one party to the contract deals with a. the futures exchange. b. the stock exchange. c. the counter-party of the forward contract. d. the opposite swap party. e. the hedger.

(c)

12.

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 to or subtracted from the accounts of the buyer and the seller. d. forward contracts always require a margin deposit. e. all of the above

(c)

13.

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.

(b)

14.

An investor planning to buy IBM stock in 30 days can protect himself against price risk by a. selling an IBM put option that matures in 30 days b. buying an IBM call option that matures in 30 days c. selling an IBM call option that matures in 30 days d. buying an IBM put option that matures in 30 days e. selling IBM stock short

(e)

15.

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. b. taking a long position in 3-month T-bill futures. c. buying a call option on 3-month T-bill futures. d. buying a put option on 3-month T-bill futures. e.

Either b or c would work.

(c)

16.

Unlike hedging with futures, hedging with options a. locks in a particular price or rate of return for a hedger. b. exposes a hedger to a risk of large losses. c. allows a hedger to benefit from the upside potential of his spot position. d. is free (i.e., creating the hedge is costless) e. both b and c

4

(d)

17.

A speculator sells one 10-year T-note futures contract for $100,000 of face value of Tnotes at 98’14. Three month later, the contract expires at 101’10.5. How much did the speculator gain (lose)? a. $2,965 b. ($2,965) c. $2,891 d. ($2,891) e. $328

(c)

18.

A speculator sold one 10-year T-note futures contract for $100,000 of face value of Tnotes at 99’04.5. He posted a $2,500 margin on his account. The contract’s closing price at the end of the day is 98’24. What is the amount of funds on the speculator’s account after marking-to-market? a. $2,500 b. $3,305 c. $2,891 d. $3,500 e. $2,109

(d)

19.

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 e. wide; narrow

(b)

20.

The lowest amount of funds required to maintain a positions in a futures contract is called a(n) _______ margin. a. initial b. maintenance c. minimum d. enforced e. futures

(d)

21.

The price sensitivity rule a. determines the number of futures contracts to trade. b. states that a hedging futures position must have the same sensitivity to interest rate changes as the asset or portfolio whose value is being hedged. c. requires determining the relative price variability of a futures contract and underlying assets given a change in interest rates. d. all of the above.

5

(a)

22.

You manage a stock portfolio worth $3,000,000 that has a beta of 1.25. In order to hedge the portfolio, you decide to trade S&P 500 futures contracts. Each contract is worth $250 per index point. How many contracts do you need to buy or sell if the S&P 500 index is currently at 1,500? a. sell 10 contracts b. buy 10 contracts c. sell 8 contracts d. buy 8 contracts e. buy 20 contracts

(b)

23.

You hedged a $2,000,000 portfolio of stocks that you manage by selling eight S&P 500 futures contracts at 1,450. Each contract is worth $250 per index point. Recently, your portfolio lost 4% of its value, while the S&P 500 index declined to 1,400. What is your total (spot plus futures) gain (loss)? a. $80,000 b. $20,000 c. ($20,000) d.

(80,000) e.

(180,000)

(d)

24.

Who will lose if the price of an underlying asset falls? 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 e. both b and c

(c)

25.

Which of the following statements is NOT true? 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 always have the same level of credit risk. d.

Unlike in a forward contract, the exact terms of exchange of the swap will vary with changes in interest rates. e.

All of the above statements are true.

(c)

26.

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 traders maintain their margin level d. to investigate violations of laws

(d)

27.

A farmer growing wheat is a. short; long b. short; selling c. long; buying d. long; selling

in wheat and may hedge by

_ wheat futures.

6

(a)

28.

A(n) margin is deposited before entering into the futures contract; thereafter, the balance cannot fall below a(n) _______ margin. a. initial; maintenance b. initial; enforced c. net; seller's d. safe; double e. first; second

(d)

29.

A bank with a high positive duration GAP wishing to hedge its interest rate risk might a. sell financial futures. b. purchase financial futures. c. sell puts on financial futures. d. both a and c

(c)

30.

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.

First National’s risk exposure is increasing. e. both b and d

(a)

31.

A small commercial bank with rate sensitive assets greater than rate sensitive liabilities sells T-bill futures. The bank is a. speculating. b. hedging. c. neither hedging nor speculating. d. both hedging and speculating.

(b)

32.

Daily changes in futures prices means one party (hedger or speculator) has gained while 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

(c)

33.

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.

7

(b)

34.

An insurance company can invest funds which are coming to the company in the future at today's interest rates by a. selling calls on financial futures. b. buying puts on financial futures. c. buying financial futures. d. selling financial futures. e. taking no action.

(b)

35.

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. accepting some default risk in the futures position.

(b)

36.

Which of the following is true about hedging using duration analysis? a.

The institution may hedge its earnings and its net worth simultaneously. 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.

(e).

37.

The value of an option varies directly with a. the price volatility of the underlying asset. b. the time to expiration. c. the level of interest rates. d. both a and b above. e. all of the above.

(c)

38.

All of the following are risks associated with futures contracts except a. margin risk. b. basis risk. c. default risk. d. manipulation risk.

(b)

39.

What action would the holder of a maturing call option take if 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

(b)

40.

The value of a call option _______ and the value of a put option with the same price and expiration date _______ when the spot price of an underlying increases. a. increases; increases b. increases; falls c. does not change; does not change d. falls; increases e. falls; falls

8

(e)

41.

You have a right to buy a security at a specific price on a specific date if you _______ on this security. a. bought a forward contract b. sold a futures contract c. bought a put option d. sold a call option e. bought a call option

(c)

42.

Which of the following terms is associated with futures as opposed to options? a. exercise price b. premium c. marking-to-market d. naked

(a)

43.

A 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 but not on the expiration date. d. exercise the option after the expiration date. e. none of the above.

(d)

44.

You speculated stock price of Cino. Co. will move toward a certain direction and decided to taken an option position of this stock to make profit. For that position, if the stock’s price drops you will get a level gain no matter how huge prices decrease. However, you could go bankrupt if the stock’s price rises. What is your option position? a.

Bought a call option b.

Bought a put option c.

Written a put option d.

Written a call option

(a)

45.

A financial institution wishing to avoid higher borrowing costs would be most likely to use: a.

A short or selling hedge in futures. b.

A long or buying hedge in futures. c.

A call option on futures contracts. d. b and c above.

(d)

46.

The number of futures contracts that a bank will need in order to fully hedge the bank's overall interest rate risk exposure and protect the bank's net worth depends upon: a.

The difference in the durations of bank assets and liabilities. b.

The duration of the underlying security named in the futures contract. c.

The price of the futures contract. d.

All of the above.

9

(c )

47.

On the second Friday of March, the market closing price of Independence & Co. stock is $100. Its March options are about to expire. One of its puts is worth $10 and one of its calls is worth $5. The exercise price of the put must be _____ and the exercise price of the call must be _____. a.

110, 95 b.

105, 95 c.

90, 105 d.

105, 90

(c)

48.

What is the regulator that approves newly issued futures contracts? a.

The Federal Reserve b.

The SEC c.

The CFTC d.

The NYSE

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, which means that the S&L's net interest margin or equity value would be hurt if interest rates were to increase. To hedge all or a part of interest rate risk, the S&L manager would sell T-Bill futures or buy puts on T-Bill futures. The sale of futures establishes a gain in the futures if interest rates rise, locking in the selling price for the futures, offsetting the "hurt" in the S&L. If interest rates fall, the futures loss would offset the gain in the "spot" or business. 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 and the put value increases. 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 is arranged between two parties for the specific amount needed. It is an off-the-exchange, negotiated contract tailored to the needs of the counterparties. A futures contract, traded on an exchange, is a standardized contract on a quantity of a commodity or financial securities. The exchange is the counterparty for all buyers and sellers of futures contracts, requiring an initial margin 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 whether a buyer or a seller of a derivative security is a hedger or a speculator?

Answer: A hedger has a position in an underlying asset or an intention to trade the asset in the future. The hedger will thus trade derivatives to offset the price risk in the "spot" market. That is, the hedger buys/sells so as to gain in the derivative securities if adverse price movements occur in the spot market.

10

A speculator in a derivative transaction has no spot position in the underlying asset or trades derivatives contracts to increase his risk exposure instead of decreasing it.

4.

What role does the SEC have in regulating options markets? How does it differ from the role of CFTC? Answer: The SEC regulates any options on individual stocks, including stock index options, based on its regulatory authority of equity markets. The Commodity Futures Trading Commission regulates options that settle with the delivery of a futures contract, even if that contract is eventually settled based on the value of a stock index.

5.

A manager of a large stock portfolio has earned a respectable return by October, and would like to protect that return for the year. How might she guarantee a certain 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 the rate of return achieved so far this year. Buying put options on the S&P 500 stock index futures (with the value contracts approximately equal to the portfolio value) 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 market positions will experience a loss, but the value of the put options will increase, offsetting the loss in the portfolio.

6.

Suppose a stock is priced at $100 currently. You are bullish on the stock and are considering buying May calls with an exercise price of $95 and $105 respectively. The call with an exercise price $95 is priced at $8.50 and the 105 call is quoted at $2.75.

Consider different price projection, what should you consider in deciding which to purchase if you do not plan on exercising prior to maturity?

Answer: The call with exercise price $95 is in the money and could be exercised right away, but the option holder would lose the ($8.50 -$5) = $3.50 time value of the call by exercising it. The stock has to move up to $108.50 before the call buyer recovers the purchase price. Buying the 105 call is cheaper; the quote is $2.75 per share because this is an out-of-the-money call. If you buy the call with exercise price $105, the stock price has to move up to $107.75 ($105 + $2.75) before you make a profit. You have a lower breakeven than with the more expensive in the money call. You can also lose much less with the out of the money call. The answer as to which is better depends on your projection of the size of movement of stock price, the underlying stock volatility, and your own risk-return tolerance.

11

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 foreign demand for U.S goods.

(T)

4.

In the balance of payments, the difference between current account flows and capital account flows is shown as statistical discrepancy.

(T)

5.

A strong dollar would make imports cheaper, and force domestic producers of goods with import substitutes to lower prices.

(T)

6.

Eurobonds are bearer bonds and do not have to be registered, which makes them more marketable.

(T)

7.

If a government buys its domestic currency from foreigners, its exchange rate will rise.

(T)

8.

Governments encourage long-term foreign investment in their countries because it helps their balance of payments.

(T)

9.

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)

10.

If a Canadian dollar costs $0.83 in U.S. dollars, a U.S. dollar costs a Canadian $1.17 in Canadian dollars.

(F)

11.

When the foreign demand for a country's goods and services increases, the demand for the foreign country's currency also increases.

(F)

12.

Exports grow rapidly when foreign currencies depreciate relative to the dollar.

(T)

13.

A "flight of capital" from a country would tend to reduce the value of the country's currency relative to other countries.

(F)

14.

If a U.S. exporter agrees to receive payment in 60 days in pounds, the British importer has assumed the exchange rate risk in the transaction.

(T)

15.

The demand for foreign exchange by an importer is a demand derived from a pending economic transaction.

(T)

16.

A deficit in the trade balance of payments puts downward pressure on the exchange rate.

(T)

17.

In balance of payments accounting, a deficit in current accounts prompts an offsetting surplus in capital accounts.

1

(F)

18.

If merchandise imports exceed merchandise exports, the trade balance is in a surplus position.

(T)

19.

If an investor can obtain more of a Euro for a Dollar in the forward market than in the spot market, then Euro is said to be selling at a discount to the spot rate.

(T)

20.

A foreign currency will, on average, appreciate against the U.S. dollar at a percentage rate approximately equal to the amount by which its inflation rate exceeds that of the United States.

(F)

21.

Speculative capital flows are investment in financial assets in money and capital market and the real assets based on prospects of real returns

MULTIPLE-CHOICE QUESTIONS (c)

1.

A foreign exchange rate 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 one currency in terms of another currency. d. the expected change in prices of international goods.

(c)

2.

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.

(a)

3.

Which of the following is NOT a reason that foreign exchange markets exist? a. to provide for efficient capital exchange between governments. b. 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.

(d)

4.

Which of the following is NOT a factor 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)

5.

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.

2

e.

both a and d

(c)

6.

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. demand U.S. dollars e. none of the above

(e)

7.

A. U.S. importer of English china would participate in which of the following foreign exchange transactions? a. supply U.S. Dollars b. demand British Pounds c. supply British Pounds d. demand Chinese Yuan e. both a and b

(a)

8.

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. b. c. d.

Make the U.S. CD investment.

Make the Canadian CD investment.

The investor is indifferent between the two because of interest parity.

One is unable to make this calculation with the data provided

(c)

9.

A U.S. investor purchased a $100,000 Canadian dollar CD 180 days ago at a rate of 7 percent. The Canadian spot rate was 1.367 C$/U.S.$ when the investment was made.

The U.S. dollar cost of the investment was ________ and the total amount of Canadian investment was _________ C$ after 180 days? a.

136,700; 107,000 b. $100,000; 107,000 c. $73,153; 103,500 d. $136,700; 103,500

(e)

10.

The current exchange rate between U.S. Dollar and Euro is $1.355/€. It means that a. one Dollar can buy 1.355 Euros b. one Euro can buy 0.738 Dollars c. one Dollar can buy 0.738 Euros d. one Euro can buy 1.355 Dollars e. both c and d

(c)

11.

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.

3

d.

the cost of a yen has increased in terms of dollars.

(b)

12.

From a trade basis, if U.S. trade deficit with Japan continues, and if U.S. inflation rates exceed those in Japan, a. the yen is likely to appreciate moving from 110 yen per dollar to 120 yen per dollar. b. the yen is likely to appreciate moving from 120 yen per dollar to 110 yen per dollar. c. the yen is likely to depreciate moving from 120 yen per dollar to 110 yen per dollar. d. the yen is likely to depreciate moving from 110 yen per dollar to 120 yen per dollar.

(a)

13.

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

(c)

14.

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.

(c)

15.

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.

(b)

16.

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.

(c)

17.

Everything else equal, 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 is correct.

4

(d)

18.

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

(d)

19.

Exchange rates are influenced by a. trade flows. b. financial flows. c. government intervention. d. all of the above.

(d)

20.

A foreign exchange transaction may be motivated by a. trade. b. speculation. c. flight of capital. d. all of the above

(a)

21.

Differences in real interest rates between countries produce what type of capital flows? a. investment capital flows. b. political capital flows c. speculative capital flows d. capital flight e. all of the above

(b)

22.

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.

(d)

23.

Which of the following is not a factor that is 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

(e)

24.

International trade flows are likely not influenced by a. barriers to trade b. consumer tastes c. productivity d. relative costs of factors of production e. activity of arbitrageurs in the foreign exchange markets

(a)

25.

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 5

d.

impose severe import restrictions

(b)

26.

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.

Buy domestic currency in the foreign exchange markets. c.

Provide low cost financing for export industries. d.

Buy foreign financial assets.

(a)

27.

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.

(b)

28.

If purchasing power parity existed in foreign exchange rates, a. foreign exchange rates would remain constant. b. goods and services would cost the same in terms of dollars everywhere in the world. c. goods and services would cost the same in each local currency. d. foreign exchange rates would be the same anywhere in the world markets.

(b)

29.

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. e.

Exchange rates do, in fact, adjust to ensure that purchasing power parity holds.

(a)

30.

An item costs $5.00 in the U.S. and 525 yen in Japan. If purchasing power parity holds, what is the yen/dollar exchange rate? a.

105 yen/dollar b.

525 yen/dollar c.

100 yen/dollar d.

125 yen/dollar e. .0095 yen/dollar

(b)

31.

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 e. €4.00

(a)

32.

If a country experiences inflation, generally a. its forward exchange rate will fall relative to countries with lower inflation b. its forward exchange rate will fall relative to countries with higher inflation 6

c. d. e.

its exports will increase significantly. its interest rates will fall. the forward exchange rate will fall relative to all other countries.

(c)

33.

If expected 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 to experience balance of payments problems in the future. c. the dollar to appreciate against the pound in the future. d.

U.S. interest rates to be above British rates.

(b)

34.

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.

(d)

35.

Which of the following are largely responsible for keeping exchange rates the same in all world markets? a. foreign exchange deals b. forward markets c. futures markets d. arbitragers e. none of the above

(c)

36.

The foreign exchange market a. is an auction market with a physical exchange floor, similar to NYSE b. has restricted trading hours c. is composed of a group of informal markets closely interlocked through international banking relationships d. ensures that purchasing power parity holds e. both a and b

(c)

37.

A U.S. commercial bank must pay 20 million Canadian dollars (C$) 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.

(a)

38.

The action of foreign exchange _______ tends to keep exchange rates among different currencies consistent with each other. a. arbitragers b. regulators c. traders d. brokers e. bankers

(a)

39.

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.

7

c. d.

in the spot market 60 days from now. all of the above

(b)

40.

An American firm sells farm equipment to a British company for ₤250,000 to be paid in 180 days. The current exchange rate is $1.98/₤. The exporter hedges its exchange rate risk by selling ₤250,000 forward 180 days at the prevailing 180-day forward exchange rate of $2.01/₤. What is the dollar amount the American firm is expected to receive in 180 days? a. $495,000 b. $502,500 c. $201,000 d. $198,000 e. ₤250,000

(c)

41.

An American firm sells farm equipment to a British company for ₤250,000 to be paid in 180 days. The current exchange rate is $1.98/₤. The exporter hedges its exchange rate risk by buying a put option on ₤250,000 with the strike exchange rate of $1.92/₤. The put expiring in 180 days cost the firm $5,000. What is the dollar amount the American firm will net on this transaction if the exchange rate is $1.96/₤ in 180 days? a. $495,000 b. $490,000 c. $485,000 d. $480,000 e. $475,000

(c)

42.

A payment guarantee issued by a commercial bank on behalf of an importer is a a. sight draft. b. time draft. c. letter of credit. d. documented transfer. e. bill of lading.

(d)

43.

A _______ draft is 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

(d)

44.

Which of the following instruments are not commonly used to facilitate international transactions? a. letters of credit b. bills of lading c. sight drafts d. repurchase agreements e.

All of the above instruments are used to facilitate international transactions.

(c)

45.

Eurodollars are 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. 8

d.

the development of a common currency in Europe.

(a)

46.

Eurocurrency is a.

Any currency held in a time deposit account outside of its country of origin. b.

Any currency held in a time deposit account in Europe. c.

Any currency held in a time deposit account outside of the U.S. d.

Euros held in a time deposit account in Europe.

(d)

47.

Eurocurrency markets are a source of attractively priced working capital loans for multinational firms because: a.

Lower regulatory costs allow lenders to offer lower cost loans. b.

With transactions starting at $500,000, economies of scale provide better pricing. c.

Lower credit checking costs and other processing costs lowers lending rates. d. all of the above

(b)

48.

Which of the following is not the reason the Eurocurrency market is an attractive place to store excess liquidity for corporations, countries, and individuals? a.

Investors are allowed to hold debt securities in bearer form b.

Automatic withholding of tax on interest earned c.

Investments earn higher returns d.

High liquidity of Eurocurrency deposits

(c)

49.

Which of the following is not the difference between Eurobonds and bonds sold in the U.S.? a.

Eurobonds are usually issued in bearer form; bonds sold in the U.S. are usually registered bonds. b.

Eurobonds usually pay interest once a year; bonds sold in the U.S. usually pay interest semiannually. c.

Eurobonds are denominated in Euros; bonds sold in the U.S. are denominated in dollars. d.

Interest on Eurobonds is computed using a 360-day year vs. a 365-day year for bonds issued in the U.S. e.

All of the above are differences between Eurobonds and bonds sold in the U.S.

(d)

50.

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 based on a 360-day year. d. all of the above.

(b)

51.

One year ago, a U.S. investor converted dollars to yen and purchased 100 shares of Nardasausau stock in a Japanese company at a price of 3,150 yen per share. The total purchasing cost was 315,000 yen. At the time of purchase, in the currency market 1 yen equaled $0.00952. Today, Nardasausau stock is selling at a price of 3,465 yen per share, and in the currency market $1 equals 130 yen. The stock does not pay a dividend. If the investor were to sell the stock today and convert the proceeds back to dollars, what would be his realized return on his initial dollar investment from holding Nardasausau stock? a. +10.00% b.

-11.12% 9

c. d. e.

+12.48% +11.12% -12.48%

(b)

52.

If interest rate parity holds and the annual Taiwan nominal interest rate is 7% and the U.S. annual nominal rate is 5% and real interest rates are 2% in both countries, then inflation in Taiwan is about _____ than in the U.S. a.

1% higher b.

2% higher c.

1% lower d.

2% lower e.

3% lower

(d)

53.

At the beginning of 2011, the exchange rate between the Australian dollar (AD) and the U.S. dollar (USD) is 2.2 AD per USD. Over the year, Australia’s inflation is 12% and the U.S. inflation is 4%. If purchasing power parity holds, at the end of 2011, the exchange rate should be approximately _____ USDs per AD. a.

2.3913 b.

0.4895 c.

2.8498 d.

0.4182 e.

0.3440

(c)

54.

Which of the following conditions may lead to a decline in the value of a country’s currency?

I. high interest rates II. high inflation III. large current account deficit IV. labor strike and violent protest a.

I only b.

I and II only c.

II, III, and IV only d.

II and IV only e.

I and III only

(a)

55.

A current account surplus of the U.S. implies that a.

More goods and services are exported than are imported b.

The U.S. borrowed from abroad more than it loaned, and/or sold off some of its assets c.

There is under consumption of foreign financial assets d.

The value of the dollar will drop e.

The country’s credit rating is going to be downgraded

ESSAY QUESTIONS 1.

Explain how and why the U.S. forward exchange rates are related to short-term interest rates in 10

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 country’s exchange rate, the amount of a foreign currency purchased with a unit of domestic currency, makes foreign goods more expensive to domestic customers 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 in the 1990s and early 2000s, which has had 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 can 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) 2) 3) 4) 5)

6) 7) 8)

The demise of fixed exchange rates in Eastern Europe and in Asia.

The revitalization of Eastern Europe.

The extraordinary budget and trade deficits of the United States since 2001.

The slowdown of Japan’s growth being offset by the developing economies in Asia, Eastern Europe and Latin America.

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.

The global trends toward financial deregulation.

The continuing integration of international product and service markets.

Improved telecommunications and computer technology leading to round the clock trading.

6.

Forrest Gump Bank, a U.S. bank, has 1-year U.S. $200 million loan that earns an average rate of return of 6%. Forrest Gump Bank also has one year single payment Euro loans of €110 million earning 8%. Forrest Gump Bank’s funding source is $300 million in US$ one year 11

NCDs, on which they are paying 4%. Initially the exchange rate is €1.10 per $1 U.S. The one year forward rate is €1.14 per $1 U.S. What is the bank's dollar % spread if they hedge fully using Euro forwards?

Answer: Since Forrest Gump Bank will receive Euro and wants to convert as US$ at the end of period, it shouldeHedge by selling € forward. The current € amount is €110 Million. In one year these loans will be worth $110 Million * 1.08 = €118,800,000. Selling this amount forward €118,800,000/€1.14 will give U.S.$104,210,526. This gives a rate of return of [U.S.$104,210,526 / U.S.$100 million] – 1 = 4.211%.

Average rate of return = (2/3 * 6%) + (1/3 * 4.211%) = 5.404% The cost rate = 4%, so the spread = 5.404% - 4% = 1.404%

12

CHAPTER 13 TRUE-FALSE QUESTIONS (F)

1.

The number of banks in the US has significantly increased from 1980’s to 2000’s while the number of branches decreased.

(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.

(F)

21.

Since 1990’s, due to financial liberalization, both the number and size of commercial banks in the U.S. has been increasing dramatically.

(F)

22.

Repurchase Agreements (Repos) are the most important non-deposit source of funds for commercial banks, which means banks buy and sell Fed Funds to adjust liquidity.

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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

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(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.

(a)

20.

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 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?

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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)

25.

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)

26.

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)

27.

Banks hold municipal bonds primarily for a. high after-tax yields. b. low default risk. c. high marketability. d. service to local communities.

(d)

28.

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)

29.

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)

30.

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.

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(d)

31.

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)

32.

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)

33.

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)

34.

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)

35.

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)

36.

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)

37.

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)

38.

A form of secured borrowing by banks is a. Eurodollars b. fed funds c. certificate of deposit

d. repurchase agreement

(c)

39.

Commercial banks borrow from their Federal Reserve Bank at the a. fed funds rate b. eurodollar rate c. discount rate d. repo rate

(a)

40.

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)

41.

The largest loan category for commercial banks is a. commercial loans b. real estate loans c. consumer loans

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d. agricultural loans.

(a)

42.

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)

43.

Investment in Treasuries provides a. liquidity b. low default risk c. income

d. all of the preceding

(c)

44.

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)

45.

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)

46.

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)

47.

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)

48.

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)

49.

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)

50.

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)

51.

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.

6

(d)

52.

Which of the following statement is NOT correct in describing the development of the U.S. banking industry between 1980’s to 2010’s: a. there are less banks but more branches b. there are many community banks but a few very large banks c. bank holding companies dominate the major market share d. small banks in general engage more hedging activities than the large banks e. large banks’ major funding sources are non-depository funds

(a)

53.

To earn fee incomes, banks provide banking services to other banks, such as check clearing, foreign exchange trading, etc. The above items are examples of a.

Correspondent banking b.

Trust services c.

Off balance sheet assets d.

Economies of scope e.

Credit derivatives

(a)

54.

The asset/liability management is a very important in bank risk management. In general, bank liabilities tend to have __________ maturities and _________ liquidity than/as bank assts. a. lower; greater b. longer; lower c. equal; equal

(d )

55.

Which agent approves chartering and merger of nationally chartered banks? a.

Federal Deposit Insurance Corporation b.

Department of Banking in each state c.

Federal Reserve Bank in each district d.

Office of Comptroller of the Currency e.

Any of the above may grant a charter and approve a merger

(a)

56.

The largest single category of loans on the typical bank's balance sheet in the recent ten years was: a.

Real estate loans b.

Commercial and industrial loans c.

Consumer loans d.

U.S. government agents loans e.

Inter-bank loans

(e)

57.

A contingent item that may eventually be placed on the left hand side of the balance sheet or recognized as income on the income statement is a/an a.

Loan commitment b.

Off balance sheet liability c.

Loan sold without recourse d.

Net charge off e.

Off balance sheet asset

7

(b)

58.

Bank equipment leasing activity involves: a.

A bank leasing its office facilities instead of buying b.

A bank buying equipment and then leasing the item to a customer c.

A customer buying equipment and then leasing it to a bank d.

A bank leasing computer equipment e.

None of the above

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”.

6.

Why the ROA for commercial banks is typically quite low as compared to non-financial firms?

Give such a low ROA, how can commercial banks attract investors?

Answer: Unlike non-financial companies, the major assets of a bank are financial securities (loans and securities), it is difficult for a bank to generate substantially positive NPVs and earn a large ROA. In practice, an ROA of 1% for a bank is an average of banking industry when economy is quite well. However, it is not easy to convince investors that a 1% return on their investment is outstanding. To get an acceptable ROE, banks must resort to using a very high financial leverage. The liability/equity ratio at a bank is usually over 9 times.

8

CHAPTER 14 TRUE/FALSE QUESTIONS 1. (T) IBFs may be established by a U. S.-chartered depository institution, a U.S. branch or agency of a foreign bank, or a U. S. office of an Edge Act Corporation.

2. (F) The Edge Act of 1919 permitted U.S. banks to create international banking facilities.

3. (F) U.S. bank regulators allow U.S. banks overseas to engage in all banking activities allowed by the host country.

4. (F) Representative offices can accept deposits and make loans in the host country.

5. (F) Foreign branches of U.S. banks are subject to both the host nation’s regulations and the regulations in the U.S. 6. (F) International banking facilities (IBFs) operate as subsidiaries of bank holding companies.

7. (T) Edge Act corporations can engage in some types of equity investments.

8. (T) Participating in a syndicated loan helps banks reduce their credit risk.

9. (T) Pooling risk entails lending by several banks to a foreign borrower.

10. (F) Pooling and third-party guarantees are two methods of reducing international currency risk.

11. (F) Expropriation and nationalization are two methods of guaranteeing payment of U.S. bank loans to developing countries.

12. (T) Until the passage of the International Bank Act of 1978, foreign banks enjoyed substantial operating advantages over domestic banks in the U.S. 13. (T) Foreign branches of U.S. banks evolved in the 1960s as a reaction to capital flow regulations in the U.S. 14. (T) Shell branches pay no local taxes and usually operate in stable political environment.

15. (T) 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.

16. (F) Representative offices are usually established to coordinate business between domestic and foreign banks.

17. (T) Shell branches are developed for international money market transactions without contact with the public of the host country.

18. (F) IBFs collect small domestic deposits and make foreign loans.

1

19. (T) Troubled sovereign loans to less developed countries are usually rescheduled rather than foreclosed.

20. (F) Correspondent banks can nprovide full banking services in foreign country.

21. (T) Most large international loans are funded in the Eurocurrency market.

22. (F) The major period for the US banks to grow internationally is after 2000 due to the deregulation of banking industry.

23. (F) Under U.S. regulations Edge Act subsidiaries must devote at least 50 percent of their business to assisting customers with export-import trade and international credit.

MULTIPLE-CHOICE QUESTIONS 1. (e) Which of the following is NOT a reason for the rapid expansion of U.S. banks overseas between 1980 and 2000 ? a. the establishment of the Edge Act b. overall expansion of U.S. world trade c. the growth of multinational corporations d. restrictions on outflow of funds from the U.S. e. the International Bank Act of 1978 2. (c) Most shell branches of U.S. banks operate in a. Japan. b. United Kingdom. c. Bahamas and British West Indies. d. Canada.

3. (a) 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. e. borrowing from foreign markets 4. (c) 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.

5. (c) Which of the following laws is NOT 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

2

6. (b) 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 7. (c) 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 8. (a) 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 e. correspondent bank 9. (d) 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 10. (a) 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 11. (c) 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 12. (c) 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.

3

13. (a) Most of the largest banks in the world are based in a. Europe b. the United States c. Japan d. China e. Latin America 14. (b) International lending based on LIBOR with a rollover-pricing feature protects the bank from a. liquidity risk. b. interest rate risk. c. default risk. d. solvency risk.

15. (b) 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. e. credit insurance.

16. (b) 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.

17. (b) Which of the following is not 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 18. (c) 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 receives an interest payment from a French borrower paid in Euros. d. A U.S. bank holds a mortgage on property in a country in the middle of a civil war.

19. (e) 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. the informal currency exchange in London. e. both a and b

4

20. (d) 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 21. (c) 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.

22. (e) 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. both a and c e. all of the above 23. (a) 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.

24. (a) Which of the following is not related 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.

25. (d) 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.

26. (b) 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 27. (d) Which of the following is NOT true about International Banking Facilities (IBFs)? a. IBFs may be established by a U.S.-chartered depository institution, a U.S. branch or agency of a foreign bank, or a U.S. office of an Edge Act Corporation. b. An IBFs is a set of asset and liability accounts segregated on the books of the establishing institution. c. IBFs can accept deposits over $100,000 from non-U.S. residents or other IBFs. d. Deposits generated can be used to make domestic loans only. e. All of the above is true.

5

28. (b) Which of the following statements is true? a. In general, U.S. banks are permitted to engage in a wider range of business activities in the U.S. than in foreign countries. b. In general, U.S. banks are permitted to engage in a wider range of business activities in foreign countries than in the U.S. c. In general, U.S. banks are permitted to engage in a wider range of business activities in the U.S. than foreign banks. d. In general, foreign banks are permitted to engage in a wider range of business activities in the U.S. than in their home countries. e. Both a and d are true statements.

29. (d) Unlike banks based in the U.S., European-based banks are allowed to a. make floating-rate loans b. pay competitive rates on deposits c. make loans to borrowers with subprime credit ratings d. take equity stakes in non-financial companies e. make overnight interbank loans 30. (c) All of the following are techniques reducing credit risk in international lending except a. foreign government guarantees of loans to private corporations. b. pooling risk through syndication with other banks. c. making floating-rate loans as opposed to fixed-rate loans. d. diversification.

31. (a) 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.

32. (b) 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) 33. (c) 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.

34. (a) An initial foothold entry into international banking is a(n) a. representative office. b. branch bank. c. Edge Act corporation. d. IBF. 6

35. (d) 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. the SEC. e. both a and b 36. (d) 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 37. (e) 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. both a and c e. all of the above 38. (c) 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 e. both a and c 39. (d) 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.

40. (c) 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.

41. (a) International participation loans is a method of reducing the _______ risk of an international lender. a. credit b. currency c. interest rate d. liquidity e. country

7

42. (c) A bank’s international loan diversification is enhanced if the historic realized rates of return on loans from loan applicant, Country A, have a. a high positive correlation with prior loans from Country A. b. a high positive correlation with the loan returns on the bank’s international loan portfolio. c. a negative correlation with the loan returns on the bank’s international loan portfolio. d. a very low negative correlation with the returns on U.S. Treasury bonds.

43. (c) 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.

44. (a) A U.S. bank is owed $10 million in interest from the Mexican government organization in 90 days. If the Mexican manager thought that the value of the peso would fall in the next 90 days, which of the following would he choose to hedge the foreign exchange 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. Either b or c would work.

45. (b) A U.S. bank has just extended a U.S. $10 million loan to a Canadian firm at the rate of U.S. prime plus 2 percent, payable in U.S. dollars, one year from now. The current Canadian dollar/U.S. dollar exchange rate is 1.367. With a prime rate of 7 percent, what is the amount of interest paid in a year? a. C$ 1,230,300 b. $900,000 c. $700,000 d. C$658,376 46. (c) A multinational firm can borrow 5 million Canadian dollars from a Canadian bank at 9 percent for one year and the same in U.S. dollars at a Detroit bank at 8 percent. With a current C$/$ exchange rate of $1.345, what one-year forward contract rate would make the borrower indifferent between the two loans? a. 1.345 b. 1.324 c. 1.357 d. 1.362 47. (a) A multinational firm can borrow 5 million Canadian dollars from a Canadian bank at 9 percent for one year and the same in U.S. dollars at a Detroit bank at 8 percent. If the C$/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.

8

48. (c) Which of the following is NOT directly related to the level of a 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.

49. (c ) Which statement regarding risk evaluation of international loan is NOT correct? a. An analysis of both the borrower and borrower's country is done by the bank’s foreign lending and economic departments. b. Evaluation involves a statistical analysis of the country’s political and economic risks. c. Since the accounting standards in different countries vary, a financial analysis of the borrower is not needed. d. If the cost of doing the analysis internally is too high, bank can use outside information sources. However, they should not be treated as reliable as the internal sources. e. The higher the cost of gathering information, the higher the loan rate, reflecting the increased risk due to unreliable information or lack of information.

50. (b) 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 guarantee of the borrower’s debt d. LIBOR is increasing, therefore increasing the odds that the borrower will be unable to meet their obligations 51. (a) The Foreign Credit Insurance Association (FCIA) is an organization of U.S. insurance companies which a. insures the foreign lending risk (trade credit) of exporters. b. insures the foreign lending risk (trade credit) of importers. c. insures bank loans made to developing nations. d. assures that foreign exporters will pay their trade credit.

52. (c) Which of the following does not cause country risk to increase? a. expropriation b. nationalization c. elimination of currency controls. d. change of government 53. (c) Which of the following is not true about shell branches set by U.S. banks? a. They conduct limited interbank money market transactions rather than retail public operations. 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

9

54. (d) Risk evaluation in international lending involves which of the following? a. an analysis of the borrower b. an analysis of the country’s political and economic risks c. an analysis of domestic economy d. both a and b e. all of the above 55. (b) Which institution created the Basel Accords for banking capital requirements? a. World Bank b. Bank for International Settlements c. European Central Bank d. Federal Reserve Board e. United Nations Financial Supervision Committee

56. (e) To reduce the risk exposure in international lending, what actions banks can take? a. Use the guarantees by governments, their central banks, and other agencies b. Pooling risk by participating syndicate loans among banks to spread risk. c. Diversification of foreign loan portfolio in different geographical regions and industry d. Selling nonperforming loans in the secondary market with a discount. e. All above.

57. (c ) Which of the combination of country and its central bank is NOT correct? a. Japan – Bank of Japan b. European Union - European Central Bank c. China – Central Bank of China d. The U.S. – Federal Reserve System e. Canada – Bank of Canada

ESSAY QUESTIONS 1. What risks are involved in international lending? What methods do banks have to reduce these risks?

Answer: In addition to credit risk, international lending involves foreign exchange risk and possibly country or political risk, which includes regulations, taxation, and other legal restrictions that may cause the actual return on a loan to be different from the expected return.

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. ExportImport 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.

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.

10

3. Explain the “rollover pricing” feature of LIBOR lending?

Answer: 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 re-priced for the new period.

With frequent reprising banks can make intermediate-term loans with little exposure to interest rate risk.

4. What were the primary reasons U.S. banks began to develop overseas operations after World War II? Answer: First of all, U.S. banks followed U.S. corporations as trade began to develop after World War II. These businesses required financial services, credit and assistance with international trade. Another reason for the expansion of American banks abroad was the restrictive nature of U.S. banking regulations. Specifically, a set of government programs restraining the outflow of funds from the U.S. was implemented in the 1960, prompting American banks to raise funds overseas. In addition, interest rate ceilings, which had been in effect for a period of time in the U.S., did not apply to overseas deposits, which meant that U.S. banks could pay market rates to depositors overseas and thus stay competitive in attracting funds.

5. Explain how syndicated bank loans work and why they are particularly popular in international lending.

Answer: International loans tend to be large loans to governments or multinational corporations.

Since such loans may be too risky for one institution, they are usually syndicated. This means that several banks participate in funding the loan packaged by one or more lead banks. This allows banks to spread their risk among a large number of loans, and it allows borrowers to obtain larger amounts of capital than would be possible otherwise.

6. How did technology innovations and internationalization of banking industry change the regulation?

How are these trends related to economies of scale and scope in the banking industry? How did these changes lead to changes in regulations of bank activities and changes in geographic restrictions ?

Answer: Technology innovations and internationalization have been the driving force that created the economies of scale and economies of scope. The U.S. banks increasingly have to compete with very large foreign banks that have not been restricted by regulations in terms of size and scope of activities. Economies of scale and scope imply that larger banks that offer more different types of financial services are more profitable. The trends encouraged banks to attempt to enter new geographic regions. At the same time, banks are encouraged to enter other lines of business that are performed by other financial institutions, such as investment banking, insurance and brokerage, adding to the overall level of competition to provide financial services. Scale economies pushed banks to merge, open up new branches, and operate across state lines and country boarder lines. This also put pressure on regulators to change existing U.S. bank laws.

11

CHAPTER 15 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 Office of the Comptroller of the Currency (OCC) 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 to 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 by Financial Services Modernization Act.

(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.

(T)

21.

In the United States, fixed premium charged for deposit insurance, regardless of risk that banks take, leads to a problem known as moral hazard.

(F)

22.

The Federal Reserve frequently changes reserve requirements for banks since the impacts 1

of these changes is not big to risk taking behavior of banks.

(F)

23.

Bank capital is the most reliable cushion that prevents a decline in asset values from threatening the integrity of bank deposits.

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

(c)

8.

Regulations limiting risk taking of financial institutions are imposed because 2

a. b. c. d.

the costs of regulation exceeds the benefits. the private costs of failure exceed the social costs of failure. the social costs of a general bank failure exceed the private costs to shareholders. risk is harmful.

(b)

9.

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)

10.

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)

11.

The maximum amount of FDIC deposit insurance per eligible retirement account is a. $25,000 b $50,000 c. $250,000 d. $150,000

(d)

12.

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)

13.

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)

14.

Most of the banks in the U.S. are _________ chartered, __________ of the Federal Reserve System and are insured by the _________. a. state; members; FDIC-DIF b. national; members; OCC-DIF c. state; nonmember; FDIC-DIF d. national; member; FRB-DIF

(d)

15.

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

3

(b)

16.

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)

17.

The FDIC pays off on a failed bank. Assets are worth $100 million. Insured deposits 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)

18.

The FDIC pays off on a failed bank. Assets are worth $100 million. Insured deposits total $60 million. Uninsured deposits and other unsecured liabilities total $80 million.

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)

19.

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)

20.

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)

21.

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)

22.

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)

23.

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)

24.

Which bank regulatory agency charters national banks?

4

a. b. c. d.

the Comptroller of the Currency the Federal Reserve the FDIC individual state agencies

(a)

25.

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)

26.

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)

27.

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)

28.

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)

29.

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)

30.

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)

31.

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.

5

(c)

32.

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)

33.

Most U.S. banking regulation focuses on a. price control b. consumer protection c. safety and soundness d. workplace safety

(c)

34.

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)

35.

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)

36.

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)

37.

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)

38.

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.

6

(b)

39.

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)

40.

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)

41.

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)

42.

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.

(c)

43.

A major deposit insurance reform of 2005 was to a. encourage S&Ls to convert their charters to commercial banks. b. reduce deposit insurance premiums c. merge BIF and SAIF into DIF d. merge FDIC and NCUSIF

(a)

44.

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

(b)

45.

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

7

(a)

46.

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)

47.

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)

48.

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)

49.

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)

50.

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)

51.

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

(e)

52.

Why financial institutions are highly regulated in all countries? a. Financial institutions are the major collectors of the public's savings. b. Financial institutions have the power to create money. c. Financial institutions provide businesses and individuals with loans that support consumption and investment spending. d. Financial institutions assist governments in conducting economic policy, collecting taxes and dispensing government payments. e. All of the above.

(a)

53.

An institutional arrangement in which federal and state authorities both have significant bank regulatory powers is referred to as: a. Dual Banking System b. Balance of Power 8

c. Federalism d. Cooperative Regulation e. Coordinated Control (d)

54.

In 1994, the law that allowed bank holding companies to acquire banks anywhere in the U.S. is: a. The Glass-Steagall Act b. The Federal Deposit Insurance Corporation Improvement Act c. The Federal Reserve Act d. The Riegle-Neal Interstate Banking and Branching Efficiency Act e. The National Bank Act

(a)

55.

In 1999, the law that allows banks to affiliate with insurance companies and investment banks to form financial services conglomerates is a. The Gramm-Leach-Bliley Act (Financial Services Modernization Act) b. The National Banking Act c. The Glass-Steagall Act d. The Garn-St. Germain Act e. The Riegle Neal Interstate Banking Act

(b)

56.

In recent years, know-your-clients (KYC) is required by international financial regulators. In the U.S., what is the act that requires financial institutions to share information about customer identities with appropriate government agencies? a. The USA Patriot Act b. The Sarbanes-Oxley Act c. The 9/11 Act d. The U.S. Treasury Department Act e. The Gramm-Leach-Bliley Act

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.

9

3.

In recent years, the Federal Government implements some important regulations to deal with the volatility in financial markets. Please explain what do the following acts do to financial markets: the Financial Services Regulatory Relief Act of 2006 and the Emergency Economic Stabilization Act in 2008?

Answer: A. The Financial Services Regulatory Relief Act of 2006 adds selected new service powers to depository institutions and also loosens regulations on depository institutions. It also grants the Federal Reserve authority to pay interest on depository institutions’ legal reserves.

B. The Emergency Economic Stabilization Act was passed in 2008 during the recent global financial crisis. It allows financial institutions an emergency sale of “bad assets” and temporarily increases the FDIC deposit insurance from $100,000 to $250,000 for all deposits. On the other hand, it empowers government to provide an injections of funds into banks and other qualified lenders and a closer surveillance of the mortgage market participants, such as brokers and lenders.

10

CHAPTER 16 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.

(F)

10.

Congress gave thrifts the right to make consumer loans so they could diversify their assets and shorten their asset durations.

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.

1

(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.

(T)

33.

Of all the depository institutions, as a percentage of assets, credit unions have the highest dependence on deposit sources of funds.

(T)

34.

Financial institutions must have at least 65% of their assets in mortgage related areas in order to maintain their favorable tax status and obtain loans from Federal Home Loan Banks.

(F)

35.

In general, commercial banks have a higher concentration of mortgage related assets on the balance sheet than savings institutions.

(F)

36.

In the U.S., most savings institutions were established as stockholder organizations or partnerships.

MULTIPLE-CHOICE QUESTIONS (a)

1.

The Office of Thrift Supervision and the Resolution Trust Corporation were created by 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.

2

(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.

3

(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 a. b. c. d.

(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.

thrifts are federally insured, few; most. most, few. very few; half. most; half.

4

are federally chartered.

(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

5

(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.

6

(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

7

(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

(c )

51.

The agency that oversees the operations of the Federal Home Loan Banks is a. Federal Reserve Board b. the U.S. Treasury c. Federal Housing Finance Agency d. banking agencies in different states e. Department of Commerce

8

(a)

52.

Comparing to commercial banks, the advantages of credit unions include: I. Credit unions are not taxed II. Credit unions are better diversified than banks III. Credit unions can collectively pool funds IV. Due to regulations credit unions have better economies of scale and scope than banks V. Because of their ties to employers credit unions have better personnel expertise than banks a. I and III only b. I and II only c. III and IV only d. III, IV and V only e. I, III and V only

(a)

53.

Which description about the finance companies is NOT correct? a. Since clients are selected, they are low-risk borrowers. b. Finance companies are highly financially leveraged. c. Most funds of finance companies are borrowed from banks and the market. d. Most larger finance companies are now subsidiaries of bank and financial holding companies. e. Finance companies are diverse and adaptive to changing needs

( e)

54.

For finance companies, the business that purchase corporate accounts receivables at a discount is: a. Equipment leasing b. Letter of credit c. Retail paper d. Wholesale paper e. Factoring

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.

9

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.

4. 50. Please list the major advantages and challenges that credit unions enjoy over banks.

Answer: A. Advantages of credit unions: 1. Credit unions are not taxed because of their non-profit status. Therefore, CUs should be able to offer either lower loan rates or pay higher deposit rates because of the tax advantage.

2. Credit unions are allowed to pool funds with each other and invest their funds collectively in money and capital markets through the corporate central and U.S. central credit unions. Credit unions may obtain loans from these entities and receive management advice.

3. Employer based credit unions may require loan payments to be directly deposited to the credit union, reducing processing and collection costs.

4. Credit unions can receive donated services and donated facilities. Therefore they may have cost advantage.

B. Challenges of credit unions: 1. Since credit unions are under the common bond requirement, they tend to be less diversified than banks. They could simultaneously experience loan defaults and deposit withdrawals due to employer default layoffs or strikes.

2. Credit unions are much smaller than the commercial bank. Therefore it is hard for credit unions to operate to reach economies of scale and scope.

3. Credit unions lack the necessary techniques and know-hows to innovate their financial services or to provide diversified services.

4. Credit unions may have less sophisticated expertise in evaluating loans and to offer other banking services that banks can offer.

5. Credit unions are disadvantageous in recruiting high-quality employees and managers. The board of directors and/or senior management serve CUs usually on a voluntary basis.

10

CHAPTER 17 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.

1

(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.

(F)

31.

Pure risk is very similar to speculative or investment risk that is related to the variability of returns. Therefore, the insured can possibly have a gain or a loss from the insurance policies.

(F)

32.

The insured need to pay premium for insurance to protect their financial loss. Therefore, insurance industry increases cost of bearing risk in society.

(F)

33.

Policy reserves are the major asset of the typical life insurance companies.

(T)

34.

Since insurance is an application of theorem of large number, the risk to be insured must be homogeneous, similar, fortuitous, and occurring by chance.

(T)

35.

If you are terminated before you are fully vested in an employer-sponsored plan, you may not get to keep previous contributions to your pension made by your employer.

2

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.

3

(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.

(d)

12.

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)

13.

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)

14.

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)

15.

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.

4

(c)

16.

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)

17.

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)

18.

The major investment area of life insurance companies is 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

, while casualty .

(b)

19.

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)

20.

Insurance companies manage all but which financial risk? a. default risk b. interest rate risk c. pure risk d. liquidity risk

(d)

21.

________ 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)

22.

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)

23.

In the last few years, which noninsurance financial institution has been able to offer

5

insurance services to the concern of the insurance industry? a. finance companies b. credit unions c. investment banks d. commercial banks (a)

24.

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)

25.

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)

26.

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)

27.

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)

28.

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)

29.

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)

30.

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)

31.

To protect against moral hazard, disability income policies 6

a. b. c. d.

do not cover disabilities from moral problems. do not provide a high percentage of pre-disability income and require a waiting period. usually pay more than 100 per cent of an insured's income. usually require a five-year waiting period before benefits begin.

(b)

32.

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.

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

(b)

33.

(c)

34.

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)

35.

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)

36.

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)

37.

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.

7

(a)

38.

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)

39.

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)

40.

Social security is a _________ pension plan. a. fully funded b. private c. pay-as-you go d. noncontributory

(c)

41.

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)

42.

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.

(d)

43.

Cootie, a 65 year-old disable retiree, has saved $1,250,000. He expects he will survive another 10 years and wishes to receive 10 annual annuity payments, beginning in one year later. If the interest rate is 5.75%, how much does he can expect to receive per year? a. $123,988 b. $133,345 c. $149,987 d. $167,829 e. $178,692

(a )

44.

In the U.S., the major regulator of insurance firms is the a.

State insurance regulator b.

Treasury Department c.

FDIC d.

Federal Reserve Banks e.

SEC

8

(b)

45.

John will retire seven years later and would like to have a 10-payment annual annuity that will have its first payment at the moment when he retires. If the payment amount is $50,000 a year and the interest rate is 12%, what is the fair value should be paid today for this annuity? a. $282,511 b. $143,129 c. $141,667 d. $316,412 e. $160,304

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.

3.

Why do property/casualty insurance companies place a large percentage of their investments in bonds? Why they also need to maintain large surpluses in certain years?

Answer: Due to the premium cycle, property/casualty insurers need stable cash flows to offset very time-varying loss ratios. In many years, it is only the investment returns that make a P&C insurer profitable. Therefore, the insurers need to invest in fixed incomes. Similarly, the large surpluses are needed for years when losses are running higher than anticipated and/or investment returns are less than expected. Moreover, in some years catastrophe losses have been quite large and the large surpluses are needed to absorb potential losses.

9

CHAPTER 18 TRUE/FALSE QUESTIONS 1. (T) Investment banking operations occur in the direct financial market.

2. (F) The Glass-Steagall Act of 1933 has eliminated banks from any underwriting activities.

3. (F) The Glass-Steagall Act of 1933 allowed firms engaged in investment banking to simultaneously engage in commercial banking.

4. (T) A security underwriting takes place in the primary market; subsequent trading in the security takes place in the secondary market.

5. (F) A dealer earns a commission for bringing buyers and sellers together.

6. (F) An underwriter's selling group assumes underwriter risk.

7. (F) Discount brokers offer investment advice at prices below full-service security brokerage houses.

8. (T) Venture capital financing usually entails some managerial involvement and equity ownership.

9. (F) The Banking Act of 1933, known as the Glass-Steagall Act, has effectively kept commercial banks out of the commercial lending area.

10. (T) Investment banking firms provide both financing and investment services for borrowers and lenders, respectively.

11. (F) 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%.

12. (F) Venture capital firms compete with commercial banks for new business loans.

13. (T) Security brokers and dealers obtain most of their funds from customers and banks.

14. (F) Venture capital recipients are often called angels.

15. (T) Seed financing is the first stage of venture capital financing.

16. (T) Under the Glass-Steagall Act commercial banks were permitted to underwrite and trade Federal government securities and general obligation bonds of states and municipalities.

17. (T) 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.

18. (F) SEC Rule 144A permitted borrowers in private placements the opportunity to trade their obligations.

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19. (T) Mezzanine or bridge financing is the interim financing before public offerings of securities.

20. (F) A best efforts sale of securities is likely to generate more revenue for the investment banker than an equivalent underwriting of securities.

21. (T) In an underwritten offer, the risk of selling the issue at a price lower than that promised to the issuer is borne by the investment bank.

22. (F) In an underwritten offer, the investment bank is compensated based on the number of securities sold.

23. (F) Universal banks are financial institutions that are allowed to do only commercial banking activities.

24. (F) Investment Banks provide services for the direct financing in markets such as collecting deposits and making business loans.

25. (F) In 2008, Lehman Brothers filed bankruptcy and many investment banks receive the bailout funds from the Treasury. This means there is very limited career opportunities in investment banking.

26. (F) Financial Services Modernization Act of 1999 is to limit investment banks to engage any commercial banking activities.

27. (T) One of the major causes of financial crisis is the subprime mortgage loans that are facilitated by investment banks.

MULTIPLE-CHOICE QUESTIONS 1. (b) All of the following were the objectives of the Glass-Steagall Act except a. discouraging speculation in financial markets. b. limiting bank mergers when the merger might adversely affect competition. c. preventing conflict of interest and self-dealing. d. restoring confidence in the commercial banking system. e. All of the above were the objectives of the Glass-Steagall Act. 2. (a) All of the following are the major services of investment banking firms except a. making commercial loans b. bringing new security issues to market c. trading securities d. brokerage 3. (c) 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.

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4. (b) Even before the Financial Services Modernization Act was passed, commercial banks could a. invest in common equities b. underwrite U.S. government securities c. underwrite corporate bond issues. d. purchase any debt securities for their own account. e. both b and c 5. (d) _______ involves an issuer of securities soliciting offers from several investment bankers. a. negotiated offering b. underwritten offer c. preliminary search d. competitive bidding e. initial underpricing 6. (d) All of the following are 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.

7. (d) 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. permits trading in private placement securities after a two-year wait, enhancing the liquidity of the investment. c. permits 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.

8. (c) The adoption of SEC Rule 144A provided private placement borrowers a. higher costs of financing because of increased regulation. b. lower-cost financing because of 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. the right not to register their issues with SEC. 9. (e) Which of the following is true about 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. The sale of securities must be restricted to a small group of accredited investors. e. All of the above is true.

10. (b) Which of the following is not true about 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. e. It is used by both lesser-known firms and large, well-known firms in need of funds.

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11. (a) 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 e. money banks 12. (c) The Glass-Steagall Act of 1933 separated a. insurance from credit. b. investment banking from mutual funds. c. investment banking from commercial banking. d. insurance from mutual funds.

13. (d) Which of the following laws is not associated with financial reform legislation in the wake of the Great Depression? a. Securities Act b. Securities Exchange Act c. Glass-Steagall Act d. Financial Services Modernization Act 14. (c) 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 private placement e. a best efforts offering.

15. (c) 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 investment banker.

16. (c) The preliminary and final prospectus provided to 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.

17. (b) Which of the following activities is not performed around the time of new debt security issue? a. securing a credit rating from a rating service provider. b. obtaining the security certificates printed by the Federal Reserve Banks. c. selecting a transfer agent. d. selecting a trustee.

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18. (b) Venture capital investments are characterized by all of the following except a. Substantial control over management decisions b. Low-risk investments with low returns c. A share of capital appreciation d. Serves as intermediate financing between founders' capital and the IPO 19. (b) The best example of an investment banker’s effort to manage the inventory risk in a new security issue 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.

20. (b) 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 21. (a) 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 22. (b) 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. 23. (c) Which of the following is not a service provided by full-service brokerage firms? a. execution of trades b. storage of securities c. making a market in the customers' securities d. margin credit to customers e. investment advice 24. (b) 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 syndicate.

25. (c) A(n) _________ is a “market-maker” in securities and trades on a bid/ask basis. a. broker b. arbitrager c. dealer d. investment banker

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26. (a) All but one of the following are merger-related services 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.

27. (d) In an underwritten IPO, investment banks in the underwriting syndicate can sell shares a. to institutional investors such as mutual funds b. to retail investors c. back to the issuer d. both a and b 28. (b) 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. commercial banks that can also sell universal life insurance policies. e. none of the above.

29. (e) 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. the investment bank guarantees the issuing firm a certain price. d. both a and b e. all of the above 30. (a) In an underwritten offer, the risk is borne by a. an investment banker b. an issuer c. investors d. a selling group e. a dealer 31. (d) Which of the following is true about a best-efforts offering? 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 risky issuers are forced to use this type of offering. d. All of the above is true.

32. (b) Which of the following is NOT a source of funds for security brokers and dealers? a. customer credit balances b. federal funds sold c. repurchase agreements d. call loans from banks e. All of the above are sources of funds for security brokers and dealers.

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33. (a) 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.

34. (c) Mezzanine or bridge financing is provided by a venture capital firm to finance a. seasonal inventory needs. b. long-term capital needs. c. before the IPO. d. research and development.

35. (d) Which of the following is not a form of a venture capital firm? a. a private fund b. a corporate subsidiary c. a publicly funded small business investment corporation d. a trust department of a commercial bank 36. (a) Venture capital firms provide _______ financing to be used for product development and initial marketing and _______ financing to initiate manufacturing and sales. a. start-up; first-stage b. seed; start-up c. seed; first-stage d. first-stage; start-up e. first-stage; second-stage (b) 37. Rehman Sisters, an investment bank, agrees to a firm commitment offering of 2 million shares of Pear Computer stock. The offer price is set at $55 and the spread is 50 cents per share. If the stock is actually sold to the public at $53.80 however, what is Rehman Sisters’ gain or loss? a. $1,400,000 gain b. $1,400,000 loss c. $500,000 gain d. $500,000 loss e. $1,000,000 loss (c ) 38. Megan Stanlee, an investment bank, agrees to a best efforts offering of 2.5 million shares of Macrohard Computer stock. The offer price is set at $35 per share. There are no other fees or expenses. If the stock is actually sold to the public at $34.50 and the banker charges a 3.45 cent commission per share sold, what is the amount of funds that Macrohard Computer receives? a. $88,750,000 b. $87,500,000 c. $86,163,750 d. $85,176,430 e. $84,122,560 (e ) 39. Which one of the following securities firms’ activities is generally the most risky? a. Best efforts offering b. Private placement c. Program trading d. Pure arbitrage e. Firm commitment offering 7

(b ) 40. Which one of the following statements about venture capitalists is NOT correct? a. Venture capitalists are aggressive investors b. Venture capitalists contribute liability financing rather than invest in equity c. Most private venture capitalists are organized as limited partnerships d. The federal government licenses some private firms to provide lower cost funds to entrepreneurs e. Angel venture capitalists are wealthy individuals who fund business startups.

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 of 1999 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 issuing 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, distributing the issue (through underwriting or best-efforts arrangement). Often a member of the IB firm will sit on the board of directors, providing a close tie to IB services.

3. Explain the differences between underwritten offers and best-effort arrangements for IPOs. Answer: In an underwritten offer, an investment banker guarantees that the issuer will receive a fixed amount of money whether the securities are sold or not. In a best-efforts arrangement, the investment banker makes no such guarantees and instead only promises to make its best sales effort. In this case, the issuer bears the risk of not all securities being sold or being sold at a desired price. Most issuers prefer underwritten offers, with only the smallest and riskiest issuers being forced to agree to best-efforts arrangements.

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4. 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: Investment bankers serve two groups of customers 1) firms or governments issuing securities and 2) the investors who may buy these newly issued securities. Registration, pricing, and underwriting are services for the issuing company; information, competitiveness, integrity, and follow-up advice are services provided to 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.”

5. 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.

6. 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 within their portfolios, corporate subsidiaries, or publicly traded smallbusiness 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.

7. YR Megan Chaze, an investment banker, agrees to a firm commitment offering of 1.2 million shares of Formosan Tech stock. The offer price is set at $25.50 and the spread is 30 cents per share. If there are no other fees or expenses, the stock is actually sold to the public at $26.00.

What is the amount of funds Formosan Tech receives?

Answer:

(25.5 − 0.3) 1,200,000 = 30,240,000

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CHAPTER 19 TRUE/FALSE QUESTIONS 1. (T) Balanced funds generate higher proportion of income than growth and income funds and are less volatile.

2. (T) Market arbitrage by hedge funds is the simultaneous buying and selling of a security or derivative of the security to exploit market pricing differentials.

3. (F) When purchasing load mutual fund, the NAV includes the load charge for purchasing the

mutual funds.

4. (T) Money market mutual funds invest in commercial paper, large bank CDs, and short-term government securities.

5. (T) Money market mutual funds are not subject to reserve requirements.

6. (F) Unit investment trusts have a high security turnover rate, increasing their costs over equivalent mutual funds.

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(F) Income funds are made up of portfolios of mortgage-backed securities only.

8. (T) Mutual funds offer diversification and professional investment management for the fees charged.

9. (F) Closed-end investment companies stand ready to redeem their shares at their NAV. 10. (F) Closed-end investment companies provide shareholders with maturity intermediation.

11. (F) No-load mutual funds are commonly sold by security brokers and dealers.

12. (T) Load mutual fund shares may be sold back to the fund.

13. (T) Closed-end investment companies’ securities often sell at a discount to their NAV. 14. (T) The major investment of mutual funds is common stock.

15. (T) Hedge funds are typically organized as limited partnerships with the fund manager as the general partner.

16. (F) Hedge funds have been popular diversification investments for small investors.

17. (T) Arbitrage activities of hedge funds tend to increase capital market efficiency.

18. (F) Short-selling activities of hedge funds look for high growth companies.

19. (F) REITs are open-end investment companies that invest in real estate.

20. (T) Total assets of mutual funds exceed those of commercial banks.

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21. (F) Due to the ability to hedge, the investors of hedge funds experienced very minor losses in subprime mortgage crisis from 2007 to 2009.

22. (T) One of the benefits investing in hedging funds is some hedge funds are not subject to taxation on fund distributions nor to U.S. estate taxes.

23. (T) Unlike mutual funds that their leverage is limited by regulation, hedge funds and REITs often have high leverages.

MULTIPLE-CHOICE QUESTIONS 1. (d) Mutual fund companies provide all but one of the following to their customers: a. diversification b. payment services c. discount brokerage d. insurance 2. (c) The key advantage of a family of mutual funds is a. the ability to diversify an investment portfolio. b. the ability 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 fund management company to another.

3. (b) Mutual fund management companies offering families of funds are attractive to pensionoriented 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.

4. (b) Mutual fund _______ promote asset gathering by providing a variety of mutual funds for their investing clients. a. managers b. families c. salesmen d. societies 5. (c) 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

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6. (b) Which type of an 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. real estate investment trusts e. none of the above 7. (b) 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. sell insurance services.

8. (d) 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 9. (d) Mutual funds that do not charge a front-end load can still impose a _______ that must be paid by investors who redeem their shares. a. back-end load b. contingent deferred sales charge c. redemption fee d. all of the above e. none of the above 10. (d) One may find the shares of which of the following traded on the national exchanges? a. money market mutual fund b. open-end investment company. c. no-load mutual fund. d. closed-end investment company.

11. (c) No-load mutual funds compensate investment managers and salespeople 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.

12. (b) 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

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13. (c) Money market mutual funds compete mostly with banks' a. demand deposits. b. time deposits. c. MMDAs. d. regular savings accounts.

14. (e) Money market mutual funds do NOT invest in a. commercial paper and banker's acceptances. b. bank CDs. c. U.S. Treasury bills. d. repurchase agreements. e. U.S. Treasury notes and bonds.

15. (c) The majority of securities owned by open-end mutual funds are: a. real, physical assets. b. money market securities. c. capital market securities. d. safe, low-risk government securities.

16. (d) 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.

17. (c) The price of a mutual fund share is a. the total 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.

18. (e) The market value per share of closed-end investment companies a. can exceed the net asset value per share. b. is determined by the market. c. can be less than the net asset value per share. d. both b and c e. all of the above 19. (b) 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.

20. (a) 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 4

21. (c) 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 pay taxes on gains and income. d. are not taxed only as long as they invest in tax-free municipal securities.

22. (c) Real estate investment trusts are ________ investment companies that tend to prosper when a. open-end; interest rates are low. b. open-end; interest rates are high. c. closed-end; interest rates are low. d. closed-end; interest rates are high 23. (d) The rapid growth of real estate investment trusts seems to be associated with a. low interest rates. b. favorable tax sheltering. c. an expanding economy. d. all of the above 24. (c) 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.

25. (d) Which of the following is associated with money market mutual funds? a. Short-term money market investments b. Provide excellent liquidity for investors c. High quality and relatively high yield when the yield curve is inverse d. all of the above 26. (c) Mutual fund managers can 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 d. redeeming shares with stock 27. (b) Which of the following is not associated with the growth of mutual funds in recent years? a. an increasing number of retiring baby boomers b. a widespread 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 e. All of the above are associated with the growth of mutual funds in recent years.

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28. (b) The largest investments of mutual funds are _______, followed by_______. a. bonds; common stocks b. common stocks; bonds c. common stocks; preferred stocks d. money market securities; common stocks 29. (a) Which of the following mutual fund types is likely to have the lowest expense ratios? a. index funds b. aggressive growth funds c. growth and income funds d. international and global equity funds 30. (b) Which of the following mutual fund types is likely to have the highest risk exposure? a. growth and income funds b. aggressive growth funds c. balanced funds d. income-equity funds e. money market funds 31. (d) 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. 32. (a) 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 33. (c) 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 e. $17.00 34. (c) You consider investing $10,000 in a stock mutual fund and you are choosing between Fund A, which has a front-end load of 3%, and Fund B, which has a back-end load of 3%. Expected returns and fees of the two funds are identical. Which fund would you choose? a. Fund A b. Fund B c. You are indifferent (total expected returns are the same after accounting for the loads) d. More information is needed to make the choice.

35. (c) 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.

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36. (a) Hedge funds are typically organized as: a. limited partnerships b. corporations c. proprietorships d. any of the above 37. (c) Hedge funds would provide investor portfolio diversification benefits if: a. the correlation of returns from the hedge fund and the investor’s portfolio is close to +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 is negative. d. the hedge fund portfolio includes none of the investments of the investor’s portfolio.

38. (d) Which of the following is not the difference between hedge funds and mutual funds? a. Mutual funds are registered with the SEC, while hedge funds are not. b. Unlike mutual funds, hedge funds borrow significant amounts of their capital. c. Unlike mutual funds, hedge funds concentrate their investment in very few areas. d. Unlike mutual funds, hedge funds are managed by professional fund managers.

39. (d) If a hedge fund manager focused on short-selling of stocks, he/she would a. invest in company stock for short-term profits. b. invest in companies with high future growth prospects. c. borrow money to invest in stocks. d. select companies where the future supply of securities might exceed demand.

40. (b) 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.

41. (b) Investment funds provide investors all of the following except: a. diversification. b. contractual rate of return. c. professional advice. d. small minimum investment.

42. (d) Unit investment trusts provide all of the following advantages to investors except: a. diversification b. professional organization and investment selection c. regular income from securities in the trust d. frequent portfolio rebalancing 43. (b) 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.

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44. (b) Which of the following is not an advantage of exchange-traded funds? a. tax advantage b. high return; low risk c. low expense ratio d. ease of buying and selling 45. (a) 12b-1 fees help mutual funds pay for a. marketing expenses b. costs of trading securities c. management salaries d. account maintenance costs 46. (d) 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 1% of average net assets per year. c. increase with higher portfolio turnover (commissions) d. All of the above is true.

47. (a) Which of the following is not true of REITs? a. REITs total assets started growing in 1974 and peaked in 1984. b. FREITs have a fixed life. 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.

48. (d) Closed-end funds can sell at a discount to their NAV for which of the following reasons? a. poor management b. tax considerations c. market demand d. both b and c e. all of the above 49. (e) Which one of the following is true about bond income funds? a. They invest in bonds that provide steady coupon cash flows and are quite varied in their risk level. b. They 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. c. They may be exposed not only to default risk, but also to interest rate risk. d. They are attractive to investors close to retirement age as the income stream of fund’s instruments provides them with necessary income. e. All of the above are true.

50. (a) Which one of the following is not true about balanced funds? a. Such funds are portfolios of mortgage securities and preferred stock. b. The proportions of stocks and bonds determine the level of return for each fund. c. They typically 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.

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51. (d) 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.

52. (d) Which of the following is true about growth & income funds? a. They seek a balance between capital gains and current income. b. They mostly invest in highly rated companies’ stock. c. They are ideal for investors who are looking for some income, but would also want to invest in growth stocks. d. All of the above is true.

53. (d) Which of the following can trade on national exchanges? a. MMMF b. open-end investment company c. no-load mutual fund d. Exchange-Traded Funds(ETF) 54. (b) Money market mutual funds (MMMFs) became popular in the 1970s because a. MMMF balances were insured by FDIC, unlike bank deposits b. MMMF were allowed to pay market rates on their balances, while commercial banks faced interest rate ceilings. c. MMMF balances were more liquid than any bank deposits. d. All of the above 55. (c ) An open end mutual fund owns 1500 share of Crispy Creme priced at $12. The fund also owns 1000 shares of Bem & Jarry's priced at $43, and 2000 shares of Pepsi priced at $50.

The fund itself has 3500 of its own shares outstanding. What is the NAV of a fund's share? a. $66 b. $56 c. $46 d. $36 e. $26 56. (a ) You have $200,000 to invest in a mutual fund with a NAV = $70. This fund has a 4% of front load, a 1% of management fee and a 0.25% of 12b-1 fee. Assume that the management and 12b-1 fees are charged based on year-end asset value. The gross annual return on the fund's shares was 9%. What was your net annual rate of return to the nearest basis point? a. 3.33% b. 7.64% c. 6.25% d. 4.52% e. 4.64%

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57. (c ) You have $15,000 to invest in a mutual fund. You choose a fund with a 3.5% front load, a 1.75% management fee and a 0.5% 12b-1 fee. Assume that the management and 12b-1 fees are charged on year end assets for simplicity. The gross annual return on the fund's shares was 12.50%. What was your net annual rate of return to the nearest basis point? a. 9.97% b. 8.25% c. 6.12% d. 5.42% e. 4.56%

ESSAY QUESTIONS 1.

Compare and contrast an open-end (mutual fund) investment fund with a closed-end investment company.

Answer: Closed-end 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 openended, and is dependent upon new shares issued (at NAV) and redeemed. Closed-end funds often trade at a discount or a premium to their 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-load funds are likely to be sold via a 1-800 number or via the Internet, not by brokers.

3.

Why are there so many different mutual funds offered for sale?

Answer: First, a tremendous flow of money into mutual funds over the last thirty years with each investor having a different risk profile and expectations presented 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 specify what it tracks.

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 very close to each other. American Stock Exchange's Standard & Poor's Depository Receipts (SPDRS) is one of the more popular ETF's.

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5.

How do hedge funds take advantage of capital market inefficiencies and end up making the markets more efficient?

Answer: Hedge funds often find price discrepancies in derivative securities and their underlying assets, such as stock index funds and the associated portfolios of stocks. They exploit these discrepancies by taking long positions in relatively underpriced instrument and short positions in relatively overpriced ones. This trading activity reduces or eliminates price discrepancies among different but related assets or markets, thereby increasing market efficiency.

6.

What are the functions that investment companies and mutual funds provide to the public?

Answer: a. Provide risk diversification by investing in a portfolio of assets. b. Denomination intermediation by allowing small minimum investments. c. Enhance liquidity of long-term investments. d. Increase economies of scale in investment management and reduce average transaction costs.

7.

You invest $1,000,000 in Formosa Growth Fund. The Fund charges a front end load of 5.75% and an annual expense fee of 1.25% of the average asset value over the year. You believe the fund’s gross rate of return will be 11% per year. What will your investment portfolio be worth in one year?

Answer: The beginning Investment amount = $1,000,000  (1-0.0575) = $942,500. After one year, the future value = $942,500  (1+0.11) = $1,046,175.

Therefore, the average asset’s value = ($1,046,175+$942,500)/2 = 994,337.5. We then obtain the annual expense fee = $994,337.5  0.0125= $12,429.

The ending value of the portfolio = $1,046,175 – $12,429 = $1,033,746

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CHAPTER 20 TRUE/FALSE QUESTIONS

1. (F) Large banks tend to rely more on deposits and small banks tend to rely more on purchased liquidity.

2. (T) Insolvency occurs when an institution's duration gap becomes positive.

3. (F) A firm informs the bank they will immediately draw down the maximum amount on their credit line. This is an example of liability side risk.

4. (T) A rate sensitive asset is one that either matures within the maturity bucket or one that will have a payment change within the maturity bucket if interest rates change.

5. (F) If a bank has a positive repricing gap, falling interest rates increase profitability.

6. (F) A bank’s financing gap is calculated as average loans minus average deposits plus liquid assets.

7. (T) The buyer of a loan in participation has a double risk exposure, one to the borrower and one to the selling bank.

8. (T) One of the most popular methods of neutralizing duration gap risks is to buy and sell financial futures contracts.

9. (T) The sensitivity of the market price of a financial futures contract depends upon the duration of the security to be delivered under the futures contract.

10. (F) In the typical quality swap a borrower with a negative duration gap is more likely to pay all or part of the other swap party's long-term interest rate.

11. (T) The number of futures contracts needed to hedge a position increases as the bank's duration gap increases.

12. (F) Maximizing a bank’s profit, providing liquidity, and maintaining solvency are goals of a consistent direction for bankers.

13. (F) If duration of asset is less than the liability leverage times the duration of liability, then falling interest rates will cause the market value of equity to rise.

14. (T) Basis risk is the risk that the prices or value of the underlying spot and the derivatives instrument used to hedge do not move predictably relative to one another.

15. (F) Writing a call option on a bond pays off if interest rates decrease.

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16. (F) Swaps are usually the best hedging tool to use to hedge short term risks in a half year or less.

17. (F) A U.S. company has a euro denominated loan it must repay in 6 months. A short position in euro futures could help offset the corporation’s foreign exchange risk.

18. (T) As interest rates increase, a long call option position on a bond decreases in value.

19. (T) Value at risk (VaR) is to measure price or market risk of a portfolio of assets and attempt to determine the maximum loss they might sustain over a designated period of time.

20. (F) The VaR are most effective in assessing potential risk for the non-traded assets.

21. (F) Microhedging is to use risk-management instruments such as futures and options to reduce the interest rate risk of banks.

MULTIPLE-CHOICE QUESTIONS

1. (D) The number of futures contracts that a bank will need in order to fully hedge the bank's overall interest rate risk exposure and protect the bank's net worth depends upon (among other factors): A) The relative duration of bank assets and liabilities.

B) The duration of the underlying security named in the futures contract.

C) The price of the futures contract.

D) All of the above.

E) None of the above.

2. (D) The gain or loss to a bank from the use of a financial futures contract depends upon: A) The duration of the underlying security named in the futures contract B) The initial futures price C) The change expected in interest rates divided by 1 + the original interest rate.

D) All of the above.

E) None of the above.

3. (A) Which one of the following situations creates the most liquidity risk?

A) Long term assets funded by short term liabilities B) Short term assets funded by short term liabilities C) Long term assets funded by long term liabilities D) Short term assets funded by long term liabilities E) Long term liabilities funded by short term assets

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4. (B) Which of the following results in a net liquidity drain?

A) Demand deposits increase $120; loans increase $80 B) Reverse repurchase agreements increase $50; demand deposit decrease $50 C) Repurchase agreements increase $100; Demand deposit decrease $50 D) Demand deposits decrease $120; loan repayments are $250 E) Demand deposits increase $10; loans decrease $10 5. (E) In 2008, many banks encounter liquidity issues and experienced deposit withdrawal or bank run. Which one of the following alternatives is an appropriate way to deal with deposit withdrawal?

A) Increasing in Euro dollar deposits B) Contacting an investment banker to find new corporate deposits C) Increasing Fed funds borrowed D) Issuance of a negotiable CD E) Selling the bank’s holdings of T-bills Refer to the information below for questions 6-8: Formosa International Bank (FIB) (mill$) Funds borrowed $6,300 Maximum amount FIB can still borrow $8,600 Cash–type assets $4,700 Excess cash reserves $ 100 Federal Reserve borrowings $ 200 6. (B) What is Formosa International Bank’s total sources of liquidity?

A) $16,520 B) $13,400 C) $14,200 D) $12,280 E) $15,760 7. (A) What is Formosa International Bank’s total uses of liquidity?

A) $6,500 B) $14,500 C) $14,900 D) $16,280 E) $15,760 8. (E) What is Formosa International Bank’s total net liquidity?

A) $4,520 B) $6,500 C) $5,200 D) $7,280 E) $6,900

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Refer to the information below for questions 9-10: Formosa Independence Bank has the following balance sheet: Assets Return Mill $ Liabilities and Equity Cash 0.00% $ 35 Fixed rate deposits Investments (< 1 year) 4.00% $400 Rate sensitive deposits Short term loans (< 1 year) 6.00% $280 Fed fund borrowings Long term fixed rate loans Long term borrowings at (maturity > 1 year) 6.75% $250 fixed rate (maturity > 1 year) Total $710 Equity Total

Cost Mill $ 3.50% $240 2.00% $360 2.50% $ 75 5.50%

$119 $ 66 $710

9. (B) The bank’s one-year gap between assets and liabilities is (Mill $) A) $425 B) $245 C) $174 D) $140 E) $126 10. (E) If all interest rates on the two sides of balance sheet decline by 65 basis points, when other things are equal, what is the change in net interest income for Formosa Independence Bank over the year?

A) $0 B) $1,400,000 C) -$1,400,000 D) $1,592,500 E) -$1,592,500 11. (A) A bank has a positive gap and estimates that the spread between risk-sensitive assets and risk-sensitive liabilities will move directly with interest rates. If interest rates fall the bank’s overall NII will A) Fall B) Rise C) Necessarily be unchanged D) Rise or fall depending on the size of the spread affect relative to the size of the CGAP effect 12. (B) Which one of the following is a source of liquidity risk for a bank?

A) Predicted increase in net deposit withdraws before holidays B) A natural disaster in the bank's community C) Corporation calls in a bond the bank is holding D) Maturation of notes payable

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13. (D ) Bank A has a loan to deposit ratio of 75%, core deposits equal 62% of total assets and borrowed funds are 5% of assets. Bank B has a loan to deposit ratio of 120%. Core deposits are 55% of assets and borrowed funds are 20% of assets. Which bank has more liquidity risk? Ceteris paribus, which bank will probably be more profitable when interest rates are low?

A) Bank A; Bank A B) Bank A; Bank B C) Bank B; Bank A D) Bank B; Bank B 14. (B) ABC Bank has $39 million invested in T-Bonds with a 16-year duration, $39 million in 6 month maturity T-Bills, and $75 million invested in consumer loans with a 3 year duration. If they are all portfolios of this bank, what is the duration of the bank's asset portfolio in years?

A) 5.95 years B) 6.50 years C) 7.23 years D) 8.78 years E) 9.51 years Refer to the information below for questions 15-17: As a portfolio manager of Asian Investments and Co., you like to evaluate the Value-at-Risk of your currency holding of Taiwanese and Japanese assets. Use the historical data in the past 20 years, you obtain the following information regarding the exchange rate between USD ($) with Taiwanese Dollar (TWD) and Japanese Yen (JPY): DEAR and VAR Calculations: Time Horizon (Days) = 10 Lower Tail 0.005 Probability= $ Amount Standard Deviation Adverse Move DEAR (TWD) 1,000,000 0.0050 2.58 DEAR (JPY) 1,000,000 0.0100 2.58 DEAR (TWD and JPY) 2,000,000 ?

2.58 where DEAR is daily earnings-at-risk, standard deviation is the volatility calculated by the historical data, adverse move is the t-value of the lower bound of the distribution of asset value.

15. (E )Please calculate the DEARs for TWD and JPN in USD. A) $9,892.55; $22,544.78 B) $11,842.32; $22,784.71 C) $15,672.22; $14,784.56 D) $11,928.93; $52, 874.78 E) $12,892.39; $25,784.78 Hint: DEAR =$ Value of Position  Price Sensitivity  Adverse Movement 5

16. (D) If the coefficient of correlation between USD/TWD and USD/JPN is 0.25. Please calculate the DEAR for this 2-million USD portfolio.

A) $29,892.55 B) $21,842.32 C) $15,672.22 D) $31,579.78 E) $25,784.66 Answer: D 17. (A) Please calculate the 10-day Value-at-Risk (VaR) for this 2-million USD portfolio.

A) $ 99,864.02 B) $111,842.52 C) $115,627.25 D) $131,529.81 E) $135,784.62 18. (A) A bank has Federal funds totaling $25 million with an interest rate sensitivity weight of 1.0. This bank also has loans of $105 million and investments of $65 million with interest rate sensitivity weights of 1.40 and 1.15 respectively. This bank also has $135 million in interest-bearing deposits with an interest rate sensitivity weight of 0.90 and other money market borrowings of $75 million with an interest rate sensitivity weight of 1.0. What is the weighted interest-sensitive gap for this bank?

A) $50.25 B) $-15 C) -$50.25 D) $34.25 19. (C) A bond has a face value of $1,000 and five years to maturity. This bond has a coupon rate of 13 percent and is selling in the market today for $902. Coupon payments are made annually on this bond. What is the yield to maturity (YTM) for this bond?

A) 13.25% B) 12.75% C) 16.00% D) 11.45% 20. (C) A bank with a positive interest-sensitive gap will have a decrease in net interest income when interest rates in the market: A) Rise B) Unchange C) Fall D) A bank with a positive interest-sensitive gap will never have a decrease in net interest income

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21. (D) A bank has an average asset duration of 1.15 years and an average liability duration of 2.70 years. This bank has $250 million in total assets and $225 million in total liabilities. This bank has: A) A negative duration gap of 1.55 years.

B) A positive duration gap of 1.28 years.

C) A negative duration gap of 3.85 years.

D) A negative duration gap of 1.28 years.

22. (E) A bond has a duration of 7.5 years. Its current market price is $1125. Interest rates in the market are 7% today. It has been forecasted that interest rates will rise to 9% over the next couple of weeks. How will this bank's price change in percentage terms?

A) This bond's price will rise by 2 percent.

B) This bond's price will fall by 2 percent.

C) This bond's price will not change D) This bond's price will rise by 14.02 percent E) This bond's price will fall by 14 .02 percent 23. (B) A bank has an average asset duration of 5 years and an average liability duration of 3 years. This bank has total assets of $500 million and total liabilities of $250 million.

Currently, market interest rates are 10 percent. If interest rates fall to 8 percent, what is this bank's change in net worth?

A) Net worth will decrease by $31.81 million B) Net worth will increase by $31.81 million C) Net worth will increase by $27.27 million D) Net worth will decrease by $27.27 million E) Net worth will not change at all 24. (A) A bank wishing to avoid higher borrowing costs would be most likely to use: A) A short or selling hedge in futures.

B) A long or buying hedge in futures.

C) A call option on futures contracts.

D) B and C above.

25. (A) Suppose a bank has an asset duration of 5 years and a liability duration of 2.5 years. This bank has $1000 million in assets and $750 million in liabilities. They are planning on trading in a Treasury bond future which has a duration of 8.5 years and which is selling right now for $99,000 for a $100,000 contract. How many futures contracts does this bank need to fully hedge itself against interest rate risk?

A) 3714 contracts B) 3125 contracts C) 2971 contracts D) 371 contracts E) 37 contacts

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26. (B) Suppose a T-Bond futures contract has a duration of 9 years and has a current market price of $98,750. Market interest rates are 6 percent today but are expected to rise to 7.5 percent. What is the change in this futures contract's market price from this change in interest rates?

A) +$12,577 B) -$12,577 C) +$62,883 D) -$62,883 E) -$33,578 27. (B) A microhedge is a A) Hedge against a change in a particular macro variable B) Hedge of a particular asset or liability C) Hedge of an entire balance sheet D) Hedge using options E) Hedge without basis risk 28. (E) A bond portfolio manager has a $25 million market value bond portfolio with a 6 year duration. The manager believes interest rates may increase 50 basis points. Which of the following could be used to help limit his risk?

I. Sell the bonds forward.

II. Buy bond futures contracts.

III. Buy call options on the bonds.

IV. Buy put options on the bonds.

A) I only B) II only C) I and III only D) II and III only E) I and IV only 29. (E) A macro hedge is a A) Hedge of a particular asset or liability B) Hedge using futures on macroeconomic variables C) Hedge using options in liabilities D) Hedge without basis risk E) Hedge of an entire balance sheet Refer to the information below for questions 30-32: XYZ Bank has DA = 2.4 years and DL = 0.9 years. The bank has total equity of $82 million and total assets of $850 million. Currently, interest rates are at 6%.

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30. (C) What is the bank’s duration gap in years?

A) 1.432 B) 1.488 C) 1.587 D) 1.656 E) 1.722 31. (D) If interest rates increase 100 basis points the predicted dollar change in equity value will equal A) $10,171,698 B) –$10,171,698 C) $12,724,528 D) –$12,724,528 E) $4,928,756 32. (C ) To get DE to equal zero to protect the equity value in the event of an interest rate change, the bank could A) Reduce DA to 1.2 years B) Increase DL to 2.5 years C) Increase DL to 2.77 years D) Reduce DA to zero E) Increase DL to 3.10 years ESSAY QUESTIONS

1. Explain the dilemma between liquidity, solvency and profitability. Why liquidity risk can lead to insolvency risk?

Answer: A FI can fail in two ways: insolvency caused by loss and illiquidity caused by a high proportion of assets in long-term investment. Therefore bankers need to reconcile the conflicting goals of profitability and safety. If a FI has to sell non-liquid assets to meet cash requirements it may have to sell them at less than face value, in most cases, at less than market value as a result of the need for a “fire sale”. If the asset write downs are large enough, equity value is reduced. Once equity is reduced to zero the institution is insolvent. This is essentially what happened to Continental Illinois Bank in the 1980s when it failed.

2.

DCB bank has an assets size $1,200 million, with duration DA = 2.5 years, DL = 0.80 years. In addition, the total liability is $1,104 million. According to the duration gap model, what size interest rate change would make the institution insolvent if rates are currently 5%?

Answer: The financial leverage of DCB bank is $1,104/$1,200=0.92.

– (1–0.92)  $1,200 (M) = – [2.5 – (0.92  0.8)]  [$1,200 million  (ΔR/1.05)]; Therefore, ΔR = 0.0476 = 4.76% 9

3.

Why the capital in a financial institution can protect against credit risk and interest rate risk?

Answer: 1. Equity is written down when loans go bad. If too many loans default and the equity is reduced to zero the FI is insolvent. Thus the more equity the FI has the lower the likelihood that loan defaults will cause insolvency. That is how capital protects credit risk.

2. Changes in interest rates can affect the market value of equity of a bank if there is an unfavorable rate change based on the duration gap. The bigger the amount of equity the more rates have to change before the insolvency occurs. That is how capital protects interest rate risk.

4.

Formosa Independence Bank has DA = 2.45 years and DL = 1.08 years. In addition, this bank has total assets of $375 million and liabilities of $337.5 million. The CFO of Formosa Independence Bank wishes to effectively reduce the duration gap to one year by hedging with T-Bond futures that have a market value of $115,000 and a DFut = 8 years. How many contracts are needed and should the bank buy or sell them? If D stands for duration.

Answer: Since the duration of liabilities is shorter the one of asset, the CFO should sell (2.45 − 0.97 − 1)  375M = 195.65 ; 196 contracts should be sold. the futures. NF = 8  115,000

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5.

The average durations and dollar amounts of assets and liabilities held in Freedom Bank are shown as the below: Asset and Liability $ Items Avg.Duration(yrs) Amount Investment Grade Bonds Commercial Loans Consumer Loans Deposits Nondeposit Borrowings

12.00 4.00 8.00 1.10

$65.00 $400.00 $250.00 $600.00

0.25

$50.00

What is the weighted average duration of Freedom Bank’s asset portfolio? What is the weighted average duration of Freedom Bank’s liability portfolio? What is the leverageadjusted duration gap?

Answer: The duration of a portfolio is the value-weighted average of duration of all assets in the portfolio. Therefore, 65 400 250 DAsset =  Wi  Di =  12 + 4+  8 = 1.0909 + 2.2378 + 2.7972 = 6.13 years 715 715 715 600 50 DLiability =  Wi  Di =  1.1 +  0.25 = 1.0154 + 1.0154 = 2.03 years .

650 650 The duration GAP is

Duration Gap = DA − DL 

TL 650 = 6.13 − 2.03  = 3.7273 (year) TA 715

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