UNIT 27: THE BASIC TOOLS OF FINANCE

Question 1
The benefit of diversification when constructing a portfolio is that it can eliminate
Select one:
a) firm-specific risk.
b) risk aversion.
c) speculative bubbles.
d) market risk.
Question 2
Most financial decisions involve two related elements:
Select one:
a) investment and taxes.
b) advice and consent.
c) time and risk.
d) saving and consumption.
Question 3
Which of the following statements best describes the economist’s view of finance and the
financial system?
Select one:
a) The financial system is very important to the functioning of the economy; however, the
tools of finance are not particularly helpful to us as individuals since we seldom make
decisions for which those tools are useful.
b) The financial system, while interesting, is not very important to the functioning of the
economy; however, the tools of finance are often helpful to us as individuals when we
find ourselves making certain decisions.
c) The financial system is very important to the functioning of the economy, and the
tools of finance are often helpful to us as individuals when we find ourselves
making certain decisions.
d) The field of finance is intimately concerned with the financial system and the tools of
finance, and financial economists see great importance in them; however, the
“mainstream” economist sees little value in studying financial markets or the tools of
finance.
Question 4
Compounding refers directly to
Select one:
a) changes in the interest rate over time on a bank account or a similar savings vehicle.
b) finding the present value of a future sum of money.
 c) finding the future value of a present sum of money.
d) interest being earned on previously-earned interest.
Question 5
Discounting refers directly to
Select one:
a) decreases in interest rates over time, while compounding refers to increases in interest
rates over time.
b) finding the present value of a future sum of money.
c) finding the future value of a present sum of money.
d) calculations that ignore the phenomenon of compounding for the sake of ease and
simplicity.
Question 6
One way to characterize the difference between compounding and discounting is to say that
Select one:
a) Compounding involves the assumption that the interest rate is zero, whereas discounting
does not involve that assumption.
b) Discounting involves the assumption that the interest rate is zero, whereas compounding
does not involve that assumption.
c) The process of compounding produces a future value, whereas the process of
discounting produces a present value.
d) The process of compounding produces a present value, whereas the process of
discounting produces a future value.
Question 7
Other things the same, when the interest rate rises, the present value of future revenues from
investment projects
Select one:
a) falls, so investment spending rises.
b) rises, so investment spending falls.
c) falls, so investment spending falls.
d) rises, so investment spending rises.
Question 8
The concept of present value helps explain why
Select one:
a) None of the above are correct; the concept of present value is of no help in explaining
why either investment or the quantity of loanable funds demanded decreases when the
interest rate increases.
 b) Investment decreases when the interest rate increases, and it also helps explain
why the quantity of loanable funds demanded decreases when the interest rate
increases.
c) Investment decreases when the interest rate increases, but it is of no help in explaining
why the quantity of loanable funds demanded decreases when the interest rate
increases.
d) The quantity of loanable funds demanded decreases when the interest rate increases,
but it is of no help in explaining why investment decreases when the interest rate
increases.
Question 9
There are many concerns for risk-averse lenders. Consider the following:
(1) Lenders are concerned that borrowers with the greatest risk are the ones most likely to
actively pursue loans.
(2) Lenders are concerned that real GDP will decline leading to reduced corporate profits.
(3) Lenders are concerned that products produced by certain corporations will become
obsolete.
Select one:
a) 1 is market risk; 2 is firm-specific risk
b) 3 is market risk; 1 is firm-specific risk
c) 2 is market risk; 3 is firm-specific risk
d) 2 is firm-specific risk; 3 is market risk
Question 10
Other things the same, an increase in the interest rate makes the quantity of loanable funds
supplied
Select one:
a) Rise, and investment spending rise.
b) Rise, and investment spending fall.
c) Fall, and investment spending fall.
d) Fall, and investment spending rise.
Question 11
If the efficient markets hypothesis is correct, then
Select one:
a) Stock prices never follow a random walk.
b) All of the above are correct.
c) The stock market is informationally efficient.
d) The number of shares of stock offered for sale exceeds the number of shares of stock
that people want to buy.
Question 12
Which of the following is correct?
Select one:
a) Stock prices are determined by fundamental analysis rather than by supply and demand.
b) The larger the percentage of stock in a portfolio, the greater the risk, but the
greater the average return.
c) Diversification cannot reduce firm-specific risk.
d) Risk-averse people will not hold stock.
Question 13
The efficient markets hypothesis says that
Select one:
a) only individual investors can make money in the stock market.
b) it should be easy to find stocks whose price differs from their fundamental value.
c) stock prices follow a random walk.
d) All of the above are correct.
Question 14
According to the efficient market hypothesis, which of the following statements is not correct?
Select one:
a) Stock market prices tend to rise today if they rose yesterday.
b) As judged by the typical person in the market, all stocks are fairly valued all the time.
c) At the market price, the number of shares being offered for sale matches the number of
shares people want to buy.
d) All of the above statements are incorrect.
Question 15
Stock market fluctuations
Select one:
a) have few, if any, macroeconomic implications.
b) often go hand in hand with fluctuations in the economy more broadly.
c) are attributable to the widespread belief that the efficient markets hypothesis is correct.
d) rarely have anything to do with fluctuations in the economy more broadly.