Money and Banking, 2023-24

Midterm Exam
Davit Keshelava
Total: 40 Points
Time: 2 Hours
Paper 1
Multiple Choice Questions (25 Points)

There is only one correct answer to each question.

1) (1 Point) Which of the following can be described as involving indirect finance?
a) People buy shares in a mutual fund
b) A corporation buys commercial paper issued by another corporation
c) A corporation takes out loans from a bank
d) Only a and c of the above
e) Only b and c of the above

2) (1 point) Which of the following statements are true?

a) A bond is a long-term security that promises to make periodic payments called dividends
to the firm’s residual claimants.
b) A debt instrument is long-term if its maturity is ten years or longer
c) The income from bonds is typically more variable than that from equities
d) Debt and equity can both be short-term financial instruments
e) All of them

3) (1 Point) Which type of stockholders has ownership in the company but usually do
not have voting rights or have limited voting rights?
a) Common Stock
b) Bondholders
c) Preferred Stock
d) Neither
e) Both
4) (1 Point) Which of the following statements are false?
a) A corporation acquires new funds only when its securities are first sold in the primary
market
b) Many common stocks are traded over the counter, although the largest corporations
usually have their shares traded at organized stock exchanges such as the New York Stock
Exchange
c) Capital market securities are usually more widely traded than shorter-term securities
and so tend to be more liquid
d) Because of their short terms to maturity, the prices of money market instruments tend
not to fluctuate wildly
e) None of them

5) (1 Point) What category of costs arises from the necessity of the lender to evaluate
the proposal for which the funds are required?
a) Search costs
b) Verification costs
c) Monitoring costs
d) Enforcement costs
e) None of them

6) (1 Point) What is one of the main differences between borrowers and lenders
regarding the time horizon for loans?
a) Borrowers prefer short time horizons, while lenders prefer long ones.
b) Borrowers prefer long time horizons, while lenders prefer short ones.
c) Both borrowers and lenders prefer short time horizons.
d) Both borrowers and lenders prefer long time horizons.
e) None of them

7) (1 Point) If expected inflation falls, the demand for long-term bonds today ____ and
the supply for long-term bonds today ____.
a) Rises; rises
b) Falls; falls
c) Rises; falls
d) Falls; rises
e) None of them
8) (1 Point) Suppose the interest rate responded to increasing money growth the
following way: in the beginning interest rates decreased sharply and then it
increased gradually to a level that is higher than the initial value. Which of these
statements is correct?
a) The liquidity effect is smaller than the expected inflation effect and interest rates adjust
quickly to changes in expected inflation
b) The liquidity effect is larger than the expected inflation effect and interest rates adjust
quickly to changes in expected inflation
c) The liquidity effect is larger than the expected inflation effect and interest rates adjust
slowly to changes in expected inflation
d) The liquidity effect is smaller than the expected inflation effect and interest rates adjust
slowly to changes in expected inflation
e) None of them

9) (1 Point) The expected return on Georgian Airways stock rises from 5 to 10

percent and the expected return on Gamma stock rises from 12 to 18 percent, then
the expected return of holding Georgian Airways stock _____ relative to Gamma stock
and the demand for Georgian Airways stock _____.
a) rises; rises
b) rises; falls
c) falls; rises
d) falls; falls
e) None of them

10) (1 Point) When the economy enters into a boom, normally the demand for bonds
________, the supply of bonds ________, and the interest rate ________.
a) increases; increases; rises
b) decreases; decreases; falls
c) increases; decreases; rises
d) decreases; increases; rises
e) none of them

11) (1 Point) Since yield curves are usually upward-sloping, the ________ indicates
that, on average, people tend to prefer holding short-term bonds to long-term bonds.
a) market segmentation theory
b) expectations theory
c) liquidity premium theory
d) both a and b of the above
e) both a and c of the above
12) (1 Point) A monetary expansion ________ stock prices due to a decrease in the
________ and an increase in the ________, everything else held constant.
a) reduces; future sales price; expected rate of return
b) reduces; current dividend; expected rate of return
c) increases; required rate of return; future sales price
d) increases; required rate of return; dividend growth rate

13) (1 Point) The January effect refers to the fact that

a) most stock market crashes have occurred in January
b) stock prices tend to fall in January
c) stock prices have historically experienced abnormal price increases in January
d) the football team winning the Super Bowl accurately predicts the behavior of the stock
market for the next year

14) (1 Point) Which of the following yield curves tend to predict recession?
a) Upward-sloping yield curves
b) Downward-sloping yield curves
c) Flat yield curves
d) U-shaped yield curves
e) None of them

15) (1 Point) According to the efficient market hypothesis

a) one cannot expect to earn an abnormally high return by purchasing a security
b) information in newspapers and in the published reports of financial analysts is already
reflected in market prices
c) unexploited profit opportunities abound, thereby explaining why so many people get
rich by trading securities
d) a) and b)
e) a), b), and c)
16) (1 Point) Let’s assume that you are trying to predict the time you need to travel
to your work. How would you do that if you follow rational expectations?
Choose multiple correct answers
a) make predictions based on the time you needed to travel to your work yesterday
b) make predictions based on your previous forecast about the time you needed to travel to
your work yesterday
c) make predictions after checking Google Maps to find out information about traffic jams
d) make predictions after reading local newspapers (or watching TV news) to find out
about demonstrations in the city
e) make predictions after checking phone messages from City Hall about the planned
renovation works

17) (1 Point) News in the newspaper: "The Samsung Galaxy Note 7 has lithium-ion
batteries manufactured in China and South Korea, and these Samsung phone
batteries explode when overcharged.". If this news provides a net benefit in
predicting price changes of Samsung at the margin, which of the following forms of
efficient market hypothesis is not satisfied?
There can be more than one correct answer.
a) Strong form of Efficient Markets Hypothesis
b) Semi-strong form of Efficient Markets Hypothesis
c) Weak form of Efficient Markets Hypothesis
d) None of them

18) (1 Point) ER is the expected return of the portfolio, Sigma is the standard
deviation of the portfolio, risk-free rate (Rf) is 5%, expected return of the market
(ERm) is 10%, and standard deviation of the market returns (SDm) is 4%. Which of
the following describes the capital market line?
a) ER=5% - 1.25%*Sigma
b) ER=5% - 5%*Sigma
c) ER=4% - 10%*Sigma
d) ER=5% + 1.25%*Sigma
e) None of them

19. (1 Point) Which one of the following portfolios cannot lie on the efficient frontier
as described by Markowitz?
a) Only portfolio A cannot lie on the efficient frontier
b) Only portfolio B cannot lie on the efficient frontier
c) Only portfolio C cannot lie on the efficient frontier
d) Only portfolio D cannot lie on the efficient frontier
e) Cannot tell from the information given

20. (1 Point) If a bank has $100,000 of deposits, a required reserve ratio of 20

percent, and holds $30,000 in reserves, then it has enough reserves to support a
deposit outflow of
a) $20,000
b) $11,000
c) $5,000
d) either $20,000 or $11,000
e) either $11,000 or $5,000

21 (1 Point) What is the ultimate constraint on money creation according to the

“Theory of Modern Money Creation”?
a) Competition among banks
b) Government regulations
c) Central bank's policies and monetary policy
d) Demand for loans from households and companies

22 (1 Point) What limits the amount of lending banks can profitably do?
a) Credit risk
b) Competition for loans and deposits
c) Government regulations
d) Capital requirements

23 (1 Point) How do banks primarily manage the risk associated with making new
loans?
a) By increasing the amount of reserves, they hold
b) By reducing their capital to attract more borrowers
c) By offering lower interest rates on loans
d) By having sufficient capital to absorb potential losses
24 (1 Point) What is the primary driver of the creation of bank deposits, as explained
in the “Money Creating in the Modern Economy”?
a) Households' saving decisions
b) Central Bank money supply
c) Interest rates set by the Bank of England
d) Profitable lending opportunities

25 (1 Point) Which type of financial instrument is bought at a price below its face
value and only repays the face value at the maturity date, without making interest
payments?
a) Simple loan
b) Coupon bond
c) Installment loan
d) Discount bond

Open Questions (15 Points)

If some information is not specified, please specify yourself.
1) (3 Points) Please match expressions and expectation formation mechanisms (you can
use expectation formation Mechanisms more than once) e – expected, * - equilibrium
Expression Expectation Formation Mechanism
e e e
a ¿ GDPt =GDP t−1 + β (GDPt −1−GDPt −1 )
e e ¿
b ¿ GDP ¿t =GDP t−1 + β (GDPt −1−GDPt −1 )
 e
c ¿ GDP ¿t =α GDP t−1 + ( 1−α ) GDPt−2
e
d ¿ GDP ¿t =GDPt −1
e
c ¿ GDP ¿t =E ¿

Expectation formation mechanisms:

i) Extrapolative expectations
ii) adaptive expectations
iii) regressive expectations
iv) rational expectations

2) (3 Points) Let’s assume that longer-term interest rates are set by Liquidity Premium
Theory. Interest rates on one-year discount bonds today are equal to 10%, are expected to
decrease further to 8% next year and increase to 9% the year after. The (three-year) term

premium is defined by the following function: Where L is the term

premium and i-s are interest rates on one-year discount bonds. What will be the three-year
interest rate? {to express A% use i=A instead of 0.0A].

3) (3 Points) Suppose you have just inherited $4,000 and are considering putting the
money in an interest-bearing checking account that earns 3%. The FDIC insures the
account against bank failure and compensates up to $3,800. In addition, the probability of
bank failure equals 0.8 if a sufficient amount of people withdraw their deposits (0.2 is the
probability that the bank survives after this big withdrawal), and the probability that
sufficient people withdraw their funds equals 0.1 (hence. there is 0.9 probability that not
sufficiently enough people withdraw their funds). If you are risk natural, would you put
money in an interest-bearing checking account?

4) (3 Points) Suppose you have just inherited $2,000 and are considering loaning the
money to one of your friend’s roommates, Tom, at an agreed-upon interest rate of 25%,
even though you believe there is a 10% chance that Tom will leave town without repaying
you. Tom is offering you to use his golden ring as collateral. If Tom does not repay a loan,
you will be able to sell his watch for $2,200 in case of favorable changes in the world
market of gold (with a corresponding probability of 0.8) or for $1,200 in case of
unfavorable changes in the world market of gold (with a corresponding probability of 0.2).
What will be the expected income (value) of your investment? If you are risk natural, would
you lend money to Tom?

5) (3 Points) We have the following equations:

E(RP) = w1 ER1 + w2 ER2

s2P = w21 s21+ w22 s22 + 2 w1 w2(  s1 s2)

w1 + w2 = 1
R – Expected Returns; w – Weights; s – Standard Deviation,  - correlation coefficient.
Assumptions:
R1= R2; s1 and s2 are non-zero; s1= s2; =-1

- Please draw the graph describing the relationship between Return and Standard
Deviation.
- What is (are) value(s) of weights (w) that provides an efficient outcome?