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FIN 310 Fall 2009 Exam 1 (25% of Course Grade) Name ________________________________________ (Print Legibly)

There are approximately seventy-four (74) questions on the exam. Answer exactly twenty (20) questions (no more, no less). All ten (10) highlighted questions must be answered (1, 4, 11, 20, 27, 36, 39, 42, 48, 71). Choose any remaining questions to complete the total of twenty (20) answered questions. If you have any questions during the exam, come to the front of the room and ask for clarification. No points are awarded after the exam for failing to properly understand a problem. No partial credit is awarded, so take care in your answers. Each answered question is weighted 1/20th of the total exam grade. Select the best or closest answer to each answered question.

Required

Solution

2. Financial market participants who provide funds are called: A) deficit units. B) surplus units. C) primary units. D) secondary units. ANSWER: B 3. Those financial markets that facilitate the flow of short-term funds are known as: A) money markets. B) capital markets. C) primary markets. D) secondary markets. ANSWER: A

Required

Solution

5. Funds are provided to the initial issuer of securities in the: A) secondary market. B) primary market. C) deficit market. D) surplus market. ANSWER: B 6. Which of the following is most likely to be described as a depository institution? A) finance companies B) securities firms C) credit unions D) pension funds E) insurance companies ANSWER: C 7. Which of the following distinguishes credit unions from commercial banks and savings institutions? A) Credit unions are non-profit. B) Credit unions accept deposits but do not make loans. C) Credit unions make loans but do not accept deposits. D) Savings institutions restrict their business to members who share a common bond. ANSWER: A 8. When a securities firm acts as a broker, it: A) guarantees the issuer a specific price for newly issued securities. B) makes a market in specific securities by adjusting its own inventory. C) executes transactions between two parties. D) purchases securities for its own account. ANSWER: C

Solution

10. The appromimte formula describing the Fisher effect states the: A) nominal interest rate equals the expected inflation rate plus the real rate of interest. B) nominal interest rate equals the real rate of interest minus the expected inflation rate. C) real rate of interest equals the nominal interest rate plus the expected inflation rate. D) expected inflation rate equals the nominal interest rate plus the real rate of interest. ANSWER: A

Required
11. If the real interest rate was negative for some historical period of time, then: A) inflation is expected to exceed the nominal interest rate in the future. B) inflation is expected to be less than the nominal interest rate in the future. C) actual inflation was less than the nominal interest rate. D) actual inflation was greater than the nominal interest rate. ANSWER: D
I(Nom) = i(Real) + INF I(Real) = i(NOM) INF < 0 I(Nom) < INF

12. If inflation turns out to be lower than expected, (Assume fixed interest rate loans for simplicity) A) savers benefit, while borrowers are adversely affected. B) borrowers benefit, while savers are not affected. C) savers and borrowers are equally affected.

D) savers are adversely affected, but borrowers benefit. ANSWER: A I(nom) = i(Real) + E(INF) INF < E(INF), then i(Real) = real return to savers (=investors) is increased by an approximate like amount [=E(INF) INF]. Borrowers end up paying an increased real return on the loan Rule of thumb, fixed interest rate borrowers desire increased inflation, thereby lowering their real interest rate paid

13. If the federal government needs to borrow additional funds due to running a budget deficit as a result of massive increases in government spending, there is ____________ shift in the supply curve in the market for loanable funds and _______ shift in the demand curve in this market. (Answer according to the lecture material, not the text.) . A) a right; a left B) a left; no C) no; left D) no; a right ANSWER: B (Crowding out effect) increase in G is a decrease in public saving (T-G) = left shift in supply and no shift in demand

14. If security prices fully reflect all available information, the markets for these securities are: A) efficient. B) primary. C) overvalued. D) undervalued. ANSWER: A

15. There is a _______ relationship between the risk of a security and the expected return from investing in the security. A) positive B) negative C) indeterminable D) none of these ANSWER: A
16. Which of the following is not a typical money market security?

A) Treasury bills B) Treasury bonds C) commercial paper

D) negotiable certificates of deposit ANSWER: B 17. The supply of loanable funds is normally: A) highly elastic. B) more elastic than the demand for loanable funds. C) more inelastic than the demand for loanable funds. D) approximately equally elastic as the demand for loanable funds. ANSWER: C Due to the governments inelastic supply (= public saving) of loanable funds 18. The equilibrium real interest rate should in the market for loanable funds: A) fall when the supply of funds exceeds the demand for funds. B) rise when the supply of funds exceeds the demand for funds. C) fall when the demand for funds exceeds the supply of funds. D) rise when demand for funds equals the supply of funds. ANSWER: A QS > QD (=surplus of loanable funds), depository institutions will lower interest rates in order to attract borrowers to demand the excess loanable funds)

19. Which of the following is likely to cause a decrease in the equilibrium U.S. real interest rate, other things being equal? A) a decrease in savings by foreign savers B) an increase in inflation C) pessimistic economic projections that cause businesses to reduce expansion plans D) a decrease in savings by U.S. households ANSWER: C A) decrease in savings by foreign savers (Increase in NCO = right shift in demand curve = increase in i-real) B) an increase in inflation (= increase in nom = no impact in mket for LF) C) pessimistic economic projections that cause businesses to reduce expansion plans (decreased demand for LF = left demand curve shift = dec. in i-real) D) a decrease in savings by U.S. households (= left shift in supply of LF = inc. in i-real)

Required

Solution

21. At any given point in time, firms would demand a _______ quantity of loanable funds at _______ rates of interest. A) greater; higher B) greater; lower C) smaller; lower D) none of these ANSWER: B

Solution

Chapter 2- My selected questions


_______________________________________

Determination of Interest Rates


23. The demand for funds resulting from business investment in assets is _______ is _________to the interest rate. A) B) C) D) inversely; positively positively; inversely inversely; inversely positively; positively

ANSWER: B 24. If economic expansion is expected to increase in the near-term, the demand for loanable funds should _______ and real interest rates should _______. A) increase; increase B) increase; decrease C) decrease; decrease D) decrease; increase ANSWER: A

25. If the real interest rate was stable over time, this would suggest that there is _______ relationship between inflation and nominal interest rate movements. A) a positive B) an inverse C) no D) an uncertain (cannot be determined from information given) ANSWER: A Fisher Effect I(Non) =i(real) + INF I(Nom) = Constant + INF

26. If investors shift funds from stocks into bank deposits, this _______ the supply of loanable funds, and places _______ real interest rates. A) increases; increases B) increases; decreases C) decreases; decreases D) decreases; increases ANSWER: B

Required
27. When Japanese real interest rates rise above the level of real interest rates in the U.S., and if exchange rate expectations remain unchanged, the most likely effect is Japanese investors will _______ their investments in the U.S., and the U.S. real interest rates will _______. A) increase; increase B) increase; decrease C) decrease; decrease D) decrease; increase ANSWER: D NCO(U.S.)>0 shifts demand for L.F. to the right in the U.S.

28. Which of the following will probably not result in an increase in the business demand for loanable funds? A) an increase in positive net present value (NPV) projects B) a reduction in interest rates on business loans C) a recession D) none of these ANSWER: C

Chapter 3- my selected questions


____________________________________

Structure of Interest Rates


29. In general, securities with _______ future cash flows will offer _______ yields. A) less risky; higher B) less risky; lower C) risky; lower D) none of these ANSWER: B 30. Default risk is likely to be highest for: A) short-term Treasury securities. B) AAA corporate securities. C) long-term Treasury securities. D) BBB corporate securities. ANSWER: D 31. All else equal, debt securities that offer lower liquidity must offer a _______ yield to be attractive to investors. A) higher B) lower ANSWER: A

32. Assume an investors tax rate is 25 percent. The before-tax yield on a security is 12 percent. What is the after-tax yield? A) B) C) D) E) 16.00 % 9.25 % 9.00 % 3.00 % 0.75%

ANSWER: C AT = BT(1-T) = 0.12(0.75) = 9% 33. An investors tax rate is 30 percent. What must the before-tax yield on a security be to have an after-tax yield of 11 percent? A) B) C) D) E) 7.7 percent 15.71 percent 130 percent 11.00 percent none of these

ANSWER: B BT=AT/(1-T) BT=0.11/0.7=.1571 34. If shorter term securities have higher yields than longer term securities, the yield curve: A) is horizontal. B) is upward sloping. C) is downward sloping. D) cannot be determined without additional information (such as the level of market interest rates). ANSWER: C ST>LT (=inverted) 35. The theory for the term structure of interest rates that says the shape of the yield curve is determined solely by expectations of future interest rates is called the: A) B) C) D) segmented markets theory. liquidity premium theory. pure expectations theory. theory of rational expectations.

ANSWER: C

Required
36. Assume the yield curve is flat. If investors flood the short-term debt market with buy orders and simultaneously flood the long-term debt market with sell orders, they may cause the yield curve

to: A) B) C) D)

remain relatively flat. become upward sloping. become downward sloping. do none of these.

ANSWER: B
Demand ( ST ) PST y ST

Supply ( LT ) PLT y LT

37. Assume today the annualized two-year interest rate is 12 percent, and the one-year interest rate is 9 percent. A three-year security has an annualized interest rate of 14 percent. What is the one-year forward rate two years from now? A) B) C) D) E) 12.67 percent 113 percent 195 percent 15.67 percent 18 percent

ANSWER: E

y 3 = 0.14 y 2 = 0.12 y1 = 0.09 (1 + y m + n ) m + n fn = m (1 + y m ) (1 + y 3 ) 3 f1 = 2 (1 + y 2 )


1 1 1 n

1
1 1

1.14 3 1 = 2 1.12

1 = 0.18

38. Assume that a yield curve is influenced by interest rate expectations and a liquidity premium. Additionally assume the yield curve is initially flat. If liquidity suddenly was no longer important to market participants, the yield curve would now have a _______ slope (assuming no other changes). A) downward B) upward C) zero

ANSWER: A LP=0

Required
39. According to the liquidity premium theory, the expected yield on a two-year security will _______ the expected yield from consecutive investments in one-year securities. A) equal B) be less than C) be greater than D) be less than or greater than, depending on the size of the liquidity premium ANSWER: C
PET (1 + y ) 2 = (1 + y1 )1 (1+1 f 1)1 In General (1 + y m +n ) m +n = (1 + y m ) m (1+m f n ) n or (1 + y m +n ) m +n fn = m m (1 + y m ) LPT
1 n

(1 + y ) 2 = (1 + y1 )1 (1+1 f 1)1 + LP2 In General (1 + y m +n ) m +n = (1 + y m ) m (1+m f n ) n + LPm +n or


m

(1 + y m +n ) m +n LPm +n fn = (1 + y m ) m

40. If the liquidity premium exists, a flat yield curve would be interpreted as the market expecting _______ in interest rates. A) no changes B) a decrease C) an increase ANSWER: B 41. The theory of the term structure of interest rates, which states that investors and borrowers choose securities with maturities that satisfy their forecasted cash needs, is the _______ theory. A) pure expectations B) liquidity premium C) market segmentation D) preferred habitat ANSWER: C Required 42. Assume a flat term structure of interest rates. According to the segmented markets theory, if most investors suddenly preferred to invest in short-term debt securities and most borrowers suddenly preferred to issue long-term debt securities, this would likely cause: A) B) C) D) a normal shaped yield curve. a flat yield curve. an inverted yield curve. none of the above

ANSWER: A ST
Demand
ST

PST y st

LT
Supply
LT

PST y st

43. A theory states that while investors and borrowers may normally concentrate on a particular natural maturity market, conditions may cause them to change their desired market maturity. This theory is called the _______ theory. A) liquidity premium B) efficient markets C) pure expectations D) preferred habitat ANSWER: D 44. Other things equal, the yield required on A-rated bonds should be _______ the yield required on Brated bonds whose other characteristics are exactly the same. A) greater than B) equal to C) less than ANSWER: C

45. If research showed that anticipation about future interest rates was the only important factor for all investors in choosing short-term or long-term securities, this would support the argument made by the _______ theory. A) liquidity premium B) pure expectations C) market segmentation D) preferred habitat ANSWER: B 46. If research showed that all investors attempt to purchase securities that perfectly match their time in which they will have available funds, this would specifically support the argument made by the _______ theory. A) liquidity premium B) pure expectations C) market segmentation D) preferred habitat ANSWER: D 47. The annualized yield on a three-year security is 13 percent; the annualized two-year interest rate is 12 percent, while the one-year interest rate is 9 percent. The one-year forward rate one-year ahead is _______ percent. A) 3 B) 4 C) 5 D) 15 E) 16 ANSWER: D

y 3 = 0.13 y 2 = 0.12 y1 = 0.09 (1 + y m + n ) m + n fn = m (1 + y m ) (1 + y 3 ) 3 f1 = 2 (1 + y 2 )


1 1 1 n

1
1 1

1.13 3 1 = 2 1.12

1 = 0.15

Required

48. The annualized yield on a three-year security is 13 percent; the annualized two-year interest rate is 12 percent, while the one-year interest rate is 9 percent. The two-year forward rate one year ahead is _______ percent. A) 13 B) 14 C) 15 D) 16 E) 17 ANSWER: C

y 3 = 0.13 y 2 = 0.12 y1 = 0.09 (1 + y m + n ) m + n fn = m (1 + y m ) (1 + y 3 ) 3 f2 = 1 (1 + y1 )


1 2 1 n

1
1 2

1.133 1 = 1 1.09

1 = 0.15

49. During recessionary periods, there is a flight to quality debt instruments by investors. This flight ________ yield spreads between high quality U.S. government debt instruments and lower quality corporate debt instruments, and is a _________ economic indicator. . A) Decreases; leading B) Decreases; lagging C) Increases; leading D) Increases; lagging

ANSWER: C Treasuries
Demand
Treas

PTreas yTreas

Non-Treasuries
Demand
Non Treas

PNon Treas y Non Treas

50. In general, interest income from municipal bonds is exempt from state taxes but is subject to federal taxes. A) true B) false ANSWER: B

Chapter 4 My selected questions


__________________________

Functions of the Fed


51. With regard to monetary policy, which of the following is under direct control of the Federal Reserves Board of Governors? A) revise required reserve requirements for depository institutions B) authorize changes in the amount of borrowing by the Treasury C) monitor the stock market for insider trading D) monitor the derivatives market for illegal trading strategies ANSWER: A Board of governors sets RRR FOMC Open Market Operaton, Fed Funds target rate, discount rate 52. A) B) C) D) The _______ rate is the interest rate charged on Fed district bank loans to depository institutions. federal funds prime discount real

ANSWER: C = discount rate 53. Which of the following is an action that the Fed uses to increase or decrease the money supply? A) buying or selling Treasury securities in the secondary market B) adjusting the tax rate imposed on income earned on Treasury securities C) adjusting the coupon rate on Treasury bonds D) buying or selling Treasury securities in the primary market ANSWER: A 54. As the supply of funds in the fed funds market _______, the federal funds rate _______. A) increases; declines B) increases; increases

C) declines, declines ANSWER: A 55. In the short-run, when open market operations are used to _______ the money supply, the yield on debt instruments _______. A) reduce; decreases B) reduce; increases C) increase; increases ANSWER: B Restrictive Monetary Policy
M S i NOM

56. The FED has direct control over most all short-term U.S. interest rates. A) True B) False ANSWER: B It only has direct control over the discount rate It has indirect control over the fed funds rate and indirect control of the Money Multiplier Actual interest rates are also influenced by the behavior of banks with respect to their actural reserve ratios (RR vs. the FEDs RRR) and the behavior of households (spend vs. save additional the increase in money supply)

57. To decrease money supply, the Fed could _______ . A) increase the required reserve requirement ratio B) purchase treasury securities through open market operations C) lower the target fed funds rate D) All of the above are Fed actions that increase the money supply ANSWER: A This is restrictive monetary policy 58. Assume the required reserve requirements ratio is 15%. An initial monetary injection of $150 million into the economy could result in a maximum change in the money supply of: A) $150 million. B) $1 billion. C) $1 million. D) $22.5 million. ANSWER: B

Maximum change in MS assumes all money is saved in depository institutions (full MM effect) and all banks operate at reserve ratios = required reserve ratios (RR=RRR) MM = 1/RRR = 1/0.15 = 6.6667

59. When the Fed purchases T-Bills, the money supply ______. This activity initiated by the FOMCs policy directive is referred to as _______ monetary policy. A) increases; expansionary B) decreases; expansionary C) decreases; contractionary D) increases; contractionary ANSWER: A 60. All activities of the Fed are transparent to the public and participants in financial markets. A) true B) false ANSWER: B 61. The discount rate is generally set _____ above the target fed funds rate. A) 0.25% B) 0.50% C) 0.75% D) 1.00% E) 3.00% D 62. Currently, the target fed funds rate is closest to ___. A) 0% B) 1% C) 2% D) 3% E) 4% A 0-0.25% 63. Though the actions of the FED are considered somewhat difficult to predict by the public in terms of altering the fed funds rate target, their actions are very predictable and actually lag the economy. A) True B) False A

Chapter 5- my selected problems


___________________________________

Monetary Policy
64. The Fed can _______ the level of spending as a means of stimulating the economy by _______ the money supply. A) increase; decreasing B) decrease; increasing C) decrease; decreasing D) increase; increasing ANSWER: D 65. In general, there is a(n): A) positive relationship between unemployment and inflation. B) inverse relationship between unemployment and inflation. C) inverse relationship between GDP and inflation. D) positive relationship between GDP and unemployment. ANSWER: B Phillips curve both bad 66. A _______ money policy can reduce unemployment, and a _______ money policy can reduce inflation. A) tight; loose B) loose; tight C) tight; tight D) loose; loose ANSWER: B 67. In general, an expansionary money policy tends to _______ economic growth and _______ the inflation rate in the long run. A) stimulate; decrease B) stimulate; increase C) inhibit; increase D) inhibit; decrease ANSWER: B

68. The time between when the Fed adjusts the money supply and when interest rates change reflects the _______ lag. A) recognition B) implementation C) impact D) business cycle ANSWER: C Recognition-Implementation-Impact

69. Which of the following best describes the relationship between the Fed, the Congress, the President and/or the Treasury Department? A) The Fed must receive approval by the Congress before conducting monetary policy. B) The Fed must implement a monetary policy specifically to the support the Presidents policy. C) The President must receive approval from the Fed before implementing fiscal policy. D) The Fed must first receive approval from the Treasury Department since the Fed operates in the secondary government debt markets and the Treasury operates in the primary government debt markets E) None of the above statements is correct. ANSWER: E 70. When the Fed attempts to counter rising real interest rates caused by an increase in the budget deficit, this expansionary monetary policy is known as: A) B) C) D) monetizing the government debt. the crowding-out effect. both monetizing the debt and the crowding-out effect. None of the above.

ANSWER: A

Required 71. A _______ dollar tends to exert inflationary pressure in the U.S. [Critical thinking skills question] A) stable B) strong C) weak D) strong and stable ANSWER: C Declining value of dollar (=depreciating $) causes increase in U.S. exports causing inflation in the U.S. (Importing inflation from abroad) Increased foreign demand for U.S. goods/services increases prices (inflation)
NX ( ) = X M

72. Historical evidence has shown that, when the Fed significantly increases the money supply, U.S. inflation tends to _______ in the long-term which in turn _______ U.S. interest rates. A) increase; increases B) increase; decreases C) decrease; decreases D) decrease; increases ANSWER: A I(nom) = i(real) + E(INF)

73. When the Fed uses open market operations by purchasing T-bills, there will be: A) a right shift in the supply of loanable funds. B) a left shift in the supply of loanable funds. C) a right shift in the demand for loanable funds. D) a left shift in the demand for loanable funds. ANSWER: A
M R S ight shift in Supply

74. If the Fed attempts to reduce inflation, it would likely increase money supply growth. A) true B) false ANSWER: B Slow the economy as its growing too fast