Chapter 5 The Risk and Term Structure of Interest Rates

5.1 Multiple Choice

1) The term structure of interest rates isA) the relationship among interest rates of different bonds with the same maturity.B) the structure of how interest rates move over time.C) the relationship among the terms to maturity of different bonds.D) the relationship among interest rates on bonds with different maturities.Answer: D

2) The risk structure of interest rates isA) the structure of how interest rates move over time.B) the relationship among interest rates of different bonds with the same maturity.C) the relationship among the terms to maturity of different bonds.D) the relationship among interest rates on bonds with different maturities.Answer: B

3) Which of the following long-term bonds should have the lowest interest rate?A) Corporate Baa bonds B) U.S. Treasury bondsC) Corporate Aaa bonds D) Municipal bondsAnswer: D

4) Which of the following long-term bonds should have the highest interest rate?A) Corporate Baa bonds B) U.S. Treasury bondsC) Corporate Aaa bonds D) Municipal bondsAnswer: A

5) The risk premium on corporate bonds becomes smaller ifA) the riskiness of corporate bonds increases.B) the liquidity of corporate bonds increases.C) the liquidity of corporate bonds decreases.D) the riskiness of corporate bonds decreases.E) either (B) or (D) occur.Answer: E

6) Bonds with relatively low risk of default are calledA) zero coupon bonds. B) junk bonds.C) investment grade bonds. D) none of the above.Answer: C

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7) Bonds with relatively high risk of default are calledA) Brady bonds.B) junk bonds.C) zero coupon bonds. D) investment grade bonds. Answer: B

8) A corporation suffering big losses might be more likely to suspend interest payments on its bonds, therebyA) raising the default risk and causing the demand for its bonds to rise.B) raising the default risk and causing the demand for its bonds to fall.C) lowering the default risk and causing the demand for its bonds to rise.D) lowering the default risk and causing the demand for its bonds to fall.Answer: B

9) (I) If a corporation suffers big losses, the demand for its bonds will rise because of the higher interest rates the firm must pay. (II) The spread between the interest rates on bonds with default risk and default-free bonds is called the risk premium.A) (I) is true, (II) false. B) (I) is false, (II) true.C) Both are true. D) Both are false.Answer: B

10) Holding everything else constant, if a corporation begins to suffer large losses, then the default risk onA) corporate bonds will increase, and the expected return on these bonds will

increase.B) corporate bonds will decrease, and the expected return on these bonds

will increase.C) corporate bonds will increase, and the expected return on these bonds will

decrease.D) corporate bonds will decrease, and the expected return on these bonds

will decrease.Answer: C

11) Holding everything else the same, if a corporation’s earnings rise, then the defaultrisk on its bonds willA) increase, and the expected return on these bonds will decrease.B) decrease, and the expected return on these bonds will decrease.C) increase, and the expected return on these bonds will increase.D) decrease, and the expected return on these bonds will increase.Answer: D

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12) If a corporation begins to suffer large losses, then the default risk onA) corporate bonds will increase, and the equilibrium interest rate on these bonds

will increase.B) corporate bonds will decrease, and the equilibrium interest rate on these bonds

will increase.C) corporate bonds will increase, and the equilibrium interest rate on these bonds

will decrease.D) corporate bonds will decrease, and the equilibrium interest rate on these bonds

will decrease.Answer: A

13) If a corporation’s earnings rise, then the default risk on its bonds willA) increase, and the equilibrium interest rate on these bonds will decrease.B) decrease, and the equilibrium interest rate on these bonds will decrease.C) increase, and the equilibrium interest rate on these bonds will increase.D) decrease, and the equilibrium interest rate on these bonds will increase.Answer: B

14) When the default risk on corporate bonds decreases, other things equal, the demandcurve for corporate bonds shifts to the _____ and the demand curve for Treasury bonds shifts to the _____A) right; right.B) right; left.C) left; left.D) left; right.Answer: B

15) (I) An increase in default risk on corporate bonds shifts the demand curve for corporate bonds to the right. (II) An increase in default risk on corporate bonds shifts the demand curve for Treasury bonds to the left.A) (I) is true, (II) false. B) (I) is false, (II) true. C) Both are true. D) Both are false.Answer: D

16) (I) An increase in default risk on corporate bonds shifts the demand curve for corporate bonds to the left. (II) An increase in default risk on corporate bonds shifts the demand curve for Treasury bonds to the right.A) (I) is true, (II) false. B) (I) is false, (II) true. C) Both are true. D) Both are false.Answer: C

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17) Following the stock market crash of 1987, the spread between interest rates on junk bonds and U.S. government bondsA) fell by two percentage points.B) fell by six percentage points.C) rose by two percentage points.D) rose by six percentage points.Answer: C

18) The stock market crash of October 19, 1987 had a major impact on bond markets.As investors began to doubt the financial health of corporations,A) the interest rate on both corporate and U.S. Treasury securities rose, but the

rate on Treasury securities rose by less than the rate on corporate securities,increasing the interest rate spread between the two.

B) the interest rate on both corporate and U.S. Treasury securities rose, but the rate on corporate securities rose by less than the rate on Treasury securities,decreasing the interest rate spread between the two.

C) the interest rate on corporate securities rose and the rate on Treasury securities declined, increasing the interest rate spread between the two.

D) the interest rate on both corporate and U.S. Treasury securities declined, but the rate on corporate securities declined by less than the rate on Treasury securities, decreasing the interest rate spread between the two.

Answer: C

19) When budget talks between congressional Republicans and President Clinton occurred in late 1995,A) fear of a government default rose, Treasury bond values fell, and interest rates

on Treasury bonds rose.B) fear of a government default rose, Treasury bond values fell, and interest rates

on Treasury bonds fell.C) no one feared a government default, but Treasury bond values fell, and interest

rates on Treasury bonds rose.D) no one feared a government default, but Treasury bond values fell, and interest

rates on Treasury bonds fell.Answer: A

20) The spread between interest rates on low quality corporate bonds and U.S. government bondsA) widened significantly during the Great Depression.B) narrowed significantly during the Great Depression.C) was reversed during the Great Depression.D) did not change during the Great Depression.Answer: A

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21) Corporate bonds are not as liquid as government bonds becauseA) fewer corporate bonds for any one corporation are traded, making them more

costly to sell.B) the corporate bond rating must be calculated each time they are traded.C) corporate bonds are not callable.D) of all of the above.E) of only (A) and (B) of the above.Answer: A

22) (I) The risk premium widens as the default risk on corporate bonds increases. (II) The risk premium widens as corporate bonds become less liquid.A) (I) is true, (II) false. B) (I) is false, (II) true. C) Both are true. D) Both are false.Answer: C

23) When the corporate bond market becomes less liquid, other things equal, the demand curve for corporate bonds shifts to the _____ and the demand curve for Treasury bonds shifts to the _____A) right; right.B) right; left.C) left; left.D) left; right.Answer: D

24) When the corporate bond market becomes more liquid, other things equal, the demand curve for corporate bonds shifts to the _____ and the demand curve for Treasury bonds shifts to the _____A) right; right.B) right; left.C) left; left.D) left; right.Answer B

25) (I) If a corporate bond becomes less liquid, the demand for the bond will fall,causing the interest rate to rise. (II) If a corporate bond becomes less liquid, the demand for Treasury bonds does not change.A) (I) is true, (II) false. B) (I) is false, (II) true. C) Both are true. D) Both are false.Answer: A

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26) (I) If a corporate bond becomes less liquid, the interest rate on the bond will fall. (II) If a corporate bond becomes less liquid, the interest rate on Treasury bonds will fall.A) (I) is true, (II) false. B) (I) is false, (II) true. C) Both are true. D) Both are false.Answer: B

27) Which of the following bonds generally has the lowest interest rate?A) Treasury bondsB) Corporate Baa bonds C) Municipal bondsD) Corporate Aaa bonds Answer: C

28) If income tax rates were lowered, thenA) the interest rate on municipal bonds would fall. B) the interest rate on Treasury bonds would rise.C) the interest rate on municipal bonds would rise. D) the price of Treasury bonds would fall.Answer: C

29) If income tax rates rise, thenA) the prices of municipal bonds will fall. B) the prices of Treasury bonds will rise.C) the interest rate on Treasury bonds will rise.D) the interest rate on municipal bonds will rise.Answer: C

30) An increase in marginal tax rates would likely have the effect of _____ the demandfor municipal bonds and _____ the demand for U.S. government bonds.A) increasing; increasingB) increasing; decreasingC) decreasing; increasingD) decreasing; decreasingAnswer: B

31) A decrease in marginal tax rates would likely have the effect of _____ the demandfor municipal bonds and _____ the demand for U.S. government bonds.A) increasing; increasingB) increasing; decreasingC) decreasing; increasingD) decreasing; decreasingAnswer: C

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32) Which of the following statements are true?A) Because coupon payments on municipal bonds are exempt from federal

income tax, the expected after-tax return on them will be higher for individualsin higher income tax brackets.

B) An increase in tax rates will increase the demand for municipal bonds, lowering their interest rates.

C) Interest rates on municipal bonds will be lower than on comparable bonds without the tax exemption.

D) All of the above are true statements.E) Only (A) and (B) are true statements.Answer: D

33) Which of the following statements are true?A) Because coupon payments on municipal bonds are exempt from federal

income tax, the expected after-tax return on them will be higher for individualsin higher income tax brackets.

B) An increase in tax rates will increase the demand for Treasury bonds, loweringtheir interest rates.

C) Interest rates on municipal bonds will be higher than on comparable bonds without the tax exemption.

D) Only (A) and (B) are true statements.Answer: A

34) When a municipal bond is given tax-free status, the demand for municipal bonds shifts ______, causing the interest rate on the bond to _____A) leftward; rise.B) leftward; fall.C) rightward; rise.D) rightward; fall.Answer: D

35) When a municipal bond is given tax-free status, the demand for Treasury bonds shifts _____, and the interest rate on Treasury bonds _____A) leftward; rises.B) leftward; falls.C) rightward; rises.D) rightward; falls.Answer: A

36) If municipal bonds were to lose their tax-free status, then the demand for Treasury bonds would shift _____, and the interest rate on Treasury bonds would _____A) rightward; fall.B) rightward; rise.C) leftward; fall.D) leftward; rise.Answer: A

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37) The Bush tax cut passed in 2001 reduces the top income tax bracket from 39 percent to 35 percent. As a result of this tax cut, the demand for muncipal bonds should shift to the ______ and the interest rate on municipal bonds should ______.A) right; declineB) right; increaseC) left; declineD) left; increaseAnswer: D

38) The relationship among interest rates on bonds with identical default risk, but different maturities, is called theA) time-risk structure of interest rates.B) liquidity structure of interest rates.C) bond demand curve. D) yield curve.Answer: D

39) Yield curves can be classified asA) upward-sloping. B) downward-sloping. C) flat. D) all of the above.E) only (A) and (B) of the above.Answer: D

40) Typically, yield curves areA) gently upward-sloping.B) gently downward-sloping.C) flat. D) bowl shaped.E) mound shaped.Answer: A

41) When yield curves are steeply upward-sloping,A) long-term interest rates are above short-term interest rates.B) short-term interest rates are above long-term interest rates.C) short-term interest rates are about the same as long-term interest rates.D) medium-term interest rates are above both short-term and long-term

interest rates.E) medium-term interest rates are below both short-term and long-term interest

rates.Answer: A

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42) Economists’ attempts to explain the term structure of interest ratesA) illustrate how economists modify theories to improve them when they are

inconsistent with the empirical evidence.B) illustrate how economists continue to accept theories that fail to explain

observed behavior of interest rate movements.C) prove that the real world is a special case that tends to get short shrift in

theoretical models.D) have proved entirely unsatisfactory to date.Answer: A

43) According to the pure expectations theory of the term structure,A) the interest rate on long-term bonds will exceed the average of expected future

short-term interest rates.B) interest rates on bonds of different maturities move together over time.C) buyers of bonds prefer short-term to long-term bonds.D) all of the above.E) only (A) and (B) of the above.Answer: B

44) According to the pure expectations theory of the term structure,A) when the yield curve is steeply upward-sloping, short-term interest rates are

expected to rise in the future.B) when the yield curve is downward-sloping, short-term interest rates are

expected to decline in the future.C) buyers of bonds prefer short-term to long-term bonds.D) all of the above.E) only (A) and (B) of the above.Answer: E

45) According to the pure expectations theory of the term structure,A) when the yield curve is steeply upward-sloping, short-term interest rates are

expected to rise in the future.B) when the yield curve is downward-sloping, short-term interest rates are

expected to remain relatively stable in the future.C) investors have strong preferences for short-term relative to long-term bonds,

explaining why yield curves typically slope upward.D) all of the above.E) only (A) and (B) of the above.Answer: A

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46) According to the pure expectations theory of the term structure,A) yield curves should be as equally likely to slope downward as slope upward.B) when the yield curve is steeply upward-sloping, short-term interest rates are

expected to rise in the future.C) when the yield curve is downward-sloping, short-term interest rates are

expected to remain relatively stable in the future.D) all of the above.E) only (A) and (B) of the above.Answer: E

47) If the expected path of one-year interest rates over the next four years is 5 percent,4 percent, 2 percent, and 1 percent, then the pure expectations theory predicts that today’s interest rate on the four-year bond isA) 1 percent.B) 2 percent.C) 4 percent.D) none of the above.Answer: D

48) If the expected path of one-year interest rates over the next five years is 1 percent,2 percent, 3 percent, 4 percent, and 5 percent, the pure expectations theory predicts that the bond with the highest interest rate today is the one with a maturity ofA) one year.B) two years.C) three years.D) four years.E) five years.Answer: E

49) If the expected path of one-year interest rates over the next five years is 2 percent,4 percent, 1 percent, 4 percent, and 3 percent, the pure expectations theory predicts that the bond with the lowest interest rate today is the one with a maturity ofA) one year.B) two years.C) three years.D) four years.Answer: A

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50) According to the market segmentation theory of the term structure,A) the interest rate for bonds of one maturity is determined by supply and demand

for bonds of that maturity.B) bonds of one maturity are not substitutes for bonds of other maturities;

therefore, interest rates on bonds of different maturities do not move together over time.

C) investors’ strong preference for short-term relative to long-term bonds explains why yield curves typically slope upward.

D) all of the above.E) none of the above.Answer: D

51) According to the market segmentation of the term structure,A) the interest rate for bonds of one maturity is determined by supply and demand

for bonds of that maturity.B) bonds of one maturity are not substitutes for bonds of other maturities;

therefore, interest rates on bonds of different maturities do not move together over time.

C) investors’ strong preference for short-term relative to long-term bonds explains why yield curves typically slope downward.

D) only (A) and (B) of the above.Answer: D

52) The liquidity premium theory of the term structureA) indicates that today’s long-term interest rate equals the average of short-term

interest rates that people expect to occur over the life of the long-term bond.B) assumes that bonds of different maturities are perfect substitutes.C) suggests that markets for bonds of different maturities are completely separate

because people have preferred habitats.D) does none of the above.Answer: D

53) The liquidity premium theory of the term structureA) assumes investors tend to prefer short-term bonds because they have less

interest rate risk.B) assumes that interest rates on the long-term bond respond to demand and

supply conditions for that bond.C) assumes that an average of expected short-term rates is an important

component of interest rates on long-term bonds.D) assumes all of the above.E) assumes none of the above.Answer: D

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54) According to the liquidity premium theory of the term structure,A) the interest rate on long-term bonds will equal an average of short-term interest

rates that people expect to occur over the life of the long-term bonds plus a liquidity premium.

B) buyers of bonds may prefer bonds of one maturity over another, yet interest rates on bonds of different maturities move together over time.

C) even with a positive liquidity premium, if future short-term interest rates are expected to fall significantly, then the yield curve will be downward-sloping.

D) all of the above.E) only (A) and (B) of the above.Answer: D

55) According to the liquidity premium theory of the term structure,A) because buyers of bonds may prefer bonds of one maturity over another,

interest rates on bonds of different maturities do not move together over time.B) the interest rate on long-term bonds will equal an average of short-term interest

rates that people expect to occur over the life of the long-term bonds plus a term premium.

C) because of the positive term premium, the yield curve will not be observed to be downward-sloping.

D) all of the above.E) only (A) and (B) of the above.Answer: B

56) If the yield curve slope is flat, the liquidity premium theory indicates that the marketis predictingA) a mild rise in short-term interest rates in the near future and a mild decline

further out in the future.B) constant short-term interest rates in the near future and further out in the future.C) a mild decline in short-term interest rates in the near future and a continuing

mild decline further out in the future.D) constant short-term interest rates in the near future and a mild decline further

out in the future.Answer: C

57) If the yield curve has a mild upward slope, the liquidity premium theory indicatesthat the market is predictingA) a rise in short-term interest rates in the near future and a decline further out in

the future.B) constant short-term interest rates in the near future and further out in the future.C) a decline in short-term interest rates in the near future and a rise further out in

the future.D) a decline in short-term interest rates in the near future and an even steeper

decline further out in the future.Answer: B

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58) According to the liquidity premium theory of the term structure, a downward-sloping yield curve indicates thatA) short-term interest rates are expected to rise in the future.B) short-term interest rates are expected to remain unchanged in the future.C) short-term interest rates are expected to decline moderately in the future.D) short-term interest rates are expected to decline sharply in the future.Answer: D

59) According to the liquidity premium theory of the term structure, when the yield curve has its usual slope, the market expectsA) short-term interest rates to stay near their current levels.B) short-term interest rates to rise sharply.C) short-term interest rates to drop sharply.D) none of the above.Answer: A

60) In actual practice, short-term interest rates are just as likely to fall as to rise; this is the major shortcoming of theA) market segmentation theory. B) pure expectations theory.C) liquidity premium theory. D) separable markets theory.Answer: B

61) Which theory of the term structure proposes that bonds of different maturities are not substitutes for one another?A) market segmentation theory. B) pure expectations theory.C) liquidity premium theory. D) separable markets theory.Answer: A

62) 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 theoryB) pure expectations theoryC) liquidity premium theoryD) both (A) and (B) of the aboveE) both (A) and (C) of the aboveAnswer: E

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63) _____ cannot explain the empirical fact that interest rates on bonds of different maturities tend to move together.A) The market segmentation theoryB) The pure expectations theoryC) The liquidity premium theoryD) both (A) and (B) of the aboveE) both (A) and (C) of the aboveAnswer: A

64) Which of the following theories of the term structure is (are) able to explain the fact that interest rates on bonds of different maturities tend to move together over time?A) The expectations hypothesisB) The segmented markets theoryC) The preferred habitat theoryD) Both (A) and (B) of the aboveE) Both (A) and (C) of the aboveAnswer: E

65) Of the four theories that explain how interest rates on bonds with different terms to maturity are related, the one that views long-term interest rates as equaling the average of future short-term rates expected to occur over the life of the bond is theA) expectations hypothesis.B) preferred habitat theory.C) liquidity premium theory. D) segmented markets theory. Answer: A

66) Of the four theories that explain how interest rates on bonds with different terms to maturity are related, the one that assumes that bonds of different maturities are not substitutes for one another is theA) expectations hypothesis.B) segmented markets theory.C) liquidity premium theory. D) preferred habitat theory.Answer: B

67) The moderately upward-sloping yield curve on March 3, 1997, indicated thatA) short-term rates were expected neither to rise nor fall in the near future.B) short-term rates were expected to remain relatively unchanged, but that long-

term rates were expected to fall.C) short-term rates were expected neither to rise nor fall, but that long-term rates

were expected to rise moderately.D) short-term rates were expected to rise moderately in the near future.Answer: A

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68) The steep upward sloping yield curve on January 2, 2002 indicated that A) short-term rates were expected neither to rise nor fall in the near future.B) short-term rates were expected to remain relatively unchanged, but that long-

term rates were expected to fall.C) short-term rates were expected neither to rise nor fall, but that long-term rates

were expected to rise moderately.D) short-term rates were expected to rise moderately in the near future. Answer: D

5.2 True/False

1) The term structure of interest rates describes how interest rates move over time.Answer: FALSE

2) The risk structure of interest rates describes the relationship between the interest rates of different bonds with the same maturity.Answer: TRUE

3) The risk premium on corporate bonds becomes smaller as the liquidity of the bonds falls.Answer: FALSE

4) An increase in income tax rates will cause the interest rates on tax exempt municipalbonds to fall relative to the interest rate on taxable corporate securities.Answer: TRUE

5) The interest rates on bonds of different maturities tend to move together over time.Answer: TRUE

6) The pure expectations theory is able to explain why yield curves are usually upward-sloping.Answer: FALSE

7) A mildly upward sloping yield curve suggests that the market is predicting constant short-term interest rates.Answer: TRUE

8) Bonds with the lowest risk of default are often referred to as junk bonds.Answer: FALSE

9) An increase in the marginal tax rate would likely increase the demand for municipal bonds, and decrease the demand for U.S. government bonds.Answer: TRUE

10) When yield curves are downward sloping, long-term interest rates are above short-term interest rates.Answer: FALSE

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5.3 Essay

1) Contrast the liquidity premium theory to the market segmentation theory of the termstructure of interest rates.

2) Why would an increase in the income tax rate reduce borrowing costs to municipalities?

3) Discuss what is shown by a yield curve.

4) Why is it unlikely that the pure expectations theory alone is the correct theory for explaining the yield curve?

5) What is meant by the risk structure of interest rates?

6) How would a severe recession affect the risk premium on corporate bonds?

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Chapter 4 The Behavior of Interest Rates

4.1 Multiple Choice Questions

1) As the price of a bond _____ and the expected return _____, bonds become moreattractive to investors and the quantity demanded rises.A) falls; risesB) falls; fallsC) rises; risesD) rises; fallsAnswer: A

2) The supply curve for bonds has the usual upward slope, indicating that as the price _____, ceteris paribus, the _____ increases.A) falls; supplyB) falls; quantity suppliedC) rises; supplyD) rises; quantity suppliedAnswer: D

3) When the price of a bond is above the equilibrium price, there is an excess _____ for (of) bonds and the price will _____A) demand; rise.B) demand; fall.C) supply; fall.D) supply; rise.Answer: C

4) When the price of a bond is below the equilibrium price, there is an excess _____ for (of) bonds and the price will _____A) demand; rise.B) demand; fall.C) supply; fall.D) supply; rise.Answer: A

5) When the price of a bond is _____ the equilibrium price, there is an excess supply of bonds and the price will _____A) above; rise.B) above; fall.C) below; fall.D) below; rise.Answer: B

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6) When the price of a bond is _____ the equilibrium price, there is an excess demandof bonds and the price will _____A) above; rise.B) above; fall.C) below; fall.D) below; rise.Answer: D

7) When the interest rate on a bond is above the equilibrium interest rate, in the bond market there is excess _____ and the interest rate will _____A) demand; rise.B) demand; fall.C) supply; fall.D) supply; rise.Answer: B

8) When the interest rate on a bond is below the equilibrium interest rate, in the bond market there is excess _____ and the interest rate will _____A) demand; rise.B) demand; fall.C) supply; fall.D) supply; rise.Answer: D

9) When the interest rate on a bond is ______ the equilibrium interest rate, in the bond market there is excess _____ and the interest rate will _____A) above; demand; rise. B) above; demand; fall. C) below; supply; fall.D) above; supply; rise.Answer: B

10) When the interest rate on a bond is _____ the equilibrium interest rate, in the bond market there is excess _____ and the interest rate will _____A) below; demand; rise. B) below; demand; fall.C) below; supply; fall.D) above; supply; rise.Answer: A

11) When the demand for bonds ______ or the supply of bonds _____, interest rate rise.A) increases; increases.B) increases; decreases.C) decreases; decreases.D) decreases; increases.Answer: D

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12) When the demand for bonds ______ or the supply of bonds _____, interest rates fall.A) increases; increases.B) increases; decreases.C) decreases; decreases.D) decreases; increases.Answer: B

13) Factors that determine the demand for an asset include changes in theA) wealth of investors.B) liquidity of bonds relative to alternative assets.C) expected returns on bonds relative to alternative assets.D) risk of bonds relative to alternative assets.E) all of the above.Answer: E

14) In a recession when income and wealth are falling, the demand for bonds _____ and the demand curve shifts to the _____A) falls; right.B) falls; left.C) rises; right.D) rises; left.Answer: B

15) During business cycle expansions when income and wealth are rising, the demandfor bonds _____ and the demand curve shifts to the _____A) falls; right.B) falls; left.C) rises; right.D) rises; left.Answer: C

16) For a holding period of one year, the expected return on a consol is _____ the higher is the price of the consol today, and _____ the higher is the price of the consolnext year.A) higher; higherB) higher; lowerC) lower; higherD) lower; lowerAnswer: C

17) Higher expected interest rates in the future ____ the demand for long-term bonds and shift the demand curve to the _____A) increase; left.B) increase; right.C) decrease; left.D) decrease; right.Answer: C

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18) Lower expected interest rates in the future ____ the demand for long-term bonds and shift the demand curve to the _____A) increase; left.B) increase; right.C) decrease; left.D) decrease; right.Answer: B

19) When people begin to expect a large stock market decline, the demand curve for bonds shifts to the _____ and the interest rate _____A) right; rises.B) right; falls.C) left; falls.D) left; rises.Answer: B

20) When people begin to expect a large run up in stock prices, the demand curve for bonds shifts to the _____ and the interest rate _____A) right; rises.B) right; falls.C) left; falls.D) left; rises.Answer: D

21) An increase in the expected rate of inflation will _____ the expected return on bonds relative to that on _____ assets, and shift the _____ curve to the left.A) reduce; financial; demandB) reduce; real; demandC) raise; financial; supply D) raise; real; supplyAnswer: B

22) A decrease in the expected rate of inflation will _____ the expected return on bonds relative to that on _____ assets.A) reduce; financialB) reduce; realC) raise; financialD) raise; realAnswer: D

23) When the expected inflation rate increases, the demand for bonds _____, the supply of bonds _____, and the interest rate ______A) increases; increases; rises.B) decreases; decreases; falls.C) increases; decreases; falls. D) decreases; increases; rises.Answer: D

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24) When the expected inflation rate decreases, the demand for bonds _____, the supply of bonds _____, and the interest rate ______A) increases; increases; rises.B) decreases; decreases; falls.C) increases; decreases; falls. D) decreases; increases; rises.Answer: C

25) When bond interest rates become more volatile, the demand for bonds _____ and the interest rate _____A) increases; rises.B) increases; falls.C) decreases; falls.D) decreases; rises.Answer: D

26) When bond interest rates become less volatile, the demand for bonds _____ and the interest rate _____A) increases; rises.B) increases; falls.C) decreases; falls.D) decreases; rises.Answer: B

27) When prices in the stock market become more uncertain, the demand curve for bonds shifts to the _____ and the interest rate _____A) right; rises.B) right; falls.C) left; falls.D) left; rises.Answer: B

28) When stock prices become less volatile, the demand curve for bonds shifts to the _____ and the interest rate _____A) right; rises.B) right; falls.C) left; falls.D) left; rises.E) more; right; rises.Answer: D

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29) When bonds become more widely traded, and as a consequence the market becomesmore liquid, the demand curve for bonds shifts to the _____ and the interest rate _____A) right; rises.B) right; falls.C) left; falls.D) left; rises.Answer: B

30) When bonds become less widely traded, and as a consequence the market becomesless liquid, the demand curve for bonds shifts to the _____ and the interest rate _____A) right; rises.B) right; falls.C) left; falls.D) left; rises.Answer: D

31) Factors that cause the demand curve for bonds to shift to the left includeA) an increase in the inflation rate.B) an increase in the liquidity of stocks.C) a decrease in the volatility of stock prices.D) all of the above.E) none of the above.Answer: D

32) Factors that cause the demand curve for bonds to shift to the left includeA) a decrease in the inflation rate.B) an increase in the volatility of stock prices.C) an increase in the liquidity of stocks.D) all of the above.E) only (A) and (B) of the above.Answer: C

33) During an economic expansion, the supply of bonds _____ and the supply curve shifts to the _____A) increases, left.B) increases, right.C) decreases, left.D) decreases, right.Answer: B

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34) During a recession, the supply of bonds _____ and the supply curve shifts to the _____A) increases, left.B) increases, right.C) decreases, left.D) decreases, right.Answer: C

35) An increase in expected inflation causes the supply of bonds to _____ and the supply curve to shift to the _____A) increase, left.B) increase, right.C) decrease, left.D) decrease, right.Answer: B

36) When the federal government’s budget deficit increases, the _____ curve for bonds shifts to the _____A) demand; right.B) demand; left.C) supply; left.D) supply; right.Answer: D

37) When the federal government’s budget deficit decreases, the _____ curve for bonds shifts to the _____A) demand; right.B) demand; left.C) supply; left.D) supply; right.Answer: C

38) When the inflation rate is expected to increase, the expected return on bonds relative to real assets falls for any given interest rate; the _____ for bonds falls and the _____ curve shifts to the left.A) demand; demandB) demand; supplyC) supply; demandD) supply; supplyAnswer: A

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39) When the inflation rate is expected to increase, the real cost of borrowing declines at any given interest rate; the _____ of bonds increases and the _____ curve shifts to the right.A) demand; demandB) demand; supplyC) supply; demandD) supply; supplyAnswer: D

Figure 4-1

40) In Figure 4-1, the most likely cause of the increase in the equilibrium interest rate from i1 to i2 isA) an increase in the price of bonds. B) a business cycle boom.C) an increase in the expected inflation rate. D) a decrease in the expected inflation rate.Answer: C

41) In Figure 4-1, the most likely cause of the increase in the equilibrium interest rate from i1 to i2 isA) an increase in the expected inflation rate.B) a decrease in the expected inflation rate.C) a sharp decline in the growth rate of the money supply.D) a combination of both (A) and (C) of the above.Answer: A

42) In Figure 4-1, the most likely cause of a decrease in the equilibrium interest ratefrom i2 to i1 is A) an increase in the expected inflation rate.B) a decrease in the expected inflation rate.C) a business cycle expansion.D) a combination of both (A) and (C) of the above. Answer: B

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43) Factors that can cause the supply curve for bonds to shift to the right includeA) an expansion in overall economic activity.B) a decrease in expected inflation.C) a decrease in government deficits.D) all of the above.E) only (A) and (B) of the above.Answer: A

44) Factors that can cause the supply curve for bonds to shift to the left includeA) an expansion in overall economic activity. B) a decrease in expected inflation.C) an increase in government deficits. D) only (A) and (C) of the above.Answer: B

45) The economist Irving Fisher, after whom the Fisher effect is named, explained why interest rates _____ as the expected rate of inflation _____A) rise; increases.B) rise; stabilizes.C) rise; decreases.D) fall; increases.E) fall; stabilizes.Answer: A

46) An increase in the expected rate of inflation causes the demand curve for bonds to _____ and the supply curve for bonds to _____A) fall; fall.B) fall; rise.C) rise; fall.D) rise; rise.Answer: B

47) A decrease in the expected rate of inflation causes the demand curve for bonds to _____ and the supply curve of bonds to _____A) fall; fall.B) fall; rise.C) rise; fall.D) rise; rise.Answer: C

48) When the economy slips into a recession, normally the demand for bonds _____, the supply of bonds _____, and the interest rate _____A) increases; increases; rises.B) decreases; decreases; falls.C) increases; decreases; falls. D) decreases; increases; rises.Answer: B

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49) 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.Answer: A

Figure 4-2

50) In Figure 4-2, one possible explanation for the increase in the interest rate from i1 to i2 isA) an increase in the expected inflation rate. B) a decrease in the expected inflation rate.C) an increase in economic growth. D) a decrease in economic growth.Answer: C

51) In Figure 4-2, one possible explanation for the increase in the interest rate from i1to i2 isA) an increase in economic growth.B) an increase in government budget deficits.C) a decrease in government budget deficits.D) a decrease in economic growth.E) a decrease in the riskiness of bonds relative to other investments.Answer: A

52) In Figure 4-2, one possible explanation for a decrease in the interest rate from i2 to i1isA) an increase in economic growth.B) an increase in government budget deficits.C) an increase in expected inflation.D) a decrease in economic growth.E) a decrease in the riskiness of bonds relative to other investments.Answer: D

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53) In Keynes’s liquidity preference framework, individuals are assumed to hold their wealth in two forms:A) real assets and financial assets. B) stocks and bonds.C) money and bonds. D) money and gold.Answer: C

54) In his liquidity preference framework, Keynes assumed that money has a zero rate of return; thus,A) when interest rates rise, the expected return on money falls relative to the

expected return on bonds, causing the demand for money to fall.B) when interest rates rise, the expected return on money falls relative to the

expected return on bonds, causing the demand for money to rise.C) when interest rates fall, the expected return on money falls relative to the

expected return on bonds, causing the demand for money to fall.D) when interest rates fall, the expected return on money falls relative to the

expected return on bonds, causing the demand for money to rise.Answer: A

55) The loanable funds framework is easier to use when analyzing the effects of changes in _____, while the liquidity preference framework provides a simpler analysis of the effects from changes in income, the price level, and the supply of _____A) expected inflation; bonds.B) expected inflation; money.C) government budget deficits; bonds. D) the supply of money; bonds.Answer: B

56) When comparing the loanable funds and liquidity preference frameworks of interest rate determination, which of the following are true?A) The liquidity preference framework is easier to use when analyzing the effects

of changes in expected inflation.B) The loanable funds framework provides a simpler analysis of the effects of

changes in income, the price level, and the supply of money.C) In most instances, the two approaches to interest rate determination yield the

same predictions.D) All of the above are true.E) Only (A) and (B) of the above are true.Answer: C

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57) A higher level of income causes the demand for money to _____ and the interest rate to _____A) decrease; decrease.B) decrease; increase.C) increase; decrease.D) increase; increase.Answer: D

58) A lower level of income causes the demand for money to _____ and the interest rate to _____A) decrease; decrease.B) decrease; increase.C) increase; decrease.D) increase; increase.Answer: A

59) A rise in the price level causes the demand for money to _____ and the demandcurve to shift to the _____A) decrease; right.B) decrease; left.C) increase; right.D) increase; left.Answer: C

60) A decline in the price level causes the demand for money to _____ and the demandcurve to shift to the _____A) decrease; right.B) decrease; left.C) increase; right.D) increase; left.Answer: B

61) A decline in the expected inflation rate causes the demand for money to _____ and the demand curve to shift to the _____A) decrease; right.B) decrease; left.C) increase; right.D) increase; left.Answer: B

62) Holding everything else equal, a decrease in the money supply causesA) interest rates to decline initially.B) interest rates to increase initially.C) bond prices to increase initially.D) both (A) and (C) of the above.E) both (B) and (C) of the above.Answer: B

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Figure 4-3

63) In Figure 4-3, the factor responsible for the decline in the interest rate isA) a decline in the price level.B) a decline in income.C) an increase in the money supply. D) a decline in the expected inflation rate.Answer: C

64) In Figure 4-3, the decrease in the interest rate from i1 to i2 can be explained byA) a decrease in money growth. B) an increase in money growth.C) a decline in the expected price level.D) only (A) and (B) of the above.Answer: B

65) In Figure 4-3, an increase in the interest rate from i2 to i1 can be explained by A) a decrease in money growth. B) an increase in money growth.C) a decline in the price level.D) an increase in the expected price level.Answer: A

66) Of the four effects on interest rates from an increase in the money supply, the one that works in the opposite direction of the other three is theA) liquidity effect.B) income effect.C) price level effect.D) expected inflation effect.Answer: A

67) Of the four effects on interest rates from an increase in the money supply, the initial effect is, generally, theA) income effect.B) liquidity effect.C) price level effect.D) expected inflation effect.Answer: B

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68) If the liquidity effect is smaller than the other effects, and the adjustment of expected inflation is slow, then theA) interest rate will fall.B) interest rate will rise.C) interest rate will initially fall but eventually climb above the initial level in

response to an increase in money growth.D) interest rate will initially rise but eventually fall below the initial level in

response to an increase in money growth.Answer: C

69) When the growth rate of the money supply increases, interest rates end up being permanently lower ifA) the liquidity effect is larger than the other effects.B) there is fast adjustment of expected inflation.C) there is slow adjustment of expected inflation.D) the expected inflation effect is larger than the liquidity effect.Answer: A

70) When the growth rate of the money supply decreases, interest rates end up being permanently lower ifA) the liquidity effect is larger than the other effects.B) there is fast adjustment of expected inflation.C) there is slow adjustment of expected inflation.D) the expected inflation effect is larger than the liquidity effect.Answer: D

71) When the growth rate of the money supply is decreased, interest rates will rise immediately if the liquidity effect is _____ than the other effects and if there is _____ adjustment of expected inflation.A) larger; fastB) larger; slowC) smaller; slowD) smaller; fastAnswer: B

72) When the growth rate of the money supply is increased, interest rates will rise immediately if the liquidity effect is _____ than the other effects and if there is _____ adjustment of expected inflation.A) larger; fastB) larger; slowC) smaller; slowD) smaller; fastAnswer: D

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73) If the Fed wants to permanently lower interest rates, then it should lower the rate of money growth ifA) there is fast adjustment of expected inflation.B) there is slow adjustment of expected inflation.C) the liquidity effect is smaller than the expected inflation effect.D) the liquidity effect is larger than the other effects.Answer: C

74) If the Fed wants to permanently lower interest rates, then it should raise the rate of money growth ifA) there is fast adjustment of expected inflation.B) there is slow adjustment of expected inflation.C) the liquidity effect is smaller than the expected inflation effect.D) the liquidity effect is larger than the other effects.Answer: D

75) Holding everything else equal, an increase in the money supply causesA) interest rates to decline initially.B) interest rates to increase initially.C) bond prices to decline initially.D) both (A) and (C) of the above.E) both (B) and (C) of the above.Answer: A

76) It is entirely possible that when the money supply rises, interest rates may _____ if the _____ effect is more than offset by changes in income, the price level, and expected inflation.A) fall; liquidityB) fall; riskC) rise; liquidityD) rise; riskAnswer: C

77) Milton Friedman contends that it is entirely possible that when the money supply rises, interest rates may _____ if the _____ effect is more than offset by changes in income, the price level, and expected inflation.A) fall; liquidityB) fall; riskC) rise; liquidityD) rise; riskAnswer: C

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Figure 4-4

78) Figure 4-4 illustrates the effect of an increased rate of money supply growth. Fromthe figure, one can conclude that theA) liquidity effect is smaller than the expected inflation effect and interest rates

adjust quickly to changes in expected inflation.B) liquidity effect is larger than the expected inflation effect and interest rates

adjust quickly to changes in expected inflation.C) liquidity effect is larger than the expected inflation effect and interest rates

adjust slowly to changes in expected inflation.D) liquidity effect is smaller than the expected inflation effect and interest rates

adjust slowly to changes in expected inflation.Answer: A

79) Figure 4-4 illustrates the effect of an increased rate of money supply growth. Fromthe figure, one can conclude that theA) Fisher effect is dominated by the liquidity effect and interest rates adjust

slowly to changes in expected inflation.B) liquidity effect is dominated by the Fisher effect and interest rates adjust

slowly to changes in expected inflation.C) liquidity effect is dominated by the Fisher effect and interest rates adjust

quickly to changes in expected inflation.D) Fisher effect is smaller than the expected inflation effect and interest rates

adjust quickly to changes in expected inflation.Answer: C

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Figure 4-5

80) Figure 4-5 illustrates the effect of an increased rate of money supply growth.From the figure, one can conclude that theA) liquidity effect is smaller than the expected inflation effect and interest rates

adjust quickly to changes in expected inflation.B) liquidity effect is larger than the expected inflation effect and interest rates

adjust quickly to changes in expected inflation.C) liquidity effect is larger than the expected inflation effect and interest rates

adjust slowly to changes in expected inflation.D) liquidity effect is smaller than the expected inflation effect and interest rates

adjust slowly to changes in expected inflation.Answer: C

81) Figure 4-5 illustrates the effect of an increased rate of money supply growth.From the figure, one can conclude that theA) Fisher effect is dominated by the liquidity effect and interest rates adjust

slowly to changes in expected inflation.B) liquidity effect is dominated by the Fisher effect and interest rates adjust

slowly to changes in expected inflation.C) liquidity effect is dominated by the Fisher effect and interest rates adjust

quickly to changes in expected inflation.D) Fisher effect is smaller than the expected inflation effect and interest rates

adjust quickly to changes in expected inflation.Answer: A

4.2 True/False

1) When interest rates change, the demand curve for bonds shifts to the left.Answer: FALSE

2) When an economy grows out of a recession, normally the demand for bonds increases and the supply of bonds increases.Answer: TRUE

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3) When the federal government’s budget deficit decreases, the demand curve for bonds shifts to the right.Answer: FALSE

4) When the price level falls, the demand curve for money shifts to the left and the interest rate falls.Answer: TRUE

5) When the Federal Reserve increases the money stock, the money supply curve shifts to the left and the interest rate falls.Answer: FALSE

6) When the growth rate of the money supply increases, interest rates end up being permanently higher if the expected inflation effect is larger than the liquidity effect.Answer: TRUE

7) When income and wealth are rising, the demand for bonds rises and the demandcurve shifts to the right.Answer: TRUE

8) An increase in the inflation rate will cause the demand curve for bonds to shift to the right.Answer: FALSE

9) In Keynes’ liquidity preference framework, individuals are assumed to hold their wealth in the form of money and bonds.Answer: TRUE

10) An increase in the money supply will always lower interest rates.Answer: FALSE

4.3 Essay

1) Distinguish between interest rates, yield to maturity, and current yield.

2) Describe the cash flows received from ownership of a coupon bond. What are the sources of income?

3) What concept is used to value a bond?

4) Why are long-term bonds more risky than short-term bonds?

5) What is interest rate risk and how is it measured?

6) Explain why interest rates may rise when money supply growth increases.

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Chapter 3 Understanding Interest Rates

3.1 Multiple Choice Questions

1) A loan that requires the borrower to make the same payment every period until the maturity date is called aA) simple loan.B) fixed-payment loan.C) discount loan.D) same-payment loan.E) none of the above.Answer: B

2) A coupon bond pays the owner of the bondA) the same amount every month until maturity date.B) the face value of the bond plus an interest payment once the maturity date has

been reached.C) a fixed interest payment every period and repays the face value at the maturity

date.D) the face value at the maturity date.E) none of the above.Answer: C

3) A credit market instrument that pays the owner the face value of the security at the maturity date and nothing prior to then is called aA) simple loan.B) fixed-payment loan.C) coupon bond.D) discount bond.Answer: D

4) (I) A simple loan requires the borrower to repay the principal at the maturity date along with an interest payment. (II) A discount bond is bought at a price below its face value, and the face value is repaid at the maturity date.A) (I) is true, (II) false. B) (I) is false, (II) true. C) Both are true. D) Both are false.Answer: C

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5) Which of the following are true of coupon bonds?A) The owner of a coupon bond receives a fixed interest payment every year until

the maturity date, when the face or par value is repaid.B) U.S. Treasury bonds and notes are examples of coupon bonds.C) Corporate bonds are examples of coupon bonds.D) All of the above.E) Only (A) and (B) of the above.Answer: D

6) Which of the following are generally true of all bonds?A) The longer a bond’s maturity, the lower is the rate of return that occurs as a

result of the increase in an interest rate.B) Even though a bond has a substantial initial interest rate, its return can turn out

to be negative if interest rates rise.C) Prices and returns for long-term bonds are more volatile than those for shorter-

term bonds.D) All of the above are true.E) Only (A) and (B) of the above are true.Answer: D

7) (I) A discount bond requires the borrower to repay the principal at the maturity dateplus an interest payment. (II) A coupon bond pays the lender a fixed interest payment every year until the maturity date, when a specified final amount (face or par value) is repaid.A) (I) is true, (II) false. B) (I) is false, (II) true. C) Both are true. D) Both are false.Answer: B

8) If a $5,000 coupon bond has a coupon rate of 13 percent, then the coupon paymentevery year isA) $650. B) $1,300. C) $130. D) $13. E) None of the above.Answer: A

9) An $8,000 coupon bond with a $400 annual coupon payment has a coupon rate ofA) 5 percent.B) 8 percent.C) 10 percent.D) 40 percent.Answer: A

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10) The concept of _____ is based on the common-sense notion that a dollar paid to you in the future is less valuable to you than a dollar today.A) present valueB) future valueC) interestD) deflation Answer: A

11) Dollars received in the future are worth _____ than dollars received today.The process of calculating what dollars received in the future are worth today is called _____A) more; discounting.B) less; discounting.C) more; inflating.D) less; inflating.Answer: B

12) The process of calculating what dollars received in the future are worth today is calledA) calculating the yield to maturity.B) discounting the future.C) deflating the future.D) none of the above.Answer: B

13) With an interest rate of 5 percent, the present value of $100 received one year fromnow is approximatelyA) $100. B) $105. C) $95. D) $90. Answer: C

14) With an interest rate of 10 percent, the present value of a security that pays $1,100 next year and $1,460 four years from now isA) $1,000. B) $2,560. C) $3,000. D) $2,000. Answer: D

15) With an interest rate of 8 percent, the present value of $100 received one year fromnow is approximatelyA) $108. B) $100. C) $96. D) $93. Answer: D

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16) With an interest rate of 6 percent, the present value of $100 received one year fromnow is approximatelyA) $106. B) $100. C) $94. D) $92. Answer: C

17) The interest rate that equates the present value of payments received from a debt instrument with its market price today is theA) simple interest rate.B) discount rate.C) yield to maturity.D) real interest rate.Answer: C

18) The interest rate that financial economists consider to be the most accurate measureis theA) current yield.B) yield to maturity.C) yield on a discount basis. D) coupon rate.Answer: B

19) Financial economists consider the ______ to be the most accurate measure of interest rates.A) simple interest rateB) discount rateC) yield to maturity real interest rateAnswer: C

20) For a simple loan, the simple interest rate equals theA) real interest rate. B) nominal interest rate.C) current yield.D) yield to maturity.Answer: D

21) For simple loans, the simple interest rate is _____ the yield to maturity.A) greater thanB) less thanC) equal toD) not comparable toAnswer: C

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22) The yield to maturity of a one-year, simple loan of $500 that requires an interest payment of $40 isA) 5 percent.B) 8 percent.C) 12 percent.D) 12.5 percent.Answer: B

23) The yield to maturity of a one-year, simple loan of $400 that requires an interest payment of $50 isA) 5 percent.B) 8 percent.C) 12 percent.D) 12.5 percent.Answer: D

24) A $10,000, 8 percent coupon bond that sells for $10,000 has a yield to maturity ofA) 8 percent.B) 10 percent.C) 12 percent.D) 14 percent.Answer: A

25) Which of the following $1,000 face value securities has the highest yield to maturity?A) A 5 percent coupon bond selling for $1,000 B) A 10 percent coupon bond selling for $1,000C) A 12 percent coupon bond selling for $1,000D) A 12 percent coupon bond selling for $1,100Answer: C

26) Which of the following $1,000 face value securities has the highest yield to maturity?A) A 5 percent coupon bond selling for $1,000 B) A 10 percent coupon bond selling for $1,000C) A 15 percent coupon bond selling for $1,000 D) A 15 percent coupon bond selling for $900Answer: D

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27) Which of the following are true for a coupon bond?A) When the coupon bond is priced at its face value, the yield to maturity equals

the coupon rate.B) The price of a coupon bond and the yield to maturity are negatively related.C) The yield to maturity is greater than the coupon rate when the bond price is

below the par value.D) All of the above are true.E) Only (A) and (B) of the above are true.Answer: D

28) Which of the following are true for a coupon bond?A) When the coupon bond is priced at its face value, the yield to maturity equals

the coupon rate.B) The price of a coupon bond and the yield to maturity are negatively related.C) The yield to maturity is greater than the coupon rate when the bond price is

above the par value.D) All of the above are true.E) Only (A) and (B) of the above are true.Answer: E

29) Which of the following are true for a coupon bond?A) When the coupon bond is priced at its face value, the yield to maturity equals

the coupon rate.B) The price of a coupon bond and the yield to maturity are positively related.C) The yield to maturity is greater than the coupon rate when the bond price is

above the par value.D) All of the above are true.E) Only (A) and (B) of the above are true.Answer: A

30) The yield to maturity on a consol bond that pays $100 yearly and sells for $500 isA) 5 percent.B) 10 percent.C) 12.5 percent.D) 20 percent.E) 25 percent.Answer: D

31) The yield to maturity on a consol bond that pays $200 yearly and sells for $1000 isA) 5 percent.B) 10 percent.C) 20 percent.D) 25 percent.Answer: C

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32) The yield to maturity for a one-year discount bond equalsA) the increase in price over the year, divided by the initial price.B) the increase in price over the year, divided by the face value.C) the increase in price over the year, divided by the interest rate.D) none of the above.Answer: A

33) If a $10,000 face value discount bond maturing in one year is selling for $8,000, then its yield to maturity isA) 10 percent.B) 20 percent.C) 25 percent.D) 40 percent.Answer: C

34) If a $10,000 face value discount bond maturing in one year is selling for $9,000, then its yield to maturity isA) 9 percent.B) 10 percent.C) 11 percent.D) 12 percent.Answer: C

35) If a $10,000 face value discount bond maturing in one year is selling for $5,000, then its yield to maturity isA) 5 percent.B) 10 percent.C) 50 percent.D) 100 percent.Answer: D

36) If a $5,000 face value discount bond maturing in one year is selling for $5,000, then its yield to maturity isA) 0 percent.B) 5 percent.C) 10 percent.D) 20 percent.Answer: A

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37) Which of the following are true for the current yield?A) The current yield is defined as the yearly coupon payment divided by the price

of the security.B) The formula for the current yield is identical to the formula describing the

yield to maturity for a discount bond.C) The current yield is always a poor approximation for the yield to maturity.D) All of the above are true.E) Only (A) and (B) of the above are true.Answer: A

38) The nearer the bond’s price is to the bond’s par value and the longer the maturity of the bond the more closely _____ approximates _____A) current yield; yield to maturity.B) current yield; coupon rate.C) yield to maturity; current yield.D) yield to maturity; coupon rate.Answer: A

39) Which of the following are true for the current yield?A) The current yield is defined as the yearly coupon payment divided by the price

of the security.B) The current yield and the yield to maturity always move together.C) The formula for the current yield is identical to the formula describing the

yield to maturity for a discount bond.D) All of the above are true.E) Only (A) and (B) of the above are true.Answer: E

40) The current yield is a less accurate measure of the yield to maturity the ______ the time to maturity of the bond and the ______ the price is from/to the par value.A) shorter; closerB) shorter; fartherC) longer; closerD) longer; fartherAnswer: B

41) The current yield on a $6,000, 10 percent coupon bond selling for $5,000 isA) 5 percent.B) 10 percent.C) 12 percent.D) 15 percent.Answer: C

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42) The current yield on a $5,000, 8 percent coupon bond selling for $4,000 isA) 5 percent.B) 8 percent.C) 10 percent.D) 20 percent.E) none of the above.Answer: C

43) For a consol, the current yield is an _____ of the yield to maturity.A) underestimateB) overestimateC) exact measureD) approximate measureAnswer: C

44) Which of the following are true of the yield on a discount basis as a measure of the interest rate?A) It uses the percentage gain on the face value of the security, rather than the

percentage gain on the purchase price of the security.B) It puts the yield on the annual basis of a 360-day year.C) It ignores the time to maturity.D) All of the above are true.E) Only (A) and (B) of the above are true.Answer: E

45) The formula for the measure of the interest rate called the yield on a discount basis is peculiar becauseA) it uses the percentage gain on the face value of the bill, rather than the

percentage gain on the purchase price of the bill.B) it ignores the time to maturity.C) it puts the yield on the annual basis of a 360-day year.D) both (A) and (B) of the above.E) both (A) and (C) of the above.Answer: E

46) The yield on a discount basis of a 180-day $1,000 Treasury bill selling for $950 isA) 10 percent.B) 20 percent.C) 25 percent.D) 40 percent.Answer: A

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47) The yield on a discount basis of a 90-day $1,000 Treasury bill selling for $950 isA) 5 percent.B) 10 percent.C) 15 percent.D) 20 percent.E) none of the above.Answer: D

48) The yield on a discount basis of a 90-day $1,000 Treasury bill selling for $900 isA) 10 percent.B) 20 percent.C) 25 percent.D) 40 percent.Answer: D

49) The yield on a discount basis of a 180-day $1,000 Treasury bill selling for $900 isA) 10 percent.B) 20 percent.C) 25 percent.D) 40 percent.Answer: B

50) The Fisher equation states thatA) the nominal interest rate equals the real interest rate plus the expected rate of

inflation.B) the real interest rate equals the nominal interest rate less the expected rate of

inflation.C) the nominal interest rate equals the real interest rate less the expected rate of

inflation.D) both (A) and (B) of the above are true.E) both (A) and (C) of the above are true.Answer: D

51) If you expect the inflation rate to be 15 percent next year and a one-year bond has a yield to maturity of 7 percent, then the real interest rate on this bond isA) 7 percent.B) 22 percent.C) -15 percent.D) -8 percent.E) none of the above.Answer: D

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52) If you expect the inflation rate to be 5 percent next year and a one-year bond has a yield to maturity of 7 percent, then the real interest rate on this bond isA) -12 percent.B) -2 percent.C) 2 percent.D) 12 percent.Answer: C

53) The nominal interest rate minus the expected rate of inflationA) defines the real interest rate.B) is a better measure of the incentives to borrow and lend than is the nominal

interest rate.C) is a more accurate indicator of the tightness of credit market conditions than is

the nominal interest rate.D) indicates all of the above.E) indicates only (A) and (B) of the above.Answer: D

54) The nominal interest rate minus the expected rate of inflationA) defines the real interest rate.B) is a less accurate measure of the incentives to borrow and lend than is the

nominal interest rate.C) is a less accurate indicator of the tightness of credit market conditions than is

the nominal interest rate.D) defines the discount rate.Answer: A

55) In which of the following situations would you prefer to be making a loan?A) The interest rate is 9 percent and the expected inflation rate is 7 percent.B) The interest rate is 4 percent and the expected inflation rate is 1 percent.C) The interest rate is 13 percent and the expected inflation rate is 15 percent.D) The interest rate is 25 percent and the expected inflation rate is 50 percent.Answer: B

56) In which of the following situations would you prefer to be borrowing?A) The interest rate is 9 percent and the expected inflation rate is 7 percent.B) The interest rate is 4 percent and the expected inflation rate is 1 percent.C) The interest rate is 13 percent and the expected inflation rate is 15 percent.D) The interest rate is 25 percent and the expected inflation rate is 50 percent.Answer: D

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57) What is the return on a 5 percent coupon bond that initially sells for $1,000 and sells for $1,200 one year later?A) 5 percentB) 10 percentC) -5 percentD) 25 percentE) None of the aboveAnswer: D

58) What is the return on a 5 percent coupon bond that initially sells for $1,000 and sells for $900 one year later?A) 5 percentB) 10 percentC) -5 percentD) -10 percentE) None of the aboveAnswer: C

59) The return on a 5 percent coupon bond that initially sells for $1,000 and sells for $1,100 one year later isA) 5 percent.B) 10 percent.C) 14 percent.D) 15 percent.Answer: D

60) The return on a 10 percent coupon bond that initially sells for $1,000 and sells for $900 one year later isA) -10 percent.B) -5 percent.C) 0 percent.D) 5 percent.Answer: C

61) Which of the following are generally true of all bonds?A) The only bond whose return equals the initial yield to maturity is one whose

time to maturity is the same as the holding period.B) A rise in interest rates is associated with a fall in bond prices, resulting in

capital losses on bonds whose term to maturities are longer than the holdingperiod.

C) The longer a bond’s maturity, the greater is the size of the price change associated with an interest rate change.

D) All of the above are true.E) Only (A) and (B) of the above are true.Answer: D

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62) Which of the following are true concerning the distinction between interest ratesand return?A) The rate of return on a bond will not necessarily equal the interest rate on that

bond.B) The return can be expressed as the sum of the current yield and the rate of

capital gains.C) The rate of return will be greater than the interest rate when the price of the

bond falls between time t and time t+1.D) All of the above are true.E) Only (A) and (B) of the above are true.Answer: E

63) If the interest rates on all bonds rise from 5 to 6 percent over the course of the year, which bond would you prefer to have been holding?A) A bond with one year to maturityB) A bond with five years to maturityC) A bond with ten years to maturityD) A bond with twenty years to maturityAnswer: A

64) Suppose you are holding a 5 percent coupon bond maturing in one year with a yield to maturity of 15 percent. If the interest rate on one-year bonds rises from 15 percent to 20 percent over the course of the year, what is the yearly return on the bond you are holding?A) 5 percentB) 10 percentC) 15 percentD) 20 percentAnswer: C

65) (I) Prices of longer-maturity bonds respond more dramatically to changes ininterest rates. (II) Prices and returns for long-term bonds are less volatile than thosefor short-term bonds.A) (I) is true, (II) false. B) (I) is false, (II) true. C) Both are true. D) Both are false.Answer: A

66) (I) Prices of longer-maturity bonds respond less dramatically to changes in interest rates. (II) Prices and returns for long-term bonds are less volatile than those for shorter-term bonds.A) (I) is true, (II) false. B) (I) is false, (II) true. C) Both are true. D) Both are false.Answer: D

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67) The riskiness of an asset’s return that results from interest rate changes has been given the special name ofA) interest-rate risk.B) liquidity risk.C) bond-market risk.D) yield-to-maturity risk.Answer: A

68) If an investor’s holding period is longer than the term to maturity of a bond, the investor is exposed toA) interest-rate risk.B) reinvestment risk.C) bond-market risk.D) yield-to-maturity risk.Answer: B

69) (I) The average lifetime of a debt security’s stream of payments is called duration. (II) The duration of a portfolio is the weighted average of the durations of the individual securities, with the weights reflecting the proportion of the portfolio invested in each.A) (I) is true, (II) false. B) (I) is false, (II) true. C) Both are true D) Both are false.Answer: C

70) The duration of a ten-year, 10 percent coupon bond when the interest rate is 10 percent is 6.76 years. What happens to the price of the bond if the interest rate falls to 8 percent?A) it rises 20 percentB) it rises 12.3 percent C) it falls 20 percentD) it falls 12.3 percent Answer: B

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3.2 True/False

1) A bond’s current market value is equal to the present value of the coupon paymentsplus the present value of the face amount.Answer: TRUE

2) The current yield is the best measure of an investor’s return from holding a bond.Answer: FALSE

3) Unless a bond defaults, an investor cannot lose money investing in bonds.Answer: FALSE

4) The current yield is the yearly coupon rate divided by the current market price.Answer: TRUE

5) Prices for long-term bonds are more volatile than for shorter-term bonds.Answer: TRUE

6) A long-term bond’s price is less affected by interest rate movements than is a short-term bond’s price.Answer: FALSE

7) Increasing duration implies that interest rate risk has increased.Answer: TRUE

8) All else being equal, the greater the interest rate the greater is the duration.Answer: FALSE

9) The real rate is equal to the nominal rate plus inflation.Answer: FALSE

10) The current yield goes up as the yield to maturity on a bond falls.Answer: FALSE

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3.3 Essay

1) Distinguish between interest rates, yield to maturity, and current yield.

2) Describe the cash flows received from ownership of a coupon bond. What are the sources of income?

3) What concept is used to value a bond?

4) Why are long-term bonds more risky than short-term bonds?

5) What is interest rate risk and how is it measured?

6) Why may a bond’s rate of return differ from its yield to maturity?

7) How does reinvestment risk differ from interest rate risk?

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Chapter 2 Overview of the Financial System

2.1 Multiple Choice Questions

1) Every financial market has the following characteristic: A) It determines the level of interest rates.B) It allows common stock to be traded. C) It allows loans to be made.D) It channels funds from lenders-savers to borrowers-spenders. Answer: D

2) Financial markets have the basic function of A) bringing together people with funds to lend and people who want to borrow

funds.B) assuring that the swings in the business cycle are less pronounced. C) assuring that governments need never resort to printing money.D) both (A) and (B) of the above. E) both (B) and (C) of the above. Answer: A

3) Which of the following can be described as involving direct finance?A) A corporation’s stock is traded in an over-the-counter market.B) People buy shares in a mutual fund. C) A pension fund manager buys commercial paper in the secondary market.D) An insurance company buys shares of common stock in the over-the-counter

markets.E) None of the above. Answer: E

4) Which of the following can be described as involving direct finance?A) A corporation’s stock is traded in an over-the-counter market.B) A corporation buys commercial paper issued by another corporation. C) A pension fund manager buys commercial paper from the issuing corporation. D) Both (A) and (B) of the above. E) Both (B) and (C) of the above. Answer: E

5) Which of the following can be described as involving indirect finance?A) A corporation takes out loans from a bank. B) People buy shares in a mutual fund. C) A corporation buys commercial paper in a secondary market.D) All of the above. E) Only (A) and (B) of the above. Answer: D

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6) Which of the following can be described as involving indirect finance?A) A bank buys a U.S. Treasury bill from one of its depositors. B) A corporation buys commercial paper issued by another corporation. C) A pension fund manager buys commercial paper in the primary market.D) Both (B) and (C) of the above. Answer: A

7) Financial markets improve economic welfare because A) they allow funds to move from those without productive investment

opportunities to those who have such opportunities. B) they allow consumers to time their purchases better. C) they weed out inefficient firms.D) they do all of the above. E) they do (A) and (B) of the above. Answer: E

8) Which of the following are securities? A) A certificate of deposit B) A share of Texaco common stock C) A Treasury billD) All of the above E) Only (A) and (B) of the above Answer: D

9) Which of the following statements about the characteristics of debt and equity are true?A) They can both be long-term financial instruments.B) They both involve a claim on the issuer’s income. C) They both enable a corporation to raise funds. D) All of the above E) Only (A) and (B) of the above Answer: D

10) Which of the following are long-term financial instruments?A) A negotiable certificate of deposit B) A banker’s acceptanceC) A U.S. Treasury bond D) A U.S. Treasury bill Answer: C

11) Which of the following are short-term financial instruments? A) A negotiable certificate of deposit B) A banker’s acceptanceC) A U.S. Treasury bond D) Both (A) and (B) of the above E) Both (B) and (C) of the above Answer: D

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12) Which of the following are short-term financial instruments? A) A banker’s acceptanceB) A share of Walt Disney Corporation stock C) A Treasury note with a maturity of 4 years D) All of the above Answer: A

13) Which of the following are primary markets? A) The New York Stock ExchangeB) The U.S. government bond marketC) The over-the-counter stock marketD) The options marketsE) None of the above Answer: E

14) Which of the following are secondary markets? A) The New York Stock ExchangeB) The U.S. government bond marketC) The over-the-counter stock marketD) The options marketsE) All of the above Answer: E

15) A corporation acquires new funds only when its securities are sold A) in the secondary market by an investment bank. B) in the primary market by an investment bank. C) in the secondary market by a stock exchange broker. D) in the secondary market by a commercial bank. Answer: B

16) Intermediaries who are agents of investors and match buyers with sellers of securities are called A) investment bankers.B) traders. C) brokers. D) dealers. E) none of the above. Answer: C

17) Intermediaries who link buyers and sellers by buying and selling securities at stated prices are called A) investment bankers.B) traders. C) brokers. D) dealers. E) none of the above. Answer: D

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18) An important financial institution that assists in the initial sale of securities in the primary market is the A) investment bank.B) commercial bank.C) stock exchange.D) brokerage house.Answer: A

19) Which of the following statements about financial markets and securities are true? A) Most common stocks are traded over-the-counter, although the largest

corporations have their shares traded at organized stock exchanges such as the New York Stock Exchange.

B) A corporation acquires new funds only when its securities are sold in the primary market.

C) Money market securities are usually more widely traded than longer-term securities and so tend to be more liquid.

D) All of the above are true. E) Only (A) and (B) of the above are true. Answer: D

20) Which of the following statements about financial markets and securities 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 intermediate term if its maturity is less than one year.C) A debt instrument is long term if its maturity is ten years or longer. D) The maturity of a debt instrument is the time (term) to that instrument’s

expiration date. Answer: C

21) Which of the following statements about financial markets and securities are true? A) Few common stocks are traded over-the-counter, although the over-the-counter

markets have grown in recent years.B) A corporation acquires new funds only when its securities are sold in the

primary market.C) Capital market securities are usually more widely traded than longer term

securities and so tend to be more liquid. D) All of the above are true. E) Only (A) and (B) of the above are true. Answer: B

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22) Which of the following markets is sometimes organized as an over-the-counter market?A) The stock market B) The bond market C) The foreign exchange market D) The federal funds marketE) all of the above Answer: E

23) Which of the following instruments is not traded in a money market?A) Banker’s acceptancesB) U.S. Treasury Bills C) Eurodollars D) Commercial paperE) None of the above Answer: E

24) Which of the following instruments is not traded in a money market?A) Banker’s acceptancesB) U.S. Treasury Bills C) Eurodollars D) Commercial paperE) Residential mortgagesAnswer: E

25) Which of the following instruments are traded in a capital market?A) U.S. government agency securities B) Negotiable bank CDsC) Repurchase agreementsD) Eurodollars E) None of the above Answer: A

26) Which of the following instruments are traded in a capital market?A) Corporate bondsB) U.S. Treasury bills C) Banker’s acceptancesD) Repurchase agreementsAnswer: A

27) Bonds that are sold in a foreign country and are denominated in that country’scurrency are known asA) foreign bonds.B) Eurobonds. C) Eurocurrencies. D) Eurodollars. Answer: A

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28) Bonds that are sold in a foreign country and are denominated in a currency other thanthat of the country in which they are sold are known as A) foreign bonds.B) Eurobonds. C) Eurocurrencies. D) Eurodollars. Answer: B

29) Financial intermediariesA) exist because there are substantial information and transaction costs in the

economy.B) improve the lot of the small saver.C) are involved in the process of indirect finance. D) do all of the above. E) do only (A) and (B) of the above. Answer: D

30) The main sources of financing for businesses, in order of importance, are A) financial intermediaries, issuing bonds, issuing stocks. B) issuing bonds, issuing stocks, financial intermediaries.C) issuing stocks, issuing bonds, financial intermediaries.D) issuing stocks, financial intermediaries, issuing bonds. Answer: A

31) The presence of transaction costs in financial markets explains, in part, why A) financial intermediaries and indirect finance play such an important role in

financial markets.B) equity and bond financing play such an important role in financial markets.C) corporations get more funds through equity financing than they get from

financial intermediaries.D) direct financing is more important than indirect financing as a source of funds. Answer: A

32) Financial intermediaries can substantially reduce transaction costs per dollar of transactions because their large size allows them to take advantage of A) poorly informed consumers. B) standardization. C) economies of scale. D) their market power. Answer: C

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33) The presence of _____ in financial markets leads to adverse selection and moral hazard problems that interfere with the efficient functioning of financial markets. A) noncollateralized riskB) free-riding C) asymmetric informationD) costly state verificationAnswer: C

34) When the lender and the borrower have different amounts of information regarding a transaction, ______________ is said to exist. A) asymmetric informationB) adverse selectionC) moral hazardD) fraud Answer: A

35) When the potential borrowers who are the most likely to default are the ones most actively seeking a loan, ______________ is said to exist. A) asymmetric informationB) adverse selectionC) moral hazardD) fraud Answer: B

36) When the borrower engages in activities that make it less likely that the loan will be repaid, _____________ is said to exist.A) asymmetric informationB) adverse selectionC) moral hazardD) fraud Answer: C

37) The concept of adverse selection helps to explain A) which firms are more likely to obtain funds from banks and other financial

intermediaries, rather than from the securities markets. B) why indirect finance is more important than direct finance as a source of

business finance. C) why direct finance is more important than indirect finance as a source of

business finance. D) only (A) and (B) of the above. E) only (A) and (C) of the above. Answer: D

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38) Adverse selection is a problem associated with equity and debt contracts arising from A) the lender’s relative lack of information about the borrower’s potential returns

and risks of his investment activities. B) the lender’s inability to legally require sufficient collateral to cover a 100

percent loss if the borrower defaults.C) the borrower’s lack of incentive to seek a loan for highly risky investments.D) none of the above. Answer: A

39) When the least desirable credit risks are the ones most likely to seek loans, lenders are subject to the A) moral hazard problem.B) adverse selection problem. C) shirking problem.D) free-rider problem.E) principal-agent problem.Answer: B

40) Financial institutions expect that A) moral hazard will occur, as the least desirable credit risks will be the ones most

likely to seek out loans. B) opportunistic behavior will occur, as the least desirable credit risks will be the

ones most likely to seek out loans. C) borrowers will commit moral hazard by taking on too much risk, and this is

what drives financial institutions to take steps to limit moral hazard. D) none of the above will occur.Answer: B

41) Successful financial intermediaries have higher earnings on their investments because they are better equipped than individuals to screen out good from bad risks, thereby reducing losses due to A) moral hazard.B) adverse selection.C) bad luck.D) financial panics.Answer: B

42) In financial markets, lenders typically have inferior information about potentialreturns and risks associated with any investment project. This difference in information is called A) comparative informational disadvantage. B) asymmetric information.C) variant information.D) caveat venditor.Answer: B

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43) The largest depository institution at the end of 2001 was A) life insurance companies.B) pension funds.C) state retirement funds. D) none of the above. Answer: D

44) The value of assets held by commercial banks in 2001 was $6.7 trillion dollars, making commercial banks the A) second most important sector of financial intermediaries after mutual funds. B) second most important sector of financial intermediaries after life

insurance companies.C) second most important sector of financial intermediaries after private

pension funds. D) largest sector of financial intermediaries.Answer: D

45) Which of the following financial intermediaries are depository institutions? A) A savings and loan association B) A commercial bank C) A credit union D) All of the above E) Only (A) and (C) of the above Answer: D

46) Which of the following is a contractual savings institution? A) A life insurance companyB) A credit union C) A savings and loan association D) A mutual fundAnswer: A

47) Which of the following are not investment intermediaries?A) A life insurance companyB) A pension fund C) A mutual fundD) Only (A) and (B) of the above Answer: D

48) Which of the following are investment intermediaries?A) Finance companiesB) Mutual fundsC) Pension fundsD) All of the above E) Only (A) and (B) of the above Answer: E

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49) The government regulates financial markets for three main reasons:A) to ensure soundness of the financial system, to improve control of monetary

policy, and to increase the information available to investors. B) to improve control of monetary policy, to ensure that financial intermediaries

earn a normal rate of return, and to increase the information available to investors.

C) to ensure that financial intermediaries do not earn more than the normal rate of return, to ensure soundness of the financial system, and to improve control of monetary policy.

D) to ensure soundness of financial intermediaries, to increase the informationavailable to investors, and to prevent financial intermediaries from earning less than the normal rate of return.

Answer: A

50) Asymmetric information can lead to widespread collapse of financial intermediaries, referred to as a A) bank holiday.B) financial panic.C) financial disintermediation.D) financial collapse.Answer: B

2.2 True/False

1) Every financial market allows loans to be made.Answer: FALSE

2) An example of direct financing is if you were to lend money to your neighbor.Answer: TRUE

3) The New York Stock Exchange is an example of a primary market.Answer: FALSE

4) Commercial paper is not traded in the capital market.Answer: TRUE

5) Eurodollars are traded in the money market.Answer: TRUE

6) The process of financial intermediation is also known as direct finance.Answer: FALSE

7) A mutual fund is not a depository institution.Answer: TRUE

8) A pension fund is not a contractual savings institution.Answer: FALSE

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9) Equity represents an ownership interest in a firm and entitles the holder to the residual cash flows.Answer: TRUE

10) Adverse selection refers to those most at risk being most aggressive in their search for funds.Answer: FALSE

2.3 Essay

1) Distinguish between direct financing and indirect financing.

2) Distinguish between primary markets and secondary markets.

3) Why is it so important for an economy to have fully developed financial markets?

4) Why are financial intermediaries so important to an economy?

5) Describe how over-the-counter markets work.

6) What are adverse selection and moral hazard?

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Chapter 1 Why Study Financial Markets and Institutions?

1.1 Multiple Choice Questions

1) Financial markets and institutions A) involve the movement of huge quantities of money.B) affect the profits of businesses. C) affect the types of goods and services produced in an economy.D) do all of the above. E) do only (A) and (B) of the above. Answer: D

2) Markets in which funds are transferred from those who have excess funds available to those who have a shortage of available funds are called A) commodity markets.B) fund-available markets.C) derivative exchange markets.D) financial markets.Answer: D

3) The price paid for the rental of borrowed funds (usually expressed as a percentage of the rental of $100 per year) is commonly referred to as the A) inflation rate.B) exchange rate.C) interest rate.D) aggregate price level. Answer: C

4) The bond markets are important because A) they are easily the most widely followed financial markets in the United States. B) they are the markets where foreign exchange rates are determined.C) they are the markets where interest rates are determined.D) of all of the above. E) of only (A) and (B) of the above. Answer: C

5) Interest rates are important to financial institutions since an interest rate increase A) decreases the cost of acquiring funds. B) increases the cost of acquiring funds. C) raises the income from assets. D) (B) and (C) of the above. E) (A) and (C) of the above. Answer: D

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6) Typically, increasing interest rates A) discourage corporate investments.B) discourage individuals from saving. C) encourage corporate expansion. D) encourage corporate borrowing. E) none of the above. Answer: A

7) Compared to interest rates on long-term U.S. government bonds, interest rates on ____ fluctuate more and are lower on average. A) medium-quality corporate bonds B) low-quality corporate bonds C) high-quality corporate bonds D) three-month Treasury bills E) none of the above Answer: D

8) Compared to interest rates on long-term U.S. government bonds, interest rates on three-month Treasury bills fluctuate _____ and are _____ on average. A) more; lowerB) less; lowerC) more; higherD) less; higherAnswer: A

9) The stock market is important because A) it is where interest rates are determined.B) it is the most widely followed financial market in the United States. C) it is where foreign exchange rates are determined.D) all of the above. Answer: B

10) Stock prices since the 1950s have been A) relatively stable, trending upward at a steady pace. B) relatively stable, trending downward at a moderate rate. C) extremely volatile.D) unstable, trending downward at a moderate rate. Answer: C

11) A rising stock market index due to higher share prices A) increases people’s wealth and as a result may increase their willingness to spend. B) increases the amount of funds that business firms can raise by selling newly

issued stock. C) decreases the amount of funds that business firms can raise by selling newly

issued stock. D) both (A) and (B) of the above. Answer: D

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12) A declining stock market index due to lower share prices A) reduces people’s wealth and as a result may reduce their willingness to spend. B) increases people’s wealth and as a result may increase their willingness to

spend.C) decreases the amount of funds that business firms can raise by selling newly

issued stock. D) both (A) and (C) of the above. E) both (B) and (C) of the above. Answer: D

13) Changes in stock prices A) affect people’s wealth and their willingness to spend. B) affect firm’s decisions to sell stock to finance investment spending. C) are characterized by considerable fluctuations. D) all of the above. E) only (A) and (B) of the above. Answer: D

14) (I) Debt markets are often referred to generically as the bond market. (II) A bond is a security that is a claim on the earnings and assets of a corporation. A) (I) is true, (II) false. B) (I) is false, (II) true. C) Both are true. D) Both are false. Answer: A

15) (I) A bond is a debt security that promises to make payments periodically for a specified period of time. (II) A stock is a security that is a claim on the earnings and assets of a corporation. A) (I) is true, (II) false. B) (I) is false, (II) true. C) Both are true. D) Both are false. Answer: C

16) The price of one country’s currency in terms of another’s is called A) the exchange rate. B) the interest rate. C) the Dow Jones industrial average. D) none of the above. Answer: A

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17) A stronger dollar benefits _____ and hurts _____ A) American businesses; American consumers.B) American businesses; foreign businesses. C) American consumers; American businesses. D) foreign businesses; American consumers.Answer: C

18) A weaker dollar benefits _____ and hurts _____ A) American businesses; American consumers.B) American businesses; foreign consumers.C) American consumers; American businesses. D) foreign businesses; American consumers.Answer: A

19) From 1980 to early 1985 the dollar _____ in value, thereby benefiting American_____A) appreciated; consumers.B) appreciated; businesses.C) depreciated; consumers.D) depreciated; businesses.Answer: A

20) Money is defined as A) anything that is generally accepted in payment for goods and services or in the

repayment of debt. B) bills of exchange. C) a riskless repository of spending power. D) all of the above. E) only (A) and (B) of the above. Answer: A

21) The organization responsible for the conduct of monetary policy in the United States is the A) Comptroller of the Currency. B) U.S. Treasury.C) Federal Reserve System.D) Bureau of Monetary Affairs. Answer: C

22) The central bank of the United States is A) Citicorp. B) Bank America.C) The treasury.D) The Fed.E) none of the above. Answer: D

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23) Economists group commercial banks, savings and loan associations, credit unions, mutual funds, mutual savings banks, insurance companies, pension funds, and finance companies together under the heading financial intermediaries. Financial intermediariesA) act as middlemen, borrowing funds from those who have saved and lending

these funds to others. B) produce nothing of value and are therefore a drain on society’s resources. C) help promote a more efficient and dynamic economy.D) do all of the above. E) do only (A) and (C) of the above. Answer: E

24) Economists group commercial banks, savings and loan associations, credit unions, mutual funds, mutual savings banks, insurance companies, pension funds, and finance companies together under the heading financial intermediaries. Financial intermediariesA) act as middlemen, borrowing funds from those who have saved and lending

these funds to others. B) play an important role in determining the quantity of money in the economy.C) help promote a more efficient and dynamic economy.D) do all of the above. E) do only (A) and (C) of the above. Answer: D

25) Banks are important to the study of money and the economy because they A) provide a channel for linking those who want to save with those who want to

invest.B) have been a source of rapid financial innovation that is expanding the

alternatives available to those wanting to invest their money.C) are the only financial institution to play a role in determining the quantity of

money in the economy.D) do all of the above. E) do only (A) and (B) of the above. Answer: E

26) Banks, savings and loan associations, mutual savings banks, and credit unions A) are no longer important players in financial intermediation.B) have been providing services only to small depositors since deregulation. C) have been adept at innovating in response to changes in the regulatory

environment.D) all of the above. E) only (A) and (C) of the above. Answer: C

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27) (I) Banks are financial intermediaries that accept deposits and make loans.(II) Included under the term banks are firms such as commercial banks, savings and loan associations, mutual savings banks, credit unions, and insurance companies.A) (I) is true, (II) false. B) (I) is false, (II) true. C) Both are true. D) Both are false. Answer: C

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1.2 True/False

1) Money is anything accepted by anyone as payment for services or goods. Answer: FALSE

2) Interest rates are determined in the bond markets.Answer: TRUE

3) A stock is a debt security that promises to make periodic payments for a specific period of time.Answer: FALSE

4) Monetary policy affects interest rates but has little effect on inflation or business cycles.Answer: FALSE

5) The government organization responsible for the conduct of monetary policy in the United States is the U.S. Treasury. Answer: FALSE

6) Interest rates can be accurately described as the rental price of money.Answer: TRUE

7) Holding everything else constant, as the dollar weakens vacations abroad becomeless attractive. Answer: TRUE

8) In recent years, financial markets have become more stable and less risky. Answer: FALSE

9) Financial innovation has provided more options to both investors and borrowers. Answer: TRUE

10) A financial intermediary borrows funds from people who have saved. Answer: TRUE

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1.3 Essay

1) Have interest rates been more or less volatile in recent years? Why?

2) Why should consumers be concerned with movements in foreign exchange rates?

3) What is monetary policy and who is responsible for its implementation?

4) What are financial intermediaries and what do they do?

5) What is money?

6) How does a bond differ from a stock?

7) Why is the stock market so important to individuals, firms, and the economy?

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