Chapter 2 Practice Problems

The current rate of return on a one-year U.S. Government security is 3%. The rate of return on a twoyear U.S. Government security is 5%. According to the expectations theory, what is the return on a oneyear U.S. Government security purchased one year from today?

.07039 (1.05)^2=(1.03)(1+x) x=.07039

Given the rate information in the table below, estimate the nominal rate for a AA-rated corporate bond. Assume a liquidity premium of 8 basis points. Identify as part of your answer the inflation risk premium, the default risk premium, the maturity premium, and the liquidity premium. 3-month T-bills 2.0% 30-year Treasury Bonds 5.0% AA-rated Corp. Bonds 8.0% Inflation Rate 1.0%

.0808 NI=(.02-.01)+.01+(.08-.05)+(.05-.02)+.0008 =.0808

Investment firms, such as Goldman Sachs, assist the transfer of capital by A) facilitating indirect transfers from savers (investing public) to borrowers (corporations needing capital). B) selling indirect securities to savers and using the funds to buy common stock for corporations needing funds. C) selling direct securities. D) selling common stock for corporate clients in the secondary market.

A

John calls his stockbroker and instructs him to purchase 100 shares of Microsoft Corporation common stock. This transaction occurs in the A) secondary market. B) primary market. C) credit market. D) futures market.

A

Which of the following securities will likely have the highest maturity risk premium? A) U.S. Treasury Bond maturing in 2027 B) BBB-rated corporate bond maturing in 2020 actively traded on a major exchange C) AAA-rated corporate bond maturing in 2015 not actively traded D) U.S. Treasury Bill

A

Which of the following statements is false? A) Brokers purchase securities for their own account. B) Most corporate bond trading takes place over the counter. C) Broker-dealers stand ready to buy and sell specific securities at selected prices. D) none of the above

A

You are considering an investment in a AAA-rated U.S. corporate bond but you are not sure what rate of interest it should pay. Assume that the real risk-free rate of interest is 1.0%; inflation is expected to be 1.5%; the maturity risk premium is 2.5%; and, the default risk premium for AAA-rated corporate bonds is 3.5%. What rate of interest should the U.S. corporate bond pay? A) 8.5% B) 6.0% C) 5.0% D) 2.5%

A (nominal rate or NI)=(real rate or RI)(inflation rate or IP)(default risk premium or DF)(maturity premium or MP)(liquidity premium or LP) (NI)=(RI)(IP)(DF)(MP)(LP) .01+.015+.035+.025+0=.085 or 8.5%

An example of a primary market transaction involving a money market security is A) a new issue of a security with a very short maturity. B) a new issue of a security with a very long maturity. C) the transfer of a previously-issued security with a very short maturity. D) the transfer of a previously-issued security with a very long maturity.

A -less than one year

General Motors raises money by selling a new issue of common stock. This transaction occurs in A) the secondary market. B) the capital market. C) the money market. D) the futures market.

B

A "normal" yield curve is A) downward sloping. B) downward sloping, then upward sloping. C) upward sloping. D) upward sloping, then downward sloping.

C

General Electric (GE) has been a public company for many years with its common stock traded on the New York Stock Exchange. If GE decides to sell 500,000 shares of new common stock, the transaction will be describe as A) an initial public offering. B) a secondary market transaction because GE common stock has been trading for years. C) a seasoned equity offering because GE has sold common stock before. D) a money market transaction because GE raises new money to fund its business.

C

Reynolds, Inc. needs to raise $5 million by selling common stock. Reynolds sells 1 million shares of stock at $5 each to Goldman Sachs, who then is responsible for selling the shares to investors. This is an example of a A) privileged subscription. B) standby agreement. C) negotiated purchase. D) commission or best-efforts agreement.

C

The investment banker performs what three basic functions? A) underwriting, distributing, and regulating B) underwriting, advising, and price-pegging C) underwriting, distributing, and advising D) underwriting, distributing, and negotiating

C

What is the term for a graphical representation of the relationship between interest rates and the maturities of debt securities? A) term curve B) maturity chart C) yield curve D) inflationary expectations

C

Which of the following is an advantage of organized stock exchanges? A) increased stock price volatility B) screening companies to ensure only low risk stocks are sold C) providing a continuous market D) only profitable companies may issue new securities on an organized exchange

C

Which of the following is an example of both a capital market and a primary market transaction? A) The U.S. Government sells 3-month Treasury Bills. B) Microsoft common stock owned by an individual investor is sold to another investor. C) Ford Motor Company sells a new issue of common stock to raise funds through a public offering. D) No transactions occur in both primary and capital markets at the same time.

C

Which of the following securities will likely have the highest liquidity premium? A) U.S. Treasury Bond maturing in 2027 B) BBB-rated corporate bond maturing in 2020 actively traded on a major exchange C) AAA-rated corporate bond maturing in 2015 not actively traded D) U.S. Treasury Bill

C

Which of the following premiums is NOT factored into the price of a long-term Treasury bond? A) a real risk-free interest rate B) a maturity premium C) a default-risk premium D) an inflation-risk premium

C -treasury does not default

Over the period 1926 to 2011 the standard deviation of returns has been the greatest for which of the following? A) treasury bills B) corporate bonds C) common stocks D) common stocks of small firms

D

The Sarbanes-Oxley Act of 2002, in order to protect investors, requires a higher level of accountability for which of the following groups? A) corporate officers B) public accountants C) boards of directors D) all of the above

D

The nominal interest rate is 7% and the expected inflation rate is 2%. Based on the Fisher effect, the real rate of interest is A) 5.0%. B) 6.86%. C) 5.1%. D) 4.9%.

D (1+nominal rate)=(1+real rate)(1+inflation rate) (1+R)=(1+r)(1+IP) (1.07)=(1+r)(1.02) r=.049 or 4.9%

(T/F) Because they occur in private, stricter regulations are placed on the private placement of securities.

F

(T/F) Dont do #11

F

(T/F)) Investment banking firms are prohibited from selling securities due to conflicts of interest.

F

(T/F) Transactions in the futures markets involve current payments for goods which will be delivered at some future agreed upon date.

F -agreement to buy/sell in fututre at price set today

(T/F) Common stock is considered a short-term security because it has no maturity date and a long-term security is one with a maturity date of more than one year.

F -common stock considered long-term?

(T/F) Saving surplus units include individuals and governments, but not corporations.

F -corporations, households, gouts, etc.

(T/F) A liquidity-risk premium is the additional return required by investors in longer-term securities to compensate them for the greater risk of price fluctuation on those securities caused by interest rate changes.

F -maturity premium

(T/F) Seasoned secondary offerings occur in the secondary market.

F -primary market

(T/F) A real interest rate is the interest rate on a fixed-income security that has no risk in an economic environment of high inflation.

F -risk-free rate

(T/F) Transactions in common stock occur in the money market, due to the large amount of money involved in such transactions.

F -transactions in common stock in capital market

(T/F) Individuals, corporations, and governments can be either savings deficit units or savings surplus units.

T

(T/F) The term structure of interest rates usually indicates that longer terms to maturity have higher expected returns.

T

(T/F) The money market includes transactions in short-term financial instruments

T -less than one year maturities

(T/F) Capital markets are all the financial institutions that help a business raise long-term capital.

T -money market is short term