Econ Midterm 1 (Ch 3), Money, Banking, and Econ, Econ Midterm 1 (Chapter 4), Econ Midterm 1 (Chapter 2), Econ Midterm 1 (Chapter 1), Econ Midterm 1 (Chapter 5)

A borrower has information that is not available to a prospective lender; this is an example of: A. a wise borrower and an unwise lender. B. a transfer of risk. C. information asymmetry. D. liquidity risk.

C

An automobile insurance company that writes millions of policies is practicing a form of: A. mutual fund. B. hedging risk. C. spreading risk. D. eliminating systematic risk.

C

At any fixed interest rate, an increase in time, n, until a payment is made: A. increases the present value. B. has no impact on the present value since the interest rate is fixed. C. reduces the present value. D. affects only the future value.

C

If 10% is the annual rate, considering compounding, the monthly rate is: A. 0.0833% B. 0.833% C. 0.00797% D. 1.0833%

C

Mary deposits funds into a CD at her bank. The CD has an annual interest of 4.0%. If Mary leaves the funds in the CD for two years she will have $540.80. What amount is Mary depositing? A. $520.00 B. $514.50 C. $500.00 D. $512.40

C

The New York Stock Exchange is an example of a: A. financial instrument. B. financial institution. C. financial market. D. bank.

C

An investment pays $1,500 half of the time and $500 half of the time. Its expected value and variance respectively are: A. $1,000; 500,000 dollars B. $2,000; (250,000 dollars)2 C. $1,000; 250,000 dollars D. $1,000; 250,000 dollars2

D

Inflation refers to growth in the economy's: A. Gross Domestic Product (GDP). B. interest rates. C. money. D. prices.

D

Investing in financial instruments in today's economy: A. is an activity practiced only by the wealthy. B. involves costly transactions. C. requires a relatively large sum of money to invest (more than $100,000). D. is made easier by the use of mutual funds.

D

The price of a coupon bond will increase as the: A. face value decreases. B. yield increases. C. coupon payments increase. D. term to maturity is shorter.

D

Which of the following expresses 5.65%? A. 0.565 B. 0.00565 C. 5.65 D. 0.0565

D

Identify the five core principles of Money and Banking.

#1) Time has value; #2) Risk requires compensation; #3) Information is the basis for decisions; #4) Markets determine prices and allocate resources; #5) Stability improves welfare.

Explain how the introduction of asset-backed securities has allowed investors to take advantage of higher returns from loans that most investors could never make on their own.

Asset-backed securities are instruments that allow the holder to share in the returns or payments arising from specific assets such as home mortgages or car loans. Investors purchase shares in the revenue that come from the underlying assets. While most investors would not or could not take the risk of making a home mortgage directly, they can purchase these securities and enjoy the higher return offered by home mortgages with less risk than would be the case if they made a home mortgage directly.

Interest rates that are adjusted for expected inflation are known as: A. coupon rates. B. ex ante real interest rates. C. ex post real interest rates. D. nominal interest rates.

B

Suppose Tom receives a one-year loan from ABC Bank for $5,000.00. At the end of the year, Tom repays $5,400.00 to ABC Bank. Assuming the simple calculation of interest, the interest rate on Tom's loan was: A. $400 B. 8.00% C. 7.41% D. 20%

B

The use of money makes us more efficient because: A. we spend more time trading and more time producing. B. people can specialize in what they do well. C. with money we borrow less. D. money increases in value over time.

B

A policy is time consistent when: A. policymakers have incentives to adhere to a policy decision made today, in the future. B. policymakers have incentives to make policy decisions in a time-sensitive fashion. C. policymakers consider the future when making current policies. D. the timing of a policy is irrelevant.

A

An insurance company is an example of a financial institution that: A. transfers risk. B. acts as a broker. C. serves as a depository institution. D. sells derivative securities.

A

An investment pays $1,200 a quarter of the time; $1,000 half of the time; and $800 a quarter of the time. Its expected value and variance respectively are: A. $1,000; 20,000 dollars2 B. $1,050; 20,000 dollars2 C. $1,000; 40,000 dollars2 D. $1,000; 80,000 dollar2

A

Another name for the expected value of an investment would be the: A. mean value. B. upper-end value. C. certain value. D. risk-free value.

A

As a result of "Check 21—The Check Clearing for the 21st Century Act": A. banks no longer have to ship paper checks to complete the process of check clearing. B. people can write checks and plan on having a couple of days to make a deposit to cover the check amount. C. canceled checks can no longer be used as proof of payment. D. the Federal Reserve is no longer involved in the check-clearing process.

A

Considering the value of a financial instrument, the more likely it is the payment will be made: A. the more valuable the financial instrument. B. the less valuable is the instrument because risk is lower. C. the less valuable is the financial instrument because it is highly liquid. D. the greater the uncertainty; therefore the less valuable is the financial instrument.

A

Derivative markets exist to allow for: A. allow for the transfer of risk. B. direct transfers of common stocks for bonds. C. cash receipts from the sale of bonds. D. reduced information asymmetry.

A

Doubling the future value will cause the: A. present value to double. B. present value to decrease. C. present value to increase by less than 100%. D. interest rate, i, to decrease.

A

During the Civil War, the North issued currency, known as "greenbacks". Which of the following is true of "greenbacks"? A. Greenbacks are still legal tender in the U.S. B. Greenbacks were tied to the value of gold and silver. C. The South used "greenbacks" to pay for salaries and supplies. D. Greenbacks are a historical example of commodity money.

A

Hedging is possible only when investments have: A. opposite payoff patterns. B. the same payoff patterns. C. payoffs that are independent of each other. D. the same risk premiums.

A

Sharon deposits $150.00 in her savings account at the bank. At the end of one year she has $156.38. What was the interest rate that Sharon earned? A. 4.25% B. 6.38% C. 4.52% D. 5.63%

A

U.S. monetary policy is best described as: A. aimed at keeping inflation low and stable and growth high and stable. B. determining the denominations of a country's currency. C. one of the most important functions of congress. D. attempting to keep inflation constant at zero percent.

A

Which of the following best expresses the future value of $100 left in a savings account earning 3.5% for three and a half years? A. $100(1.035)3.5 B. $100(0.35)3.5 C. $100 × 3.5 × (1.035) D. $100(1.035)3/2

A

Which of the following is not considered to be a shadow bank? A. Credit unions B. Brokerages C. Insurers D. Money-market mutual funds

A

Which of the following is true? A. Investments with higher risk generally have a higher expected return than risk-free investments. B. Investments that pay a return over a longer time horizon generally have less risk. C. Investments with a greater variance in the size of the future payoff generally pay a lower expected return. D. Risk-free investments are the best benchmark for measuring the risk of all investment strategies.

A

Which of the following statements best describes financial markets? A. Financial markets lower the cost and increase the speed of buying and selling financial instruments. B. Financial markets increase the speed of buying and selling, but they also increase the cost since people are earning fees for these transactions. C. Financial markets are a good example of unregulated markets. D. Financial markets today offer fewer instruments than they did in the past.

A

Which of the following statements is most correct? A. Money is wealth but not all wealth is money. B. Money is a means of payment but is not part of wealth. C. In order to be considered part of a person's wealth, an asset must have a positive return. D. Wealth is a store of value and a means of payment.

A

Which of the following statements is most correct? A. Usually higher expected returns are associated with higher risk premiums. B. Usually higher risk premiums are associated with lower expected returns. C. Usually lower expected returns are associated with higher risk premiums. D. Usually expected returns are not associated with risk premiums.

A

Which of the following statements is true? A. Leverage increases expected return and increases risk. B. Leverage increases expected return and reduces risk. C. Leverage decreases expected return but has no effect on risk. D. Leverage decreases expected return and increases risk.

A

Trading in electronic exchanges has grown tremendously in recent years, what are some of the disadvantages of trading in decentralized electronic exchanges?

Electronic operations have proven prone to errors that threaten the existence of brokers. In addition, amid the complex system of multiple, imperfectly linked exchanges, new trading patterns have arisen that render the entire system fragile, raising serious worries among investors about the liquidity and value of their stocks. Efforts to speed up electronic trading drain resources from more efficient uses. To see this point, imagine that an HFT firm relocates its computing facilities closer to an exchange so that it can cut the transmission time for orders by a few microseconds (millionths of a second). The goal of the move is to profit by trading an instant faster than competitors when new information becomes available, such as a stock issuer's quarterly profit statement or the nation's monthly employment report. Yet microsecond gains in trading speed likely diminish the willingness of market makers to provide liquidity because they don't wish to be "picked off" by well-equipped HFTs. Over time, market makers also may be forced to invest heavily to keep up with the faster turnover of stocks, with little gain to the broader economy. Finally, the advent of multiple electronic exchanges and ECNs has not resulted in a single, integrated, and transparent U.S. stock market.

What is the relationship between financial market development and economic growth?

A country's economic growth is linked to financial market development. As the text points out, a country's financial system has to grow as its level of economic activity rises, or the country will stagnate. Economic research has shown that there is strong positive correlation between financial market development and economic growth across countries.

Explain why credit cards are not considered money even though people seem to use them like money.

A credit card isn't money for a few reasons. One, it is not an asset. The use of a credit card actually creates a liability for the user. A credit card is a promise by a bank to lend the cardholder money with which to make purchases. The store supplying the goods being purchased receives money, but the money that is used does not belong to the buyer. The credit card provides the cardholder with access to someone else's money.

An annuity is a contract that makes monthly payments as long as someone lives. Explain why an individual would want to purchase such a contract. What risk is being transferred?

An annuity transfers the risk that the buyer will live longer than expected. If an individual had certainty regarding his/her life expectancy he/she could plan accordingly and set up a budget that would exhaust his/her wealth at the time of death. We do not usually have such certainty and the risk is that we may live longer than we expect and could run out of funds before we die. With an annuity the individual transfers this risk to a company (for a fee) who is pooling many of these individuals and with the "law of large numbers" is better equipped to take this risk.

You do some research and find for a driver of your age and gender the probability of having an accident that results in damage to your automobile exceeding $100 is 1/10 per year. Your auto insurance company will reduce your annual premium by $40 if you will increase your collision deductible from $100 to $250. Should you? Explain.

An increase of a deductible from $100 to $250 exposes you to an out-of-pocket possible loss of $150 when you have an accident. But the chances of incurring this out-of-pocket loss is 1/10(0.10) each year, so we can calculate the expected loss as E.L. = 0.1($150) + 0.9($0) = $15.00. Since this expected loss is less than the $40 in premium savings it makes good sense to increase the deductible.

In the chapter you read that it costs the U.S. Treasury's Bureau of Engraving and Printing around nine cents to print a note (currency), whether that bill is a one-dollar or one-hundred dollar bill. It seems the Treasury could generate a nice profit for the government by simply printing currency and using this currency to purchase the goods and services the government needs. In fact, this seems to be a way to eliminate the problem of budget deficits for the U.S. government. Comment on this idea.

At first it seems the Treasury could buy one hundred dollars worth of goods for an actual cost of less than six cents, the cost of printing the note. Plus the Treasury can avoid having to borrow to finance the difference between tax receipts and expenditures. But what may be profitable for the Treasury can be very harmful to the economy. The printing of this additional currency can have many serious consequences. The additional currency will increase the money supply, which can fuel higher prices, lowering the real purchasing power of money. If the problem becomes large enough it can actually make people reluctant to accept the currency as a means of payment and they would revert to increased use of barter which can make the economy less efficient.

13. If an investment has a 20%(0.20) probability of returning $1,000; a 30%(0.30) probability of returning $1,500; and a 50%(0.50) probability of returning $1,800; the expected value of the investment is: A. $1,433.33 B. $1,550.00 C. $2,800.00 D. $1,600.00

B

A $600 investment has the following payoff frequency: a quarter of the time it will be $0; three quarters of the time it will pay off $1000. Its standard deviation and value at risk respectively are: A. $750; $600 B. $433; $600 C. $0; $1000 D. $433; $1000

B

A coupon bond is a bond that: A. always sells at a price that is less than the face value. B. provides the owner with regular payments. C. pays the owner the sum of the coupons at the bond's maturity. D. pays a variable coupon rate depending on the bond's price.

B

A financial intermediary: A. is an agency that guarantees a loan. B. is a third-party that facilitates a transaction between a borrower and a lender. C. would be used in direct finance. D. must be a depository institution.

B

A primary financial market is: A. located only in New York, London, and Tokyo but can handle transactions anywhere in the world. B. one where the borrower obtains funds directly from the lender for newly issued securities. C. a market where U.S. Treasury bonds are traded. D. one that can only deal in the highest investment grade securities.

B

A risk-averse investor compared to a risk-neutral investor would: A. offer the same price for an investment as the risk-neutral investor. B. require a higher risk premium for the same investment as a risk-neutral investor. C. place more focus on expected return and less on return than the risk-neutral investor. D. place less focus on expected return than the risk-neutral investor.

B

A risk-averse investor versus a risk-neutral investor: A. will never take a risk, while the risk neutral investor will. B. needs greater compensation for the same risk versus the risk neutral investor. C. will take the same risks as the risk neutral investor if the expected returns are equal. D. needs less compensation for the same risk versus the risk neutral investor.

B

A share of Ford Motor Company stock is an example of: A. a non-standardized financial instrument. B. a standardized financial instrument. C. a non-standardized financial instrument since their prices can differ over time. D. a financial instrument without risk.

B

According to the rule of 72: A. any amount should double in value in 72 months if invested at 10%. B. 72/interest rate is the number of years approximately it will take for an amount to double. C. 72 × interest rate is the number of years it will take for an amount to double. D. the interest rate divided by the number of years invested will always equal 72%.

B

An advantage that money has over other assets is that it: A. increases in value over time. B. has lower transaction costs to use as a means of payment than other assets. C. provides a higher return to the owner. D. is a safer asset to hold during times of inflation.

B

An investment will pay $2,000 half of the time and $1,400 half of the time. The standard deviation for this investment is: A. $90,000. B. $300. C. $1,700. D. $30.

B

An investment with a large spread between possible payoffs will generally have: A. a low expected return. B. a high standard deviation. C. a low value at risk. D. both a low expected return and a low value at risk.

B

Checks and currency function similarly, however: A. currency is a more effective means of payment. B. carrying currency entails greater risk, because it cannot be replaced if lost or stolen. C. currency is a better store of value than checking deposits. D. checks are not included in measures of money, whereas currency is.

B

Commissions paid to a stock broker are an example of: A. risk transfer. B. transaction costs. C. information asymmetry. D. liquidity.

B

Compound interest means that: A. you get an interest deduction for paying your loan off early. B. you get interest on interest. C. you get an interest deduction if you take out a loan for longer than one year. D. interest rates will rise on larger loans.

B

Considering the data on real and nominal interest rates for the U.S. from 1979 to 2012, which of the following statements is most accurate? A. The real interest rate remains unchanged over time. B. There have been times when the real interest rate has been negative. C. Nominal interest rates higher in 2000 than they had been at any other point in time. D. The inflation rate is always greater than the real interest rate.

B

Considering the roughly $1.2 trillion in U.S. currency held by the public: A. over 90% of the amount is held in the form of $1 bills. B. more than three-fourths is held in the form of $100 bills. C. over half of the currency held in the form of $20 bills. D. the Federal Reserve distributes the amount equally across all denominations of bills.

B

Considering the value of a financial instrument, the circumstances under which the payment is to be made influence the value because: A. we like uncertain payoffs because this adds to the return. B. payments that are made when we need them the most are more valuable. C. the sooner the payment is to be made the better. D. we know when certain events are going to occur and that is when we want the payment.

B

Countries that lack well-defined property laws and legal structures: A. have large secondary financial markets because the primary markets do not exist. B. will not develop as fast economically as counties with clear property rights and a formal legal system. C. will have much lower transaction costs associated with any level of lending. D. will not have any financial markets at all.

B

Credit: A. probably came into being at the same time as coinage. B. predates coinage by 2,000 years. C. did not exist until the middle ages. D. first became popular due to the writings of Aristotle.

B

Derivatives would include all of the following except: A. options. B. U.S. Treasury securities. C. swaps. D. futures.

B

Financial institutions: A. raise the level of transaction costs relating to borrowing/lending. B. can lower the information asymmetry involved with borrowing/lending. C. decrease the liquidity to savers. D. are required for all financial transactions.

B

Higher savings usually requires higher interest rates because: A. everyone prefers to save more instead of consuming. B. saving requires sacrifice and people must be compensated for this sacrifice. C. higher savings means we expect interest rates to decrease. D. of the rule of 72.

B

How do financial institutions evaluate the creditworthiness of potential borrowers? A. They offer high interest rates because only the best borrowers will be able to afford them. B. They gather information regarding the borrowers' finances. C. They do not evaluate creditworthiness because everyone is treated the same. D. They do not evaluate the creditworthiness because they know the borrower will honor his/her obligation to repay the loan.

B

If an investment offered an expected payoff of $100 with $0 variance, you would know that: A. half of the time the payoff is $100 and the other half it is $0. B. the payoff is always $100. C. half of the time the payoff is $200 and the other half it is $0. D. half of the time the payoff is $200 and the other half it is $50.

B

If the probability of an outcome equals one, the outcome: A. is more likely to occur than the others listed. B. is certain to occur. C. is certain not to occur. D. has unquantifiable risk.

B

In comparing money to a share of Microsoft stock held by an individual, we can say: A. the share of stock is an asset, but money is a liability. B. only the money is a means of payment, but both are stores of value. C. only the money is a means of payment, but both are units of account. D. both the Microsoft stock and the money are liabilities.

B

In investment matters, generally young workers compared to older workers will: A. minimize expected return and focus more on variability. B. be less risk-averse. C. have equal concern for expected return and variability. D. be more risk-averse.

B

In reading the national business news, you hear that mortgage rates increased by 50 basis points. If mortgage rates were initially at 6.5%, what are they after this increase? A. 6.55% B. 7.0% C. 11.5% D. 56.5%

B

In the United States, control of the quantity of money is given to the: A. President. B. Federal Reserve System. C. Bureau of Printing and Engraving. D. Department of the Treasury.

B

Loans made between borrowers and lenders are: A. liabilities to the lenders and assets to the borrowers since the borrower obtains the funds. B. assets to the lenders and liabilities of the borrowers since the promises are made to the lenders. C. not part of either parties' assets or liabilities until the loans are repaid. D. liabilities to both the lenders and the borrowers.

B

Many financial instruments are standardized because: A. it is believed that most parties to a contract do not read them anyway. B. complexity is costly, the more complex a contract, the more it costs to create. C. the standardization of contracts makes them harder to understand. D. it is required by the government.

B

Mary purchases a U.S. Treasury bond; the bond is a(n): A. asset of the U.S. government as well as an asset for Mary. B. liability of the U.S. government and an asset for Mary. C. asset for Mary but not a liability of the U.S. Government. D. asset for the government but a liability for Mary.

B

More detailed financial instruments tend to be: A. less costly because all possible contingencies are covered. B. more costly because it will cost more to create. C. more desirable than less detailed ones, no matter what the price. D. less costly because they can be standardized more easily.

B

Most financial markets in the United States operate under a system: A. without any formal rules or regulation. B. with many rules and regulation to ensure a fair market. C. where it depends on which state where the financial market is located since some states do not have any regulations. D. that is totally controlled by the federal government.

B

Most individuals borrow: A. directly without the use of a financial intermediary. B. using a financial intermediary because it lowers the cost of borrowing. C. using a financial intermediary, but would save money if they financed directly. D. without using financial intermediaries, preferring credit cards.

B

Risk-free investments have rates of return: A. equal to zero. B. with a standard deviation equal to zero. C. that are uncertain, but have a certain time horizon. D. that exhibit a large spread of potential payoffs.

B

Secondary financial markets: A. are financial markets for all financial instruments rated less than investment grade. B. are financial markets where existing securities are bought and sold. C. eliminate the transaction costs for buyers and sellers. D. are only for stock.

B

Spreading risk involves: A. finding assets whose returns are perfectly negatively correlated. B. adding assets to a portfolio that move independently. C. investing in bonds and avoiding stocks during bad times. D. building a portfolio of assets whose returns move together.

B

Sue has a checking account at the First National Bank; her checking account is a(n): A. asset to the bank and a liability to Sue. B. asset to Sue and a liability to the bank. C. asset to Sue but actually a liability to the Federal Reserve. D. liability to Sue until she spends the funds.

B

Sue uses a credit card to purchase a new pair of jeans. Sue is: A. using money to buy her jeans since credit cards is money. B. creating a liability that she will ultimately have to pay with money. C. using an electronic payment form of money. D. using a form of money included in M2.

B

The amount of information an individual would seek before making a decision: A. is about the same across all individuals. B. varies directly with the importance of the decision. C. is the same across all decisions but varies across individuals. D. depends on how much time it will take to get the information regardless of the decision.

B

The central bank of the United States is: A. the Bank of America B. the Federal Reserve System C. the U.S. Treasury D. Citibank

B

The future value of $100 at a 5% per year interest rate at the end of one year is: A. $95.00 B. $105.00 C. $97.50 D. 107.50

B

The greater the standard deviation of an investment the: A. lower the return. B. greater the risk. C. lower the risk. D. lower the risk and return.

B

The high volume of shares of stock that are traded on a normal day on stock markets reflects the: A. high transaction costs associated with these financial markets. B. low transaction costs and high liquidity associated with these markets. C. low transaction costs and low liquidity associated with these markets. D. high transactions costs and low liquidity associated with these markets.

B

The higher the future value of the payment the: A. lower the present value. B. higher the present value. C. future value doesn't impact the present value, only the interest rate really matters. D. lower the present value because the interest rate must fall.

B

The main reason for diversification for an investor is to: A. take advantage of the fact that returns of assets are perfectly positively correlated. B. take advantage of the fact that returns on assets are not perfectly correlated. C. lower transaction costs. D. gain from the greater returns that come from greater risk.

B

The most prominent of asset-backed securities is: A. shares of stock in corporations since stockholders own the assets. B. securities backed by home mortgages. C. U.S. Treasury bonds since they are backed by all public assets. D. movie box-office receipts.

B

The pool of information collected by financial markets is usually: A. only available to lenders. B. summarized in the form of a price. C. valuable and not made available until the parties pay for it. D. more than a borrower needs to make a loan.

B

The present value and the interest rate have: A. a direct relationship; as i increases, pv increases. B. an inverse relationship; as i increases, pv decreases. C. an unclear relationship; whether it is direct or inverse depends on the interest rate. D. no relationship.

B

The primary concern of current critics of fiat money is that: A. fiat money is too costly to produce. B. governments issue too much money threatening its value. C. fiat money is too easy to counterfeit. D. government will issue too little threatening economic growth.

B

The primary function of central banks is to: A. increase risk and volatility to increase compensation. B. control inflation, as well as help reduce the size and frequency of business cycle fluctuations. C. increase the uncertainty that firms face in making investment decisions. D. eliminate the need for banks to collect financial information.

B

The primary use of derivative contracts is: A. for IRA and other pension plans since they only have value well into the future. B. to shift risk among investors. C. for investors seeking a greater return by taking greater risk. D. to add to the profits an investor obtains through information asymmetry.

B

The process of financial intermediation: A. creates a net cost to an economy. B. increases the economy's ability to produce. C. is always used when a borrower needs to obtain funds. D. is used primarily in underdeveloped countries.

B

The store of value characteristic of money refers to the fact that: A. people save most of their money. B. money allows people to shift purchasing power into the future. C. money is not valuable unless it is stored. D. money is the only way people have to store value.

B

The value of $100 left in a certificate of deposit for four years that earns 4.5% annually will be: A. $120.00 B. $119.25 C. $117.00 D. $145.00

B

Which of the following would not be an example of a secondary financial market transaction? A. You call a broker and purchase 100 shares of McDonalds Corp. stock. B. You go to the bank and purchase a $5000 certificate of deposit. C. You call a broker and purchase a U.S. Treasury bond. D. You call a broker and purchase a bond issued by General Motors.

B

Which of the following would not be included in a definition of risk? A. Risk is a measure of uncertainty. B. Risk can always be avoided at no cost. C. Risk has a time horizon. D. Risk usually involves some future payoff.

B

While money is an asset not all assets are money because: A. only money stores value. B. money works as a means of payment. C. only money is a good asset to hold during times of inflation. D. money must be legal tender.

B

You buy an asset for $2500. The asset will return $3300 half of the time and $2700, the other half. The expected return is 20%(a gain of $500) and the standard deviation is 12%($300). How would using $1,250 of borrowed funds change the expected return and standard deviation specifically?

Borrowing 50% of the funds needed to purchase the asset is using leverage. It will double the expected return as well as the standard deviation. For example, if the asset returns the $3,300, the lender will have to be repaid $1,250, but this leaves $2,050 for you. If the asset returns $2,700 the lender still needs to be repaid, leaving $1,450 for you. Since each of these outcomes is equally likely, we can calculate the expected return and standard deviation of leverage. Expected value = ½($2,050) + ½($1,450) = $1,750. The $1,750 expected value on a $1,250 investment is an expected return of 40%. So the expected return doubled using leverage. The standard deviation can also be calculated: sd= SqR .5($2,050-$1,750)^2 + .5($1,450-$1,750)^2 = $300 or 24% of the actual amount invested. So while the expected return doubled, so did the standard deviation.

A bank is a financial intermediary. Which of the following statements is most accurate? A. The bank's depositors are the ultimate lenders and the bank is the ultimate borrower. B. People seeking loans from the bank are the ultimate spenders while the bank is the ultimate lender. C. The bank's depositors are the ultimate lenders, while those seeking loans from the bank are the ultimate spenders. D. Those seeking loans from the bank are the ultimate spenders; the bank's stockholders are the ultimate lenders.

C

A change in the interest rate: A. has a smaller impact on the present value of a payment to be made far into the future than on one to be made sooner. B. will not make a difference in the present values of two equal payments to be made at different times. C. has a larger impact on the present value of a payment to be made far into the future than on one to be made sooner. D. has a larger impact on the present value of a bigger payment to be made far into the future than on one of lesser value.

C

A derivative instrument: A. comes into existence after the underlying instrument is in default. B. is a low-risk financial instrument used by highly risk-averse savers. C. gets its value and payoff from the performance of the underlying instrument. D. should be purchased prior to purchasing the underlying security.

C

A financial instrument would include: A. only a written obligation and a transfer of value. B. only a written obligation and a specified date. C. a written obligation, a transfer of value, a future date, and certain conditions. D. a written obligation, a transfer of value, a specific date for payment, uncertain conditions.

C

A mortgage, where the monthly payments are the same for the duration of the loan, is an example of a(n): A. variable payment loan. B. installment loan. C. fixed payment loan. D. equity security.

C

A portfolio of assets has lower risk than holding one asset, but the same expected return and higher transaction costs. Which of the following statements is most correct? A. The portfolio is attractive to people who are risk-averse and risk-neutral, but not to risk seekers. B. The portfolio is attractive to investors who are risk-neutral. C. The portfolio is not attractive to investors who are risk-neutral. D. The portfolio is attractive to investors who are risk seekers.

C

A share of Microsoft stock would best be described as which of the following? A. A derivative instrument B. A means of payment C. An underlying instrument D. A debt instrument

C

A society without any money: A. could never exchange goods and/or services. B. would find people doing everything for themselves. C. would have to rely on barter. D. would be more efficient since people would be more self-sufficient.

C

Agencies exist which rate bonds based on characteristics of the borrower Such bond rating agencies are an example of a financial market response designed to: A. increase information asymmetry. B. decrease the real return to bondholders. C. provide a lower cost solution to the high cost of information. D. transfer risk from the buyer to the rating agency.

C

All of the following are depository institutions, except: A. commercial banks. B. credit unions. C. insurance companies. D. savings banks.

C

All other factors held constant, an investment: A. with more risk should offer a lower return and sell for a higher price. B. with less risk should sell for a lower price and offer a higher expected return. C. with more risk should sell for a lower price and offer a higher expected return. D. with less risk should sell for a lower price and offer a lower return.

C

An automobile insurance company on average charges a premium that: A. equals the expected loss from each driver. B. is less than the expected loss from each driver. C. is greater than the expected loss from each driver. D. equals 1/(expected loss) of each driver.

C

An individual who is risk-averse: A. never takes risks. B. accepts risk but only when the expected return is very small. C. requires larger compensation when the risk increases. D. will accept a lower return as risk rises.

C

An individual who stores wealth in art rather than money will find that he/she: A. suffers larger real losses during periods of high inflation. B. has far more liquidity than most savers. C. will incur higher transaction costs when he/she ultimately makes purchases. D. will have to resort to barter exchanging the art for desired goods.

C

An investment carrying a current cost of $120,000 is going to generate $50,000 of revenue for each of the next three years. To calculate the internal rate of return we need to: A. calculate the present value of each of the $50,000 payments and multiply these and set this equal to $120,000. B. find the interest rate at which the present value of $150,000 for three years from now equals $120,000. C. find the interest rate at which the sum of the present values of $50,000 for each of the next three years equals $120,000. D. subtract $120,000 from $150,000 and set this difference equal to the interest rate.

C

An investment has grown from $100.00 to $130.00 or by 30% over four years. What annual increase gives a 30% increase over four years? A. 7.50% B. 6.30% C. 6.78% D. 7.24%

C

An investor deposits $400 into a bank account that earns an annual interest rate of 8%. Based on this information, how much interest will he earn during the second year alone? A. $25.60 B. $32 C. $34.56 D. $64

C

An investor practicing hedging would be most likely to: A. avoid the stock market and focus on bonds. B. purchase shares in general motors and buy U.S. treasury bonds. C. purchase shares in general motors and Amoco oil. D. put his/her invested funds in CDs.

C

An investor puts $1,000 into an investment that will return $1,250 one-half of the time and $900 the remainder of the time. The expected return for this investor is: A. $1,075 B. 5.0% C. 7.5% D. 15.0%

C

As inflation increases, for any fixed nominal interest rate, the real interest rate: A. also increases. B. remains the same, that's why it is real. C. decreases. D. decreases by less than the increase in inflation.

C

Brokerage commissions: A. are set by government regulators so they cannot vary across firms for the same services. B. can vary but typically don't because firms tend to set them at the same levels. C. can differ reflecting the different services being offered. D. are always a percentage of the amount of the trade.

C

Comparing a lottery where a $1 ticket purchases a chance to win $1 million with another lottery in which a $5,000 ticket purchases a chance to win $5 billion, we notice many people would participate in the first but not the second, even though the odds of winning both lotteries are the same. We can perhaps best explain this outcome by: A. higher expected value for the lottery paying $1 million. B. higher expected value for the lottery paying $5 billion. C. lower value at risk for the lottery paying $1 million. D. higher value at risk for the lottery paying $1 million.

C

Comparing checks and currency, we can say: A. both are money but only currency is legal tender. B. only checks are both money and legal tender. C. a check isn't money but currency is. D. both are money and legal tender.

C

Consider the price paid for debt issued by the State of California. Which of the following would lead to a decrease in the value of State of California bonds? A. The State of California bonds are in small dollar amounts. B. The State of California bonds have a shorter maturity. C. The State of California experiences a fiscal crisis that makes it less likely it will be able to honor its interest payments. D. The State of California pays back its previous bonds ahead of schedule.

C

Considering the value of a financial instrument, the bigger the size of the promised payment the: A. less valuable the financial instrument because risk must be greater. B. longer an investor has to wait for the payment. C. more valuable the financial instrument. D. greater the risk.

C

Considering the value of a financial instrument, the sooner the promised payment is made: A. the less valuable is the promise to make it since time is valuable. B. the greater the risk, therefore the promise has greater value. C. the more valuable is the promise to make it. D. the less relevant is the likelihood that the payment will be made.

C

Current critics of fiat money are urging governments to do what? A. Return to a system of legal tender. B. Move to a system of electronic transactions only. C. Return to a gold standard. D. Place limits on the creation.

C

Disability Income Insurance is: A. insurance borrowers can take out in case the company they invest in defaults. B. insurance that makes payments of wages to workers when the company they work for is disabled due to a natural disaster. C. insurance that makes payments to workers when they are unable to work due to an injury. D. only available through the government as part of the Social Security System.

C

Diversification is the principle of: A. eliminating risk. B. reducing the risk we carry to just two. C. holding more than one asset to reduce risk. D. eliminating investments from our portfolio that have idiosyncratic risk.

C

Financial instruments are different from money because they: A. can act as a store of value and money cannot. B. can't be a means of payment but money can. C. can allow for the transfer of risk. D. have greater liquidity.

C

Financial instruments used primarily as stores of value do not include: A. asset backed securities. B. U.S. Treasury bonds. C. a car insurance policy. D. a bank loan.

C

Financial intermediaries handle a larger flow of funds than do primary markets primarily because financial intermediaries: A. have a government-provided monopoly. B. have government-regulated prices, so there is little competition. C. can lower transaction costs and increase liquidity for savers. D. do not have to worry about information asymmetry.

C

From the Fisher equation we see that the nominal interest rate and expected inflation have: A. an inverse relationship. B. a relationship which is direct but less than one-to-one. C. a relationship which is direct and one-to-one. D. no relationship.

C

Identify which item is not one of the six parts of the financial system. A. Financial markets B. Central banks C. Credit cards D. Financial institutions

C

If ABC Inc. and XYZ Inc. have returns that are perfectly positively correlated: A. adding XYZ Inc. to a portfolio that consists of only ABC Inc. will reduce risk. B. adding ABC Inc. to a portfolio that includes only XYZ Inc. will increase risk. C. adding XYZ Inc. to a portfolio that consists of only ABC Inc. will neither increase nor decrease the risk of the portfolio. D. adding XYZ Inc. to a portfolio that consists of only ABC Inc. will neither increase nor decrease idiosyncratic risk but will lower systematic risk.

C

If a bond has a face value of $1000 and a coupon rate of 4.25%, the bond owner will receive annual coupon payments of: A. $425.00 B. $4.25 C. $42.50 D. a value that cannot be determined from the information provided.

C

If a fair coin is tossed, the probability of coming up with either a head or a tail is: A. ½ or 50 percent. B. Zero. C. 1 or 100 percent. D. Unquantifiable.

C

If a lender wants to earn a real interest rate of 3% and expects inflation to be 3%, he/she should charge a nominal interest rate that: A. is at least 7%. B. is anything above 0%. C. equals the real rate desired plus expected inflation. D. equals the real rate desired less expected inflation.

C

If a saver has a positive rate of time preference then the present value of $100 to be received 1 year from today is: A. more than $100. B. not calculable. C. less than 100. D. unknown to the saver.

C

If an investment will return $1,500 half of the time and $700 half of the time, the expected value of the investment is: A. $1,250. B. $1,050. C. $1,100. D. $2,200.

C

If the interest rate is zero, a promise to receive a $100 payment one year from now is: A. more valuable than receiving $100 today. B. less valuable than receiving $100 today. C. equal in value to receiving $100 today. D. equal in value to receiving $101 today.

C

If the returns of two assets are perfectly positively correlated, an investor who puts half of his/her savings into each will: A. reduce risk. B. have a higher expected return. C. not gain from diversification. D. reduce risk but lower the expected return.

C

In a barter economy with "n" number of goods there will always be: A. exactly "n" relative prices. B. fewer than "n" relative prices. C. more than "n" relative prices. D. "n/2" relative prices.

C

In a barter system people: A. have to specialize in order to have goods to trade. B. cannot specialize because they never know what goods will be desired. C. are less likely to specialize as extensively as they would in a monetary economy. D. must be self sufficient.

C

In comparing money to a U.S. Treasury bond held by an individual, we can say: A. the treasury bond is an asset but money is not. B. money is an asset but the U.S. bond is a liability of the individual. C. both are stores of value. D. money is a store of value but the bond is not.

C

In countries with low inflation: A. M2 growth is a very strong forecaster of inflation. B. there tends to be a greater reliance on checks than electronic payments. C. M2 growth is a poor forecaster of inflation. D. money stocks are a larger percentage of GDP.

C

Investment A pays $1,200 half of the time and $800 half of the time. Investment B pays $1,400 half of the time and $600 half of the time. Which of the following statements is correct? A. Investment A and B have the same expected value, but A has greater risk. B. Investment B has a higher expected value than A, but also greater risk. C. Investment A and B have the same expected value, but A has lower risk than B. D. Investment A has a greater expected value than B, but B has less risk.

C

Leverage: A. reduces risk. B. is synonymous with risk-free investment. C. increases expected rate of return. D. leads to smaller changes in the investment's price.

C

Loans made between borrowers and lenders are: A. usually not taxable at the federal level. B. legal only in the state of origination. C. assets of the lenders. D. assets of the borrowers.

C

Mutual funds have: A. been created for very wealthy individuals with a lot of money to invest. B. increased the risks associated with constructing a portfolio. C. reduced the costs associated with gathering information on stocks and bonds. D. increased the transactions costs associated with participating in financial markets.

C

Small savers would rather use financial institutions than lend directly to borrowers because: A. financial institutions will offer the savers higher interest rates than the savers could obtain directly from borrowers. B. lenders wouldn't want to deal with small savers. C. it allows them to diversify risk. D. the liquidity is lower with financial institutions but the return is higher.

C

Specialization usually increases the output of a country; however effective specialization requires: A. everyone in the country producing the same thing. B. that workers have very similar skills. C. an effective low-cost means to exchange goods and services. D. a large stock of capital.

C

Standardization of financial instruments has occurred as a result of: A. the rule of 70. B. the law of demand. C. economies of scale. D. the law of supply.

C

Stock prices are: A. set by the company issuing the stock. B. set by the central bank. C. determined by market transactions. D. unrelated to the value of the company issuing the stock.

C

Studying money and banking through five core principles is helpful because: A. studies have shown students have a difficult time remembering more than five topics. B. everything in economics can be reduced to five core principles. C. money and banking can undergo drastic changes overtime, but the five principles do not. D. these five principles are understood by everyone.

C

Suppose Mary receives an $8,000 loan from First National Bank. Mary repays $8,480 to First National Bank at the end of one year. Assuming the simple calculation of interest, the interest rate on Mary's loan was: A. 8.00% B. $480 C. 6.00% D. 5.66%

C

Systematic risk: A. is the risk eliminated through diversification. B. represents the risk affecting a specific company. C. cannot be eliminated through diversification. D. is another name for risk unique to an individual asset.

C

The Consumer Price Index (CPI) is: A. an example of an index that uses variable expenditure weights. B. a fixed-expenditure-weight index used to measure changes in the GDP Deflator. C. a fixed-expenditure-weight index used to measure changes in purchasing power for households. D. the least commonly used measure of inflation.

C

The U.S. Treasury estimates that the fraction of U.S. currency held outside the United States is: A. about one-fourth. B. about half. C. between two-thirds and three-quarters. D. less than 10%.

C

The difference between standard deviation and value at risk is: A. nothing, they are two names for the same thing. B. value at risk is a more common measure in financial circles than is standard deviation. C. standard deviation reflects the spread of possible outcomes where value at risk focuses on the value of the worst outcome. D. value at risk is expected value times the standard deviation.

C

The expected value of an investment: A. is what the owner will receive when the investment is sold. B. is the sum of the payoffs. C. is the probability-weighted sum of the possible outcomes. D. cannot be determined in advance.

C

The fact that U.S. currency is legal tender means: A. U.S. currency is good anywhere in the world. B. the only money the government will accept for settlement of debts is U.S. currency. C. private businesses in the U.S. and the U.S. government must accept currency for payment. D. it cannot be backed by gold or other metals.

C

The fact that not everyone places all of his/her savings in U.S. Treasury bonds indicates that: A. most investors are not risk averse. B. many investors are actually risk seekers. C. even risk-averse people will take risk if they are compensated for it. D. most people are risk-neutral.

C

The fact that over the long run the return on common stocks has been higher than that on long-term U.S. Treasury bonds is partially explained by the fact that: A. A lot more money is invested in common stocks than U.S. Treasury bonds. B. There are regulations on the interest rates U.S. Treasury bonds can offer. C. The risk premium is higher on common stocks. D. Risk-averse investors buy more common stock.

C

The fundamental characteristics influencing the value of a financial instrument include each of the following except: A. the size of the payment promised. B. when the promised payment will be made. C. where the instrument is traded. D. the likelihood of payment.

C

The future value of $100 that earns 10% annually for n years is best expressed by which of the following? A. $100(0.1)n B. $100 × n × (1.1) C. $100(1.1)n D. $100/(1.1)n

C

The high transaction costs associated with a barter system refers to the: A. fact that, often times, these exchanges are taxed by governments. B. risk associated with having to carry an inventory of goods to trade. C. high cost associated with finding someone with whom to exchange. D. cost of drawing up complete contracts.

C

The information concerning the issuer of a financial instrument: A. needs to be complete and closely monitored by the buyers of the instrument for change. B. is somewhat non-standardized to minimize the cost of the instrument. C. is usually standardized to the essential information required by the buyers. D. is closely monitored by the buyers of these instruments for change.

C

The interest rate that equates the price of a bond with the present value of its payments: A. will vary directly with the value of the bond. B. should be the one that makes the value equal to the par value of the bond. C. will vary inversely with the value of the bond. D. should always be greater than the coupon rate.

C

The internal rate of return of an investment is: A. the same as return on investment. B. zero when the present value of an investment equals its cost. C. the interest rate that equates the present value of an investment with its cost. D. equal to the market rate of interest when an investment is made.

C

The money aggregate M1 includes each of the following, except: A. currency in the hands of the public. B. travelers checks that have been issued. C. currency in the vaults of commercial banks. D. demand deposits at commercial banks.

C

The price of a coupon bond is determined by: A. taking the present value of the bond's final payment and subtracting the coupon payments. B. taking the present value of the coupon payments and adding this to the face value. C. taking the present value of all of the bond's payments. D. estimating its future value.

C

The purchasing power of money: A. rises when inflation rises. B. decreases as the price level decreases. C. decreases with inflation. D. is not impacted by inflation, only by monetary policy.

C

The risk premium for an investment: A. is negative for U.S. treasury securities. B. is a fixed amount added to the risk-free return, regardless of the level of risk. C. increases with risk. D. is zero (0) for risk-averse investors.

C

The rule of 72 says that at 6% interest $100 should become $200 in about: A. 72 months B. 100 months C. 12 years D. 7.2 years

C

The standard deviation is generally more useful than the variance because: A. it is easier to calculate. B. variance is a measure of risk, where standard deviation is a measure of return. C. standard deviation is calculated in the same units as payoffs and variance isn't. D. it can measure unquantifiable risk.

C

The statement "risk requires compensation" implies that people: A. do not take risk. B. only accept risk when they absolutely have to. C. will only accept risk when they are rewarded for doing so. D. avoid risk at all cost.

C

The ultimate role of the financial system of a country is to: A. provide a place for wealthy households to save. B. be a low-cost source of funds for government. C. facilitate production, employment, and consumption. D. provide jobs in the financial sector.

C

The unit of account characteristic of money: A. makes it difficult to compare the relative prices of goods and services. B. refers to how we use money to transfer purchasing power over time. C. means prices are expressed in terms of money. D. means that money finalizes payments.

C

The value of fiat money: A. comes from its intrinsic value. B. is worth more as a commodity than its value as money. C. comes from government decree. D. means that it is more desirable than currency.

C

The value of money as a means of payment: A. is independent of changes in the amount of money in the economy. B. is fixed once relative prices are set. C. depends on the amount of money in the economy, among other things. D. depends on whether the majority of M1 is in currency or demand deposits.

C

Today the primary distinction between direct and indirect finance is in: A. direct finance the asset holder has a claim on a financial institution while in indirect finance the asset holder has a direct claim on the borrower. B. indirect finance the lender has a direct claim on the borrower while in direct finance the lender has a claim on a financial institution. C. direct finance the asset holder has a direct claim on the borrower while in indirect finance the asset holder has a claim on a financial institution. D. indirect finance the asset holder has a claim on the government while in direct finance the asset holder has a direct claim on a private sector corporation.

C

Tom obtains a car loan from Old Town Bank. A. The car loan is Tom's asset and the bank's liability. B. The car loan is Tom's asset, but the liability belongs to the bank's depositors. C. The car loan is Tom's liability and an asset for Old Town Bank. D. The car loan is Tom's liability and a liability of the bank until Tom pays it off.

C

Uncertainties that are not quantifiable: A. are what we define as risk. B. are factored into the price of an asset. C. cannot be priced. D. are benchmarks against which quantifiable risks can be assessed.

C

Up to what amount would a risk-neutral gambler pay to enter a game where on the flip of a fair coin, if you call the correct outcome the payoff is $2,000? A. More than $1000 but less than $2000. B. Up to $2,000. C. Up to $1,000. D. More than $1,500.

C

Which of the following best expresses the payment a saver receives for investing their money for two years? A. PV + PV B. PV + PV(1 + i) C. PV(1 + i)2 D. 2PV(1 + i)

C

Which of the following best expresses the present value of $500 that you have to wait four years and three months to receive? A. ($500/4.25) × (1 + i) B. $500 × 4.25 × (1 + i) C. $500/(1 + i)4.25 D. ($500/4) × (1 + i)3

C

Which of the following best expresses the proceeds a lender receives from a one-year simple loan when the annual interest rate equals i? A. PV + i B. FV/i C. PV(1 + i) D. PV/i

C

Which of the following financial instruments is used mainly to transfer risk? A. Asset-backed securities B. Bonds C. Options D. Stocks

C

Which of the following investment strategies involves generating a higher expected rate of return through increasing risk? A. Diversifying B. Hedging risk C. Leverage D. Value at risk

C

Which of the following is likely to be a primary financial market transaction? A. You cash the check your grandmother sent you for your birthday. B. You call a broker and purchase bonds for your retirement fund. C. A city issues bonds to finance new road construction. D. A supermarket needs to borrow the funds for a second location and takes out a loan from a commercial bank to pay for it.

C

Which of the following is not a financial intermediary? A. A bank B. An insurance company C. The New York Stock Exchange D. A mutual fund

C

Which of the following statements best describes financial instruments? A. All financial instruments are a means of payment. B. Financial instruments can transfer resources between people but not risk. C. Financial instruments can transfer resources and risk between people. D. Financial instruments can transfer risk but not resources between people.

C

Which of the following statements is correct? A. If you can buy the same goods this year as you bought last year with less money there must have been inflation. B. If purchasing the same goods today that were purchased one year ago requires more money, there must have been deflation. C. If purchasing the same goods today as one year ago requires less money, the money supply likely decreased. D. If purchasing the same goods today as one year ago requires less money, the money supply likely increased.

C

Which of the following would not be considered a characteristic of money? A. It is a store of value. B. It is a means of payment. C. It must have intrinsic value. D. It is a unit of account.

C

Without the use of money, workers in an economy would: A. become more specialized B. have to spend a lot less time trading C. probably specialize less D. be far more productive

C

he expected return from a portfolio made up equally of two assets that move perfectly opposite of each other would have a standard deviation equal to: A. 1.0 B. -1.0 C. 0.0 D. 0.5

C

What distinguishes commodity money from fiat money?

Commodity money, such as gold or silver, has value even if it is not used as money. For example, gold coins could be melted down and converted to jewelry. Fiat money, such as U.S. paper currency really has no value other than its use as money. Its value derives from the fact that it is deemed to be legal tender by the U.S. government and along with people's willingness to accept it.

Explain why the Fisher equation is not highly accurate at high rates of inflation. Use an example.

Consider a lender who loans $100 for a year, in an environment of 10% inflation. If the lender wants to earn a real interest rate of 2%, the Fisher equation says he/she should charge a nominal interest rate of 12.0%. The reality is, however, that the lender wanted to have 2% more purchasing power at the end of the loan. Since inflation also impacts the interest earned, we can calculate the actual interest rate he/she needs to charge by realizing that if the lender wanted $2.00 more purchasing power per hundred dollars loaned, we can take $102 and multiply this by 1 + the rate of inflation or 1.1. $102 × 1.1 = $112.20. Thus he/she really needs to charge a nominal interest rate of 12.2% or slightly more than the 12.0% of the Fisher equation.

A collection of assets is known as a(n): A. asset-backed security. B. derivative. C. futures contract. D. portfolio.

D

A counterparty to a financial instrument is always the: A. issuer of the financial instrument. B. government agency guaranteeing the value of the instrument. C. person or institution that purchases the financial instrument. D. person or institution that is on the other side of the financial contract.

D

A cross-country analysis of money growth supports the conclusion that: A. there is no correlation between the growth rate of the quantity of money and the rate of inflation. B. the correlation between the money growth rate and inflation in most countries was positive but very small. C. the correlation between inflation and money growth in most industrialized countries was actually negative. D. the correlation between inflation and the money growth rate was positive and relatively strong.

D

A lender is promised a $100 payment (including interest) one year from today. If the lender has a 6% opportunity cost of money, he/she should be willing to accept what amount today? A. $100.00 B. $106.20 C. $96.40 D. $94.34

D

A primary financial market is: A. a market just for corporate stocks. B. a market only for AAA rated Securities. C. the New York Stock Exchange. D. one in which newly issued securities are sold.

D

A risk-averse investor will: A. always accept a greater risk with a greater expected return. B. only invest in assets providing certain returns. C. never accept lower risk if it means accepting a lower expected return. D. sometimes accept a lower expected return if it means less risk.

D

An investment grows from $100.00 to $150.00 or 50% over five years. What annual increase gives a 50% increase over five years? A. 12.00% B. 10.00% C. 9.25% D. 8.45%

D

An investment pays $1000 three quarters of the time, and $0 the remaining time. Its expected value and variance respectively are: A. $1,000: 62,500 dollars2 B. $750; 46,875 dollars C. $750; 62,500 dollars D. $750; 187,500 dollars2

D

An investment will pay $2000 a quarter of the time; $1,600 half of the time and $1,400 a quarter of the time. The standard deviation of this asset is: A. $600 B. $1,650 C. $47,500 D. $217.94

D

An investor puts $2,000 into an investment that will pay $2,500 one-fourth of the time; $2,000 one-half of the time, and $1,750 the rest of the time. What is the investor's expected return? A. 12.5% B. $250.00 C. 6.25% D. 3.125%

D

An investor who diversifies by purchasing a 50-50 mix of two stocks that are not perfectly positively correlated will find that the standard deviation of the portfolio is: A. the sum of the standard deviations of the two individual stocks. B. greater than the sum of the standard deviations of the individual stocks. C. greater than the standard deviation from holding the same balance in only one of these stocks. D. less than the standard deviation from holding the same balance in only one of these stocks.

D

An over-the-counter (OTC) market is: A. made up of dealers who only sell government bonds. B. an example of a centralized market. C. made up of dealer who buy and sell only for their own accounts. D. made up of dealers who buy and sell for their customers and for their own accounts.

D

Ava buys a $2,000 computer using a paper check. At which step does $2,000 get recorded in M1? A. When Ava hands the $2,000 check to the computer merchant. B. Once the $2000 is credited to the merchant bank's reserve account and is debited from Ava's bank account. C. Once the Federal Reserve sends the paper check (or an electronic image) to Ava's bank. D. The check is never M1. The $2000 is M1 both in Ava's bank account and, later, in the merchant's account. It is the deposit balance that is counted.

D

Diversification can eliminate: A. all risk in a portfolio. B. risk only if the investor is risk averse. C. the systematic risk in a portfolio. D. the idiosyncratic risk in a portfolio.

D

Financial intermediaries pool funds of: A. many small savers and provide it to a few large borrowers. B. few large savers and provide it to many small borrowers. C. few large savers a few large borrowers. D. many small savers and provide it to many borrowers.

D

Gold would be a superior commodity money compared to wheat because: A. wheat has a high value relative to weight, which gold does not. B. it is easier to divide wheat into small units. C. wheat has more practical uses than gold. D. wheat is perishable.

D

Gross Domestic Product in the U.S. is roughly: A. equal to M1. B. twice as large as M2. C. equal to M2. D. more than five times M1.

D

Identify which of the following is not one of the five core principles of money and banking. A. Risk requires compensation B. Time has value C. Information is the basis for decisions D. Stability creates risk

D

If financial markets didn't exist: A. required returns would be lower since fewer instruments would trade. B. liquidity would diminish and returns would be lower. C. more funds would flow directly between borrowers and savers. D. liquidity would diminish, reducing the flow of funds between borrowers and savers.

D

If the probability of an outcome is zero, you know the outcome is: A. more likely to occur. B. certain to occur. C. less likely to occur. D. certain not to occur.

D

In comparing money to a U.S. Treasury bond held by an individual, we can say: A. both are legal tender. B. both are units of account. C. only the bond is legal tender since it is an obligation of the U.S. government. D. both are stores of value.

D

Inflation presents risk because: A. inflation is always present. B. inflation cannot be measured. C. there are different ways to measure it. D. there is no certainty regarding what inflation will be in the future.

D

Investing in a mutual fund made up of hundreds of stocks of different companies is an example of all of the following except: A. spreading risk. B. diversifying. C. risk reduction. D. increasing the variance of a portfolio.

D

Loans made between lenders and borrowers are: A. assets to the borrowers. B. liabilities of the lenders. C. not taxable in the state of origination. D. liabilities of the borrowers.

D

Mary deposits funds into a CD at her bank. The CD has an annual interest of 4.0%. If Mary leaves the funds in the CD for two years she will have $540.80. Assuming no penalties for withdrawing the funds early, what amount would Mary have at the end of one year? A. $521.60 B. $490.00 C. $500.00 D. $520.00

D

Money as a means of payment refers to: A. only actual currency. B. only coins and currency. C. only coins, currency and credit cards. D. anything that is generally accepted as payment for goods and services.

D

Money markets are where trades occur for: A. stocks. B. bonds of all maturities. C. derivatives. D. short-term bonds issued by both governments and private companies.

D

Most of the non-cash retail payments made each year in the United States are made by: A. check. B. credit card. C. debit card. D. electronic funds transfers.

D

Non-depository institutions would include all of the following except: A. finance companies. B. pension funds. C. insurance companies. D. credit unions.

D

Nondepository institutions: A. do not serve as intermediaries. B. only serve as brokers. C. only transform assets. D. do not accept deposits.

D

One advantage of using checks over a debit card is: A. checks can be replaced if lost or stolen, a debit card cannot. B. the bank is responsible if someone steals your checks and uses them; this isn't the case with debit cards. C. a cancelled paper check is the only generally accepted proof of payment. D. the person has "float," meaning time between writing the check and depositing funds to cover it.

D

One major difference between a debit card and a credit card is: A. only the debit card helps you to build a credit history. B. the debit card has lower minimum monthly payments. C. you do not need to actually have the funds in your account when you use a debit card. D. debit cards have no late fees.

D

Over-the-counter (OTC) markets: A. employ specialists to minimize price volatility. B. are centralized exchanges but you must be a dealer to be part of an exchange. C. only deal in the stocks of companies with over $100 million in capital. D. are networks of security dealers linked electronically.

D

Professional gamblers know that the odds are always in favor of the house (casinos). The fact that they gamble says they are: A. irrational. B. risk-neutral. C. risk-averse. D. risk seekers.

D

Reasons for the rapid structural change in financial markets in recent years include all of the following except: A. globalization. B. technological advances in computing. C. technological advances in communication. D. high real interest rates.

D

Sophia receives a $400 gift card for her campus bookstore from her parents. Which of the following is true regarding the $400 gift card? A. It is counted only in M1. B. It is included in both M1 and M2. C. It is counted in only M2. D. Stored-value cards are not counted in either M1 or M2.

D

Suppose that Fly-By-Night Airlines Inc., has a return of 5% twenty percent of the time and 0% the rest of the time. The expected return from Fly-By-Night is: A. 10%. B. 0.1%. C. 0.2%. D. 1.0%.

D

Suppose that in a barter economy Tom bakes bread and Hans produces chocolates. Tom wants chocolates but Hans doesn't like bread, so Hans is unwilling to trade with Tom. Tom's problem is an example of which problem associated with a barter system? A. Too much specialization B. Not enough prices C. The law of diminishing returns D. The double coincidence of wants problem

D

The better the information provided to financial markets the: A. less the amount of funds transferred between savers and borrowers. B. greater the amount of funds transferred between savers and borrowers though risk increases. C. higher the return required by lenders. D. greater will be the flow of funds in these markets.

D

The future value of $200 that is left in account earning 6.5% interest for three years is best expressed by which of the following? A. $200(1.065) × 3 B. $200(1.065)/3 C. $200(1.065)n D. $200(1.065)3

D

The largest regulatory change in U.S. financial markets since 1930 is known as: A. Basel III. B. the Fred-Bob Act. C. the Gramm-Leach-Bliley Act. D. the Dodd-Frank Act.

D

The measure of risk that focuses on the worst possible outcome is called: A. expected rate of return. B. risk-free rate of return. C. standard deviation of return. D. value at risk.

D

The money aggregate M2 includes: A. large denomination time deposits. B. stock and bond mutual fund shares. C. savings deposits but not money market deposit accounts. D. M1.

D

The most commonly quoted monetary aggregate is: A. money-market mutual fund shares. B. M1 since it is the most liquid. C. public currency. D. M2 since its movement is most closely related to interest rates and economic growth.

D

The owner of a small business applies for a bank loan and tells the loan officer that the funds will be used to expand inventory for the upcoming holiday season. The small business finds itself in need of additional funds to meet the monthly rent for the next quarter and the owner uses the loan proceeds to pay the rent. This is an example of: A. liquidity risk. B. default risk. C. a lack of diversification for the bank. D. information asymmetry.

D

The value of $100 left in a savings account earning 5% a year, will be worth what amount after ten years? A. $150.00 B. $160.50 C. $159.84 D. $162.89

D

Unique risk is another name for: A. market risk. B. systematic risk. C. the risk premium. D. idiosyncratic risk.

D

Usually an investment will be profitable if: A. the internal rate of return is less than the cost of borrowing. B. the cost of borrowing is equal to the internal rate of return. C. it is financed with retained earnings. D. the cost of borrowing is less than the internal rate of return.

D

When an individual obtains a car loan and makes all of the regular monthly payments, the sum of the payments made will exceed the purchase price of the car. This is due primarily to the core principle: A. risk requires compensation. B. information is the basis for decisions. C. markets determine prices and allocate resources. D. time has value.

D

Which of the following individuals is least likely to use value at risk as an important factor in his/her investment decision? A. An individual considering a mortgage to buy his first home. B. A family considering purchasing health insurance. C. A policy maker considering regulation of depository institutions. D. A mutual fund manager choosing the allocation of investments in the fund's portfolio.

D

Which of the following is necessarily true of coupon bonds? A. The price exceeds the face value. B. The coupon rate exceeds the interest rate. C. The price is equal to the coupon payments. D. The price is the sum of the present value of coupon payments and the face value.

D

Which of the following statements is incorrect? A. If you can buy the same goods this year as you bought last year with less money there must have been deflation. B. If you can buy the same goods this year as you purchased one year ago with the same amount of money, prices are stable. C. If purchasing the same goods today that were purchased one year ago requires more money, there must have been inflation. D. If you can buy the same goods this year as you bought last year with the same money there must have been deflation.

D

nvestment A pays $1,200 half of the time and $800 half of the time. Investment B pays $1,400 half of the time and $600 half of the time. Which of the following statements is correct? A. Investment A and B have the same expected value, but A has greater risk. B. Investment B has a higher expected value than A, but also greater risk. C. Investment A has a greater expected value than B, but B has less risk. D. None of the statements are correct.

D

The role of financial markets

Liquidity, Information, Risk Sharing

Why didn't the over-the-counter (OTC) exchanges suffer the disruption of service that the New York Stock Exchange did after the terrorist attacks of September 11, 2001?

The New York Stock Exchange is a centralized exchange, meaning it is one physical location. Since it was located in New York near the World Trade Center it had to close as it was impossible for people to get into the area. The OTC exchange on the other hand is electronic networks where each dealer is linked electronically to other dealers. As a result, the bombing in New York certainly disrupted the ability of some New York dealers to trade, but the remainder of the exchange continued to function.

Compute the interest rate for a $1,000 face value a bond that sells for $280 and matures in 20 years. The bond has no coupon payments, only the face value payment.

Using a financial calculator and inserting $280 for the present value, $1,000 for the future values, 20 for n, and solving for i, we can compute this to be 6.57%.

You are considering purchasing a home. You find one that you like but you realize that you will need to obtain a mortgage for $100,000. The mortgage company presents you with two options: a 15-year mortgage at a 6.0% annual rate and a 30-year mortgage at a 6.5% annual rate. What will be the fixed annual payment for each mortgage?

Using a financial calculator or a spreadsheet we can determine the 15-year mortgage will require annual payments of $10,296.28; the 30-year mortgage will require annual payments in the amount of $7,657.74.

Explain why countries with high and volatile inflation rates are likely to have volatile nominal interest rates.

Using the Fisher equation (that says the nominal interest rate equals the sum of the real interest rate and the expected rate of inflation), a country where inflation is volatile will have lenders adding a high expected inflation component, thus raising the nominal interest rate. The higher volatility of nominal interest rates is directly the result of the volatility in the inflation rate

five core principles of money and banking

(1) Time has value (2) Risk requires compensation (3) Information is the basis for decisions (4) Markets determine prices and allocate resources (5) Stability improves welfare

3 Characteristics of money

(1) means of payment (2) unit of account (3) store of value

Consider the following two investments. One is a risk-free investment with a $100 return. The other investment pays $2000 20% of the time and a $375 loss the rest of the time. Based on this information, answer the following: (i) Compute the expected returns and standard deviations on these two investments individually. (ii) Compute the value at risk for each investment. (iii) Which investment will risk-averse investors prefer, if either? Which investment will risk- neutral investors prefer, if either?

(i) The expected rate of return is $100 for the risk-free investment. The risk-free investment has a standard deviation of zero because the return is certain. For the risky investment: Expected return = 0.2($2000) + 0.8(-$375) = $100 Standard Deviation = 0.2 * (2000 - 100)2 + 0.8 * (-375 - 100)2 = 902500 = 950 (ii) The value at risk for the risk-free investment is $100 because it pays a certain return. The value of risk for the risky investment is -$375, this is the maximum amount the investor can lose. (iii) The risk-averse investor will prefer the risk-free investment. The risk-neutral investor will not have a preference between the two investments because they pay the same expected return.

Calculate the expected value, the expected return, the variance and the standard deviation of an asset that requires a $1000 investment, but will return $850 half of the time and $1,250 the other half of the time.

Expected value is = 0.5($850) + 0.5($1,250) = $1,050 Expected return = $1,050/$1,000 = 0.05 or 5.0% Variance = 0.5(850 - 1,050)2 + 0.5(1,250 - 1,050)2 = 40,000 dollars2 Standard deviation = the square root of the variance or in this case = $200

An investment grows from $2,000 to $2,750 over the period of 10 years. What average annual growth rate will produce this result?

First we determine the overall percentage change in the investment is 37.5%, [(2750 - 20000/2000] × 100 = 37.5. Next, we ask what annual growth rate over 10 years produces this result? We can determine this by using the following: (1 + i)10 = (1.375); which with a little manipulation turns into: i = (1.375)1/10 - 1; which says i = .03236, or an annual growth rate of 3.24% produces this result. Notice this is different than the answer you would obtain by simply dividing 37.5% by 10.

Has M2 always been a useful tool for forecasting inflation? Explain.

From 1960 to 1980 it seemed that growth of M2 was a good tool to forecast inflation, with a two-year lag; in fact the correlation was over 0.5. For the years 1990 to 2013 this does not seem to be the case, in fact the correlation was 0. There is no clear explanation for why the growth of M2 has ceased being a good forecast tool for inflation, but there are some ideas economists are researching.

Have the growth rates of the two measures of money moved together over time? Explain.

From 1960 to 1980 the growth rates of the two money measures did move together. After 1980 M1 behaved very differently than M2. The main reason for this seems to be the high rates of inflation that began in the late 1970s and fostered innovation into other types of accounts that people could hold to earn a higher return and yet were relatively liquid, such as money market accounts.

Briefly discuss the relationship between present value and each of the following: a) future value b) time c) interest rate

Holding time and interest rate constant, any percentage change in the future value will cause the same percentage change in the present value. Holding the future value and the interest rate constant, and increase in the time until payment reduces the present value and any decrease in time increases the present value. Holding future value and time constant, an increase in the interest rate reduces the present value and a decrease in the interest rate increases the present value.

Discussions in recent years about the vulnerability of the Social Security System cause some people to feel the payments promised will not materialize. Discuss the possible changes we might observe now.

If people working now begin to question the viability of Social Security and yet if they want to retire at the planned age and keep their lifestyle during retirement, they will have to increase saving now. The idea is that people will need to build a larger fund at the time of retirement and to do this will require they decrease their current consumption. If people do not alter their saving, they either believe that Social Security will honor their payments and/or they plan on reducing their consumption during retirement.

Explain how money solves the problem of the "double coincidence of wants."

In an economy that does not rely on the use of money, if people are going to specialize at all they have to resort to barter, which is the exchange of one good or service for another. In the situation of barter, it may be likely that the individual who has what the other person wants will not want what the other person has. In this case multiple trades may be necessary to ultimately obtain what is desired. With the use of money, since everyone generally accepts it, one exchange will suffice. In reality you can say that money creates an immediate double coincidence of wants.

Consider an individual who plans to buy a new home. He has two options: (i) pay for mortgage insurance (that insures the lender in case the borrower defaults), or (ii) pay the lender a higher interest rate for the mortgage. Describe how these two options are related to the concept of risk premium and the lender's aversion to risk. Why does the interest rate on the mortgage differ in these two options?

In option (ii), the risk premium on the mortgage is positive because the lender realizes there is some risk in the homeowner's ability to repay the loan. Therefore, the borrower will have to pay the risk premium in order to obtain a mortgage from the lender. If the home owner takes option (i), he pays no premium to the lender. This is because the policy holder is paying someone else to take the risks associated with the mortgage. This is why the borrower will not need to pay a risk premium to the lender in option (i). If the borrower pays a risk premium to the mortgage lender, the lender takes on the risk (option i). If the borrower pays for insurance, then the insurance company takes the risk (option ii).

Identify at least three possible sources for a risk an individual may face in planning for retirement.

In planning for retirement an individual faces at least the following uncertainties: Life span, there is uncertainty regarding how long an individual's life will be. Unexpected inflation, no one knows what the inflation rate will be in the future. This makes earning a targeted real return difficult. Health problems or other unforeseen contingencies can use up funds that were being set aside for retirement.

Compute the expected return, standard deviation, and value at risk for each of the following investments: Investment (A): Pays $800 three-fourths of the time and a $1200 loss otherwise. Investment (B): Pays $1000 loss half of the time and a $1600 gain otherwise. State which investment will be preferred by each of the following investors, and explain why. (i) a risk-neutral investor. (ii) an investor who seeks to avoid the worst-case scenario. (iii) a risk-averse investor.

Investment (A) Expected return = 0.25(-$1200) + 0.75($800) = $300 Standard Deviation = sqrt[0.25 * (-1000 - 300)2 + 0.75 * (800 - 300)2 ] = 750000 = 866 Value at Risk = -$1200 Investment (B) Expected return = 0.5(-$1000) + 0.5($2000) = $500 Standard Deviation = sqrt[0.5 * (-1000 - 500)2 + 0.5 * (1600 - 500)2 ] = sqrt[1690000] = 1300 Value at Risk = -$1000 (i) The risk-neutral investor is indifferent between these two investments because they pay the same expected return. (ii) The investor who seeks to avoid the worst-case scenario will choose Investment (B) because it has the lower value at risk. (iii) The risk-averse investor will prefer Investment (A) because it has a lower standard deviation. This suggests that there is less uncertainty about the expected return relative to Investment (B).

What was the double liquidity shock that occurred in the U.S. financial system in the summer of 2007?

Investors began to doubt the value of a wide class of securities so market liquidity for those instruments disappeared and financial institutions that held them faced large losses. In turn, funding liquidity for these institutions dried up as the potential losses caused their lenders to be worried about their safety.

How has Islamic banking redefined lending to deal with Islam's prohibition of usury?

Islamic banking has found alternative mechanisms for encouraging the flow of funds from savers to borrowers through banks that pay no interest on deposits, or loans. This provides savers with access to their liquid assets, while capturing the lower transactions costs and risk sharing associated with depository institutions and other financial intermediaries. On the lender side, the bank is entitled to a share of the gains the borrower generates from the loan (e.g., from investing in capital or some other physical asset), or purchases goods on behalf of the borrower. Since the bank benefits from economies of scale, it is able to generate profits by negotiating lower prices (or lower per-unit cost) than an individual could.

Consider the following: there are two countries, A and B. Each country has the same resources, and produces the same goods. The residents of country A use money; the residents of country B rely on bartering of goods. Will each country produce the same quantity of output? Explain.

No, the residents of Country B will definitely spend more of their time transacting, trying to create a double coincidence of wants, and may have to rely on multiple trades to do so. They will also likely specialize less, reducing the gains to the country from specialization. In country A the residents will be able to transact immediately using money, and will also be able to specialize in what they do well creating a more efficient economy.

A famous American has been visiting the same tropical island for 15 years for vacations. When she goes she pays for everything by writing checks drawn on her U.S. bank. The currency the natives use are not U.S. dollars; they use a currency called a fungo. The natives never cash her checks. She is so well known on the island that the natives simply trade her checks among themselves. The question you need to answer, complete with an explanation, is: who is paying for her vacation? (You can assume her bank would honor the checks if presented for payment even after a considerable period of time has passed.)

Obviously neither the famous American nor her bank is paying for the vacation since the checks are never presented for payment. On the other hand, the famous American is providing the people on the island with additional money, which they seem very comfortable using. As a result, the money supply on the island has increased by the amount of these checks. One result of the added money will be inflation, so islanders will see the real purchasing power of their money decrease, thus their loss in real purchasing power has been used to pay for the famous American's vacations.

How do central banks, like the U.S. Federal Reserve, contribute to the welfare of a society?

One of the core principles is that stability improves welfare (primarily by reducing risk). One of the functions of a central bank is to try to get rid of the risk that people cannot get rid of on their own, like the risk that comes from economic fluctuations, volatile price level changes or volatility in economic growth. To whatever degree the central bank can smooth these fluctuations, risk can be reduced and the overall welfare of a society can be improved.

Explain why a company offering homeowners insurance policies would want to insure homes across a wide geographic area.

One of the lessons from this chapter is the ability to reduce risk through diversification, and one way to effectively diversify is through spreading of risk. Since the homes can be exposed to losses which can hit specific areas, like hurricanes, tornadoes, wild fires, floods, etc. (a form of idiosyncratic risk). An insurance company would not be spreading risk effectively if all or most of the homes they insured were located in one specific area. By insuring homes across a wide geographic area the insurance company can effectively spread risk.

Consider two barter economies: Duos and Varietas. Duos produces two different goods, whereas Varietas produces 80 different goods. Both countries have the same number of people. In which barter economy is it more likely that the means of payment and the units of account would be efficient? How many relative prices are there in Duos compared with Varietas? Which economy would benefit more from adopting money?

Payments would be far easier and efficient in Duos. With fewer goods to be traded, the likelihood of reaching a double coincidence of wants would be greater. Also, with fewer goods being produced, the need for specialization is not as great as it would be in Varietas. With 80 different goods, people in Varietas are likely to be specialized. Also, with many different goods, the need for information is much greater in Varietas. Duos would have one relative price, 1 = 2(2 - 1)/2. Varietas would have thousands of relative prices: 3160 = 80(80 - 1)/2. This suggests that quoting prices and recording debts would be easier in Duos. Varietas would benefit more from adopting money, for the reasons cited above.

Apply the definition of risk provided in the textbook to an individual's decision to purchase a car insurance policy. Suppose that the individual has two possibilities: no accident ($0 gain/loss) and accident (-$30,000 loss). If the probability of an accident is lower than the probability of an accident occurring (say the probability of an accident is 10%), then why do people buy car insurance? How is this related to the concept of value at risk and the time horizon of investment decisions?

People buy car insurance in order to share risk with other policy holders. Even the risk- neutral investor would purchase car insurance because the expected return from driving one's car on a regular basis is involves a loss and never a financial gain. Risk-averse investors are willing to pay even more because of the uncertainty in outcomes and the possibility of a large loss. Value at risk refers to the worst possible outcome. This is often something drivers consider because if they drive often, and plan to drive over long periods of time, the probability of observing the worst-case scenario is higher over one's lifetime (compared with a situation where an individual drives for one day only).

Historically, many cultural groups have outlawed usury, or the practice of levying interest on loans. Some groups oppose usury because it exacerbates problems of income inequality (as wealthier individuals can afford to lend to poorer individuals), while others claim investment and loans should be made charitably. Evaluate these arguments against usury based on your knowledge of present value. Do such prohibitions make sense?

Prohibitions on interest payments (or usury) are problematic when we apply the concept of opportunity cost. For every dollar that is lent, the lender gives up the use of these funds that could go elsewhere. For example, the funds could be used for consumption, or for earning return on some other investment (such as a bank deposit or bond). If usury is outlawed, then there is no incentive to lend, outside of the perceived benefit the lender receives from charitable contributions to his/her colleagues.

Briefly explain the difference between idiosyncratic risk and systematic risk. Provide an example of each.

Systematic risk is risk resulting from something that will impact all firms, such as a general slowdown in the economy. Idiosyncratic risk will impact specific firms or industries, such as a harmful bacterium that is discovered in beef.

Why do economists claim the Consumer Price Index (CPI) tends to overstate the actual rate of inflation?

The CPI is measured using a fixed-expenditure-weight index. As a result, when the price of a good included in the index increases the assumption is people continue to purchase the same quantity of this item when in reality many consumers (to whatever degree possible) may stop purchasing this item and select a lower priced substitute. This substitution toward a lower-priced good is not reflected in the reported CPI.

Many college campuses use student ID cards as a way for students to pay for on-campus expenses, such as books, photocopies, and food. For convenience, some students will maintain a balance on their ID cards. Are these balances a means of payment? Are they a store of value? Explain why or why not.

The balances on the cards serve as both a means of payment and a store of value. Using the student ID card in this way is an example of a stored-value card, similar to a gift card for a store, or a card used to pay for public transportation. While these stored value cards are not included in the money supply, they are used as a means of payment and a store of value.

You purchase a good by writing a check for $1,000. Considering the financial payments system this check follows, when is the check money? Explain.

The check itself is never money; rather it is the balances on deposit that represent money. Therefore the $1,000 was money when it was in your checking account and that $1,000 will be money again when the Federal Reserve credits the reserve account of the bank receiving the check (and debits your bank's reserve account).

A lender expects to earn a real interest rate of 4.5% over the next 12 months. She charges a 9.25% (annual) nominal rate for a 12-month loan. What inflation rate is she expecting? If the lender is in a 30% marginal tax bracket, the borrower in a 25% marginal tax bracket, and they both have the same inflation expectations, what are the real after-tax rates each expects?

The first part she expected an inflation rate of 4.75%. We obtain this answer using the Fisher equation where i = r + πe. For the second part we need to use a variation of the Fisher equation. The lender receives an after-tax nominal rate of 6.475% from which we subtract the inflation rate of 4.75% and the lender expects a real after-tax rate of 1.725%. The borrower expects to pay an after-tax real rate of 2.188%.

Explain why an investor cannot simply compare the size of promised payments from different investments, even if the interest rates and other risk factors are the same.

The key here is time. Payments that are promised at different times are not equal in value; we could say they are really different units of value. We employ the concept of present value to allow us to make comparisons of promised payments that are due at different time periods. We know that payments that are promised sooner are worth more, other factors held constant (for example interest rates), than payments we have to wait for longer. This is seen from the present value formula. So a saver who is going to make a thorough comparison of different investments must consider the timing of the payments and convert all future payments to present value amounts so they can be compared in the same units.

Consider a typical individual who owns the following financial instruments: A life insurance policy for $250,000; a certificate of deposit for $10,000; homeowner's and auto insurance policies; $50,000 in a mutual fund, and $150,000 in her pension fund at work. Which of these are instruments used primarily as stores of value and which are being used to transfer risk?

The life insurance policy, the homeowner and auto insurance policies are instruments being used to primarily transfer risk. The cost of an untimely death or loss resulting from an auto accident or damage to her house is a risk the individual prefers to transfer to someone else. The certificate of deposit, the balances in her mutual fund and pension are instruments that are serving primarily as stores of value. In these instruments wealth is being accumulated and stored for use at a later time.

Suppose a two-year coupon bond has payments of $40 and a face value of $800. The interest rate is 8%. Compute the present value of the coupon payments and the principal payment of the bond. What is the price of this bond?

The present values are: Pcp=($40/(1+0.08)+ $40/(1+.08)^2)=$37.04 + $71.33 Psp= $800/(1+.08)^2=$685.87 P=Pcp+Psp=$71.33+$685.87=$757.20 The price of the bond is equal to the present value of future payments on the bond. The future payments include the $40 coupon payments paid over two years (with a present value of $71.33) and the $800 face value payment (with a present value of $685.87). The price of the bond is, therefore, the sum of these two amounts, $757.20.

A high school basketball player decides to bypass college and go right into the NBA, (the National Basketball Association). Describe the risk the individual is taking and a contract that might transfer the risk

The risks the individual is taking are numerous; one, he may not be as talented as he thinks and does not perform as well as he thinks he will and his value decreases. Perhaps more important, he could suffer a career-ending injury. In either case by bypassing college he has left himself with fewer options than he might otherwise have. These risks can be transferred through a few different types of contracts. First, he can negotiate a guaranteed contract that will pay him even if he is injured and can't play. The team would likely go along with this if the annual compensation is reduced. The individual could ask for the majority of his first contract to be in a guaranteed upfront payment which can then be used to purchase an annuity to provide income for the rest of his life. The individual could also purchase a disability insurance policy to provide a specified income in the event that he is injured and cannot do his job.

What would be the standard deviation for a $1000 risk-free asset that returns $1,100?

The standard deviation for this asset would have to be $0. If it is truly risk-free the return is certain, and if the return is certain there is no variance in the return, therefore no standard deviation.

Calculate the internal rate of return for a machine that costs $500,000 and provides annual revenue of $115,000 per year for 5 years. You can assume all revenue is received once a year at the end of the year.

To solve this we equate the cost of the machine to the sum of the present value for each annual payment and solve for the interest rate. Using a financial calculator or a spreadsheet we obtain an internal rate of return of 4.85%.

Why are options referred to as derivative instruments?

Unlike underlying instruments, such as stocks and bonds, derivatives are instruments where the value and the payoff of the instrument are derived from the behavior of the underlying asset. As an example, suppose Tom has a contract allowing him to purchase 100 shares of stock in ABC company at a price of $10 per share six months from now. The value of his option contract will increase as the actual price of the ABC stock (the underlying instrument) rises and exceeds $10 per share.

You win your state lottery. The lottery officials offer you the following options: you can accept annual payments of $50,000 for 20 years or receive an upfront payment of $700,000. Ignoring issues like mortality tables, taxes, etc.; and assuming the first payment is made immediately, what market interest rate would make it more attractive to take the upfront payment?

Using a financial calculator or a spreadsheet we can equate the $700,000 to the sum of the present value flow of receiving $50,000 a year for the next 20 years, and the internal rate of return is 4.121%. If you are confident that you can earn an average annual return greater than 4.121% a year over the next 20 years, the upfront payment may be the option to select.

If there are 1,000 people, each of whom owns a $100,000 house, and they each stand a 1/1,000 chance each year of suffering a fire that will totally destroy their house, what is the minimum that they would have to pay annually for fire insurance?

We can calculate the expected loss for any one individual as: E.L. = 0.001($100,000) + 0.999($0) = $100.00. Since the expected loss for each individual is $100 per year, the minimum that each would have to pay is $100.00 a year, in fact, given the probability of 1 in a 1000 homeowners in this group suffering a fire each year, at $100 each, on average, there should be just enough to compensate the person suffering the fire.

Compute the future value of $1,000 at a 6 percent interest rate after three different lengths of time. Use 6, 10 and 20 years into the future.

We can use a calculator and the formula FV = PV(1 + i)n to solve this problem. To calculate the future value for six years the formula will be: FV = $1000(1.06)6 which equals $1418.52. Using a similar approach for 10 years: FV = $1000(1.06)10 which equals $1790.85. And finally for 20 years: FV = $1000(1.06)20 which equals $3207.14.

An individual is currently 30 years old, wants to work until the age of 65 and plans on dying at the age of 85. How much will the individual need to have saved by the time he or she is 65 if he or she plans on spending $40,000 per year while retired? You can assume the individual can earn an interest rate of 5.0% and the $40,000 is in addition to any Social Security that may be received.

We can use a financial calculator to determine that in order to determine that the individual will need to amass a fund of $498,488 at the time he/she plans on retiring to obtain $40,000 a year for 20 years. Now since the individual has 35 years to amass this fund, this will require him/her to set aside $5,519 each year for 35 years.

Considering leverage, can you explain why a mortgage lender would want borrowers to have larger down payments, and when the borrower doesn't the mortgage lender may require mortgage insurance?

We saw that leverage can do two things for the borrower: it will increase the expected return but it also increases risk. As an example, a homebuyer putting 10% down rather than 20% increases the leverage factor from 5 to 10, this will double the expected return for the borrower but also double the risk. The mortgage lender (the counterparty) is certainly concerned with the risk since the doubling of the risk also works against them. As a result, they would want a larger down payment or insurance protection in the event that the borrower does not meet their obligations.

What matters more: having a credit card with a low rate or paying off your balance as quickly as possible? Explain.

Whatever the rate of interest on your credit card, the faster you pay off the balance the better. For example, if you had a balance of $2,000 on a credit card with a 10% interest rate, paying $50 a month will mean it will take you more than 4 years to pay off the principal (and the interest accumulated on it along the way). If you made payments of $75 instead, it would take you only about 30 months to pay off the balance. If the credit card interest rate were twice as high (20%), paying off $2,000 in $50 a month increments will mean it takes over 5 years to achieve a zero balance. But even at that much higher rate, paying $75 a month means it takes about 34 months to pay it off. Therefore, whatever the credit card rate, paying it off sooner is better than paying it off more slowly.

Credit cards usually charge higher rates of interest than most other forms of lending. In terms of information, collateral and monitoring, how might these higher rates be explained?

When providing credit cards to customers, banks have the ability to obtain information at the time of application and based on this information they decide to issue or not issue the card. Once issued however, the ability of the bank to obtain further information and monitor the behavior of the individual is limited and before the card issuer can respond the cardholder can incur significant debt. Also, these are basically unsecured loans, meaning there is no collateral for the lender to seize if payment is not made. All of these facts and more make credit card loans risky and demanding of the higher rate.

Consider an island where people use sand dollars (shells) as currency. For simplicity, assume that people consume only one good: fish. Currently, there are 400 sand dollars in circulation and there are 200 fish purchased each year. Based on this information, what is the price of fish? Now, suppose that a change in climate leads to new sand dollars washing ashore, leaving a total of 500 sand dollars. If there are still 200 fish purchased each year, what is the new price of fish? In order to prevent inflation, what would have to happen to the amount of fish purchased each year?

When there are 400 sand dollars and 200 fish purchased in a year, this implies that each fish costs 2 sand dollars (= 400/200). When the number of sand dollars increases to 500, the price of fish will increase to 2.5 sand dollars per fish (= 500/200). In order to prevent this inflation in fish prices, the number of fish would have to be increased to 250. That is, if there are 500 sand dollars and 250 fish, the price of fish would go back to 2 sand dollars per fish (= 500/250).

An individual owns a $100,000 home. She determines that her chances of suffering a fire in any given year to be 1/1000(0.001). She correctly calculates her expected loss in any year to be $100. Explain why this really isn't a good way to measure her potential for loss.

While all of her calculations may be accurate this individual may be better off considering value at risk, which is the worst outcome. The value at risk from a fire for her in this case is $100,000 which, if suffered, could prove devastating.

Briefly explain one function of financial instruments that can make them very different from money.

While financial instruments can function as a means of payment and a store of value, similar to money, one function that can make them very different from money is their ability to transfer risk between buyer and seller. A good example of this is the use of a futures contract that guarantees to the seller of the contract a price well into the future. Another common example is an insurance policy that transfers risk from the insured (a homeowner) to the insurer (the insurance company).

During the U.S. Civil War the Confederate government had to resort to printing currency to obtain the goods they needed. Comment on what you think happened to both prices and the value of this currency at the end of the war.

While the Confederate government was printing this currency in increasing amounts the prices in the South undoubtedly were rising. Any time currency is made increasingly available the eventual result will be higher prices. In addition, when the war ended and the Confederate states lost, the currency was basically worthless since there was no government that could guarantee its value. It was probably the case that as it was becoming clearer to people living in Confederate states that the outcome of the war was not going to be in their favor, it would not have been surprising if the people relied less on the currency and more on barter.

You study horse racing avidly and discover for this year's Kentucky Derby you think you have the field pretty well figured out. In fact, you calculate the expected return and it is the same as the expected return you are getting from the stock market. Is this investment in the race valuable to you?

While the opportunity to win at the horse race is present, so is the opportunity to lose your investment. The same situation exists with the stock market. One key difference, however, is the stock market offers the opportunity to diversify risk through spreading, this opportunity does not exist with a single horse race, it will be all or nothing.

How might the behavior of professional investment managers prior to the financial crisis of 2007-2009 contributed to the depth of the plunge of corporate and mortgage security prices during the crisis?

With market interest rates low and stable, investment managers may have been trying to generate high interest payments by taking greater risks in a search for yield. When the risk came to fruition during the financial crisis the prices of the riskier securities fell disproportionately.

A borrower seeking a mortgage today is often presented with the choice between a mortgage whose interest rate and monthly payment stays fixed for the duration of the loan, or a mortgage whose interest rate and monthly payment can change as other interest rates change. Typically the interest rate on the fixed-rate mortgage is higher. Having learned the five core principles, does this make sense?

Yes. The lender is shifting risk to the borrower. The risk here is that the lender agrees to a mortgage at (for example) 6% but then over the life of the loan (which can be 10, 25, even 30 years) interest rates in the market go up, putting the lender in the position of being "stuck" with the 6%. If the rate on the mortgage would change with market rates the lender would not have the risk. But remember, risk requires compensation, so to entice the borrower to take on the added risk the lender provides an inducement in the lower rate. A smart borrower will make the decision about whether or not the lower but changeable rate is a good decision based on information about interest rates (information, stability), and the decision may also depend on how long the borrower plans to live in the house (time).

Explain why countries that have volatile inflation rates are likely to have high nominal interest rates.

You could argue that volatile inflation means the inflation rate changes, but it doesn't always mean it increases. The rate could also decrease, and then the average rate may not be that bad. So why is the nominal interest rate higher? The answer can be found in the positions of the party and counterparty to any agreement. For example, in a country where inflation is low, a change of 1 percentage point, say from 1% to 2% can benefit one party and harm the other party, but the harm/benefit is somewhat minimal. In a country where inflation may average 4% (for example), but is highly volatile, the volatility can cause the rate to change by a larger amount (more percentage points), meaning the potential harm can be much larger. To compensate for this risk, the nominal interest rates will have to be higher.

Which core principle(s) could you use to explain why credit card issuers charge such high rates of interest?

You could explain the high rates of interest from three principles. First, risk requires compensation, and certainly the credit card issuers are taking a risk when they let people use the cards. There is a risk that some users may not repay the credit card company. Second, you can also justify it from the principle that time has value. The borrowers are using the issuer's funds, and the issuer needs to be compensated for letting the borrower use these funds. Some borrowers do not repay for considerable periods of time. Third, you could also invoke the principle that people use information in making their decisions. Credit card issuers need to acquire information on each applicant before a card is issued and this process is costly. Unfortunately, the applicants who are denied do not get the card, but those who are approved must help cover the information costs.

The "coupon rate" is: A. the annual amount of interest payments made on a bond as a percentage of the amount borrowed. B. the change in the value of a bond expressed as a percentage of the amount borrowed. C. another name for the yield on a bond, assuming the bond is sold before it matures. D. the total amount of interest payments made on a bond as a percentage of the amount borrowed.

a

Financial instruments used primarily to transfer risk

insurance contracts, futures contracts, options

Six parts of the financial system

money, financial instruments, financial markets, financial institutions, government regulatory agencies, and central banks

A monthly interest rate of 1% is a compounded annual rate of: A. 12.68% B. 10.00% C. 14.11% D. 6.00%

A

Asymmetric information in financial markets is a potential problem usually resulting from: A. borrowers having more information than the lenders. B. lenders having more information than borrowers. C. the fact that people are basically dishonest. D. the uncertainty about Federal Reserve monetary policy.

A

Carlos pays his cable bill using his bank's internet banking web site to withdraw funds from his checking account. This transaction is a(n): A. automated clearinghouse transaction (ACH). B. digitized-check transaction. C. e-money transaction. D. fedwire transaction.

A

Central banks can improve the welfare of a society by doing all of the following except: A. serving the interests of government rather than the public at large. B. helping to promote economic growth. C. focusing on keeping the overall level of prices stable. D. helping to reduce the volatility of business cycles.

A

Given a choice between two investments with the same expected payoff most people will: A. choose the one with the lower standard deviation. B. opt for the one with the higher standard deviation. C. be indifferent since the expected payoffs are the same. D. calculate the variance to assess the relative risks of the two choices.

A

How many prices would a trader of a particular good need to know in a barter economy with 20 goods? A. 190 B. 100 C. 20 D. 40

A

Which of the following statements is most correct? A. We can always compute the ex post real interest rate but not the ex ante real rate. B. We cannot compute either the ex post or ex ante real interest rates accurately. C. We can accurately compute the ex ante real interest rate but not the ex post real rate. D. None of the statements are correct.

A

What does it mean to say that an asset is "liquid"?

An asset is liquid when it can be converted into a means of payment, quickly without suffering a loss in value.

Financial instruments used primarily as stores of value include each of the following, except: A. bonds. B. futures contracts. C. stocks. D. home mortgages.

B

Financial markets: A. enable buyers and sellers to exchange financial instruments but not risk. B. enable buyers and sellers to exchange risk by buying and selling financial instruments. C. only allow the transfer of risk through derivative securities. D. do not allow for the transfer of risk but do help reduce it.

B

Hedging risk and spreading risk are two ways to: A. increase expected returns from a portfolio. B. diversify a portfolio. C. lower transaction costs. D. match up perfectly positively correlated assets.

B

How many prices would a trader of a particular good need to know in a barter economy with 5 goods? A. 5 B. 10 C. 20 D. 50

B

If a bond has a face value of $1,000 and the bondholder receives coupon payments of $27.50 semi-annually, the bond's coupon rate is: A. 2.75% B. 5.50% C. 27.5% D. a value that cannot be determined from the information provided.

B

M1 has decreased in its usefulness in understanding inflation due to: A. the increased use of checks in the economy. B. the introduction of money market mutual fund shares and similar checking substitutes. C. more reliance on the use of currency. D. the increased use of electronic payments.

B

Suppose a family wants to save $60,000 for a child's tuition. The child will be attending college in 18 years. For simplicity, assume the family is saving for a one-time college tuition payment. If the interest rate is 6%, then about how much does this family need to deposit in the bank today? A. $10,000 B. $21,000 C. $42,000 D. $57,000

B

Which of the following is not true of over-the-counter markets? A. Traders are linked by computer. B. Dealers buy and sell only for their customers. C. Trading does not take place in one physical location. D. Traders are willing to buy and sell stocks and bonds at posted prices.

B

15. Which of the following is not a financial instrument? A. A share of Microsoft stock B. A U.S. Treasury Bond C. An electric bill D. A life insurance policy

C

Equity markets are markets: A. of U.S. Treasury bonds. B. for AAA rated bonds. C. for stocks. D. for either stocks or bonds.

C

In order to benefit from diversification, the returns on assets in a portfolio must: A. be perfectly positively correlated. B. be perfectly negatively correlated. C. positively correlated but not perfectly. D. have the same idiosyncratic risks.

C

M1 is: A. a more useful measure of the relationship between the money supply and inflation because it includes the most liquid assets. B. the money supply the Federal Reserve pays the most attention to in conducting monetary policy. C. less useful than M2 for understanding inflation. D. the fastest growing of all of the money aggregates.

C

Most of the buying and selling in primary markets: A. is in the public view. B. is highly transparent and closely monitored by the SEC. C. involve an investment bank. D. is done by the Federal Reserve.

C

The lower the interest rate, i, the: A. lower is the present value. B. greater must be n. C. higher is the present value. D. higher is the future value.

C

Unexpected inflation can benefit some people/firms and harm others. This is an example of: A. systematic risk. B. unmeasured risk. C. idiosyncratic risk. D. zero risk since the effects balance.

C

Well-run financial markets: A. keep transactions costs high to benefit brokers B. prevent the widespread pooling of information C. ensure that resources are allocated efficiently D. are usually the result of little or no government regulation

C

What is the present value of $100 promised one year from now at 10% annual interest? A. $89.50 B. $90.00 C. $90.91 D. $91.25

C

When the price level increases, the purchasing power of money: A. increases by a similar amount. B. stays the same since the purchasing power of money is not impacted by price levels. C. decreases. D. first increases and then decreases as people get used to higher prices.

C

Which formula below best expresses the real interest rate, (r)? A. i = r - πe B. r = i + πe C. r = i - πe D. πe = i + r

C

Which of the following could not be commodity money? A. Gold coins B. Cigarettes C. U.S. Currency D. Silk

C

What are some of the advantages of trading in decentralized electronic exchanges?

Customers can see the orders, the orders are executed quickly, trading occurs 24 hours a day, and costs are low.

A saver knows that if she put $95 in the bank today she will receive $100 from the bank one year from now, including the interest she will earn. What is the interest rate she is earning? A. 5.10% B. 6.00% C. 5.52% D. 5.26%

D

Compounding refers to the A. calculation of after tax interest returns. B. internal rate of return a firm earns on an investment. C. real interest return after taxes. D. process of earning interest on both the principal and the interest of an investment.

D

Debt instruments that have maturities less than one year are traded in the: A. primary market exclusively. B. bond markets exclusively. C. bond market if they are already in existence. D. money market.

D

Doubling the future value will cause: A. the present value to fall by half. B. the interest rate i, to double. C. no change to present value, only the interest rate. D. the present value to double.

D

Farou invests $2,000 at 8% interest. About how long will it take for Farou to double his investment (e.g., to have $4,000)? A. 4 years B. 5 years C. 8 years D. 9 years

D

Financial instruments used primarily to transfer risk would include all of the following, except: A. an insurance contract. B. a futures contract. C. options. D. a bank loan.

D

The price of a coupon bond is determined by taking the present value of: A. the bond's final payment and subtracting the coupon payments. B. the coupon payments and adding this to the face value. C. the bond's final payment. D. all of the bond's payments.

D

What is the future value of $1,000 after six months earning 12% annually? A. $1,050.00 B. $1,060.00 C. $1,120.00 D. $1,058.30

D

What is the present value of $200 promised two years from now at 5% annual interest? A. $190.00 B. $220.00 C. $180.00 D. $181.41

D

Which of the following expresses 5.5%? A. 0.0055 B. 5.50 C. 0.550 D. 0.0550

D

Which of the following is not a reason why interbank lending dried up during the financial crisis of 2007-2009? A. Banks preferred to hold on to their liquid assets in case their own need for them increased. B. Banks grew increasingly concerned about the ability of their trading partners to repay the loans. C. The increased cost of loans. D. The Fed grew increasingly wary of making liquidity available to banks.

D

Which of the following lists correctly orders assets from most liquid to least liquid? A. Stocks, house, paper currency, savings deposits B. Stocks, paper currency, house, savings deposits C. Savings deposits, paper currency, house, stocks D. Paper currency, savings deposits, stocks, house

D

Explain why a riskier asset offers a higher expected return.

Due to the higher risk, savers will require a risk premium be added to the risk free return in order to entice the asset.

Explain why, if real interest rates are so important, we see most interest rates quoted in nominal terms.

It is almost impossible to quote real interest rates ex ante. For any given nominal interest rate, the real interest rate is the nominal interest rate less the rate of inflation. The problem is no one knows what the rate of inflation will be exactly. As a result it is easier to quote nominal interest rates.

What is the monthly interest rate if you are asked to convert a 12 percent annual rate to a monthly rate (calculate to 4 decimal places)?

It is not as simple as dividing 12 percent by 12 and thus obtaining an answer of 1.000 percent. The monthly rate, im, can be determined by using the following formula: (1 + im)12 = (1.12) which we can manipulate to (1 + im) = (1.12)1/12 which equals 1.0095. Therefore the monthly interest rate is 0.95%.

Convert each of the following basis points amounts to percents: a) 412.5 b) 10 c) 125.7 d) 1075 e) 1

Since 1 basis point equals .01 percent, we can determine that: a) 412.5 basis points is 4.125% b) 10 basis points is 0.1% c) 125.7 basis points is 1.257% d) 1075 basis points is 10.75% e) 1 basis point is 0.01%

Uses of Financial Instruments

Means of payment, store of value, transfer of risk

Rank the following assets from most liquid to least liquid. a) Common stock b) Houses c) Currency d) Art e) Savings accounts f) Checking account deposits.

Ranked from most liquid to least liquid: #1) Currency; #2) Checking account deposits; #3) Savings accounts; #4) Common Stock; #5) Houses; #6) Art.

A bond offers a $50 coupon, has a face value of $1,000, and has 10 years to maturity. If the interest rate is 4.0% what is the value of this bond?

Realizing that the price of the bond is the sum of the present value of all payments we simply calculate the present value of each payment and sum these. With the help of a financial calculator or a spreadsheet if necessary, we see the value of the bond is $1,081.10.

A bond offers a $40 coupon, has a face value of $1000, and 10 years to maturity. If the interest rate is 5.0%, what is the value of this bond?

Realizing that the price of the bond is the sum of the present value of all payments we simply calculate the present value of each payment and sum these. With the help of a financial calculator or spreadsheet if necessary, we see the value of the bond is $922.78.

Explain the following: Risk results from the fact that more outcomes could happen than will happen.

Risk results from uncertainty, not knowing what will happen. For example before a coin is flipped we know that there are two possible outcomes, heads or tails. Once the coin is flipped, there will only be one outcome. The risk is in not knowing a priori what is going to happen. If there is only one possible outcome, there is certainty and therefore, no risk.

Using the rule of 72, determine the approximate time it will take $1000 to double given the following interest rates. a) 5.5% b) 10.0% c) 30.0% d) 2.0% e) 4.5%

Since the rule of 72 says if we take 72/i we get the approximate number of years it takes for an amount to double, we can determine the answer for each interest rate. a) 72/5.5 = 13.1 years b) 72/10 = 7.2 years c) 72/30 = 2.4 years d) 72/2 = 36 years e) 72/4.5 = 16 years

What makes a financial instrument valuable?

Size: Payments that are larger are more valuable Timing: Payments that are made sooner are more valuable Likelihood: Payments that are more likely to be made are more valuable Circumstances: Payments that are made when we need them most are more valuable

Can a financial instrument be bought and sold in both a primary and secondary financial market? Explain.

The answer is yes and highly likely. When a financial instrument is new, say a newly issued U.S. Treasury bond, it is initially sold in a primary financial market. Perhaps the bond is purchased directly by the Federal Reserve. At some later time, however, the Federal Reserve may decide to sell the bond and this transaction would be a secondary market transaction since the instrument already exists.

Suppose you negotiate a one-year loan with a principal of $1000 and the nominal interest rate is currently 7%. You expect the inflation rate to be 3% over the next year. When you repay the principal plus interest at the end of the year, the actual inflation rate is 2.5%. Compute the ex ante and ex post real interest rate. Who benefits from this unexpected decrease in inflation? Who loses?

The ex ante real interest rate is 4% (= 7% - 3%). The ex post real interest rate is 4.5% (= 7% - 2.5%). The unexpected decrease in inflation benefits the lender because he/she receives a higher real interest rate than what was expected. The borrower loses because his/her real interest rate is higher than expected.

What is the expected value of a $100 bet on a flip of a fair coin, where heads pays double and tails pays zero?

The expected value of this event is calculated as E.V. = PH (H) + PT(T); where H is the payoff from the coin turning up heads and T is the payoff if the coin turns up tails. PH and PT are the probabilities of the coin turning up heads or tails respectively. Substituting actual values in out formula reveals: E.V. = 0.5($200) + 0.5($0) = $100

Is the obtaining of a car loan a primary or secondary market transaction?

The obtaining of a car loan is a primary market transaction since the loan represents a newly-issued instrument by the bank.

Why has the pace of structural change in financial markets accelerated in recent years?

The pace of structural change has accelerated dramatically in the past few years, driven by (1) ongoing technological advances in computing and communications and (2) increasing globalization. The former dramatically lowered the importance of a physical location of an exchange—as new technology allowed the rapid low-cost transmission of orders across long distances—while the latter encouraged unprecedented cross-border mergers of exchanges, integrating larger pools of providers and users of funds.

What is meant by the "paradox of leverage?"

The paradox of leverage occurs when all financial institutions try to deleverage at once. This will prove counterproductive as falling asset prices will mean more losses, diminishing their net worth still more, raising leverage and making the assets they hold seem riskier, compelling further sales, and so on.

Identify the six parts of the financial system.

They are: money, financial markets, financial instruments, financial institutions, government regulatory agencies, and central banks.

Explain why an increase in expected inflation will result in an increase in nominal interest rates, holding other factors constant.

This follows from the Fisher equation that says the nominal interest rate equals the sum of the real interest rate and the expected rate of inflation. So, for any given real interest rate, an increase in the expected rate of inflation will cause the nominal interest rate to increase.

Why isn't it correct to say that people who are risk averse avoid risk?

This statement really isn't correct. A better statement would be that people who are risk averse need to be compensated to take additional risk. The degree of additional compensation is referred to as the risk premium and this will vary depending on the degree of risk aversion.

What is the primary function of U.S. regulatory agencies in the U.S. financial system?

To provide wide-ranging financial regulation—rules for the operation of financial institutions and markets—and supervision—oversight through examination and enforcement.

Considering the concept of compounding, explain why in determining the future value of a $100 investment at 5 percent annual interest, you can't simply multiply $100 by (1.10) and get the correct answer.

To simply multiply $100 by 1.10 ignores the effect of compounding which is interest paid on the principal and on the interest earned. That is why the correct formula would be FV = $100(1.05)2.

What would be the impact of leverage on the expected return and standard deviation of purchasing an asset with 10% of the owner's funds and 90% borrowed funds?

We can use the general formula: Leverage factor = Cost of Investment/Owner's Contribution to the Purchase In this case the leverage factor would be 10; so the expected return and the standard deviation would both increase by a factor of 10.

Calculate which has a higher present value: an annual payment of $100 received over 3 years or an annual payment of $50 received over 7 years. In both cases the interest rate is 7% (or 0.07).

We can use the present value formula to answer this question. In the case of the $100 payment, the present value = $262.43. In the case of the $50 payments received over 7 years, the present value is $269.46. So the 7 payments of $50 each have a higher present value.

M2 currency

equals all of M1 plus assets that cannot be used directly as a means of payment and are difficult to turn into currency quickly

M1 currency

includes only currency and various deposit accounts

What are the four characteristics of a financial instrument?

1) A financial instrument is a written legal obligation; (2) A financial instrument transfers something of value to another party; (3) A financial instrument specifies some future date for this transfer to occur; and (4) A financial instrument specifies certain conditions under which payment will be made.

Suppose a saver is looking for the opportunity to make a very large return in a very short period of time. Would you recommend diversification for this individual?

An individual looking to make a very large return in a short period of time will not likely benefit from diversification. As we saw from the chapter one of the benefits of diversification is the reduction in risk that results. But another lesson was that the lower the risk the lower the return. If an individual is interested in a large, short-term return he/she is going to have to be willing to accept a larger risk. In this case the individual is more likely to want to concentrate on one or two assets (or gambles) and put all of his/her eggs in that basket and hope for the best. If it turns out well the actual return is likely to be higher than it would have been under a diversification strategy, however, he/she is more likely to lose using this approach as well. So while the expected return may be the same, without diversification the risk is far greater which is why the actual return could be larger.

Consider the following two assets with probability of return = Pi and return = Ri. Calculate the expected return for each and the standard deviation. Which one carries the greatest risk? Why?

Asset A Asset B P1 R1 P1 R1 .4 12% .2 11.5% .5 8.5% .5 10% .1 -2% .3 0% For asset A, the expected return = 0.4(12) + 0.5(8.5) + 0.1(-2.0) = 8.85% For asset B, the expected return = 0.2(11.5) + 0.5(10.0) + 0.3(0) = 7.30% For asset A, the standard deviation is 3.98 = SqR .4(12-8.85)^2 + .1(-2-8.85)^2 For asset B, the standard deviation is 4.81 = SqR .2(11-5-7.3)^2 +.5(10-7.3)^2 + .3(0-7.3)^2 Since asset B has a higher standard deviation than asset A, its return has higher risk.

A credit card that charges a monthly interest rate of 1.5% has an effective annual interest rate of: A. 18.0% B. 19.6% C. 15.0% D. 17.50%

B

Compare and contrast financial institutions that act as brokers to those that transform assets. In what sense are both types of institutions financial intermediaries? Provide one example of each type and describe how each functions as a financial intermediary.

Financial institutions that act as brokers provide a way for lenders/savers to buy securities from borrowers/spenders. Such institutions make it easier for borrowers and savers direct access financial markets. Financial institutions that transform assets collect deposits (and payments for insurance policies) to raise funds that are then loaned to borrowers/spenders. These institutions allow borrowers and savers to interact indirectly. Depository institutions accept deposits from savers and issue loans to borrowers. Insurance companies accept premiums from policy holders (savers) and invest these funds in securities. When a policy holder makes a claim (borrower), he/she receives compensation in the even of a bad event (accident, illness, theft, etc.). Pension funds invest contributions from savers and provide payments to retirees (borrowers). Securities firms provide brokerage services, allowing investors (savers) the ability to buy securities (issued by borrowers) in financial markets. Investment banks serve as underwriters, easing access to markets by bringing securities issued by borrowers into secondary markets for purchase by savers. Mutual funds mainly transform assets, allowing savers to purchase a diverse group of securities (issued by borrowers) with a small initial investment. Finance companies raise funds from buying securities in financial markets and loan out funds to borrowers. Government-sponsored programs, such as Social Security, provide the same services that pension funds and insurance companies provide privately.

Explain the various ways that financial intermediaries increase the efficiency of an economy.

Financial intermediaries increase an economy's efficiency in a number of ways. First, they provide a means for savers to channel funds to borrowers (spenders). This puts otherwise idle resources to use, increasing an economy's output. While savers theoretically could lend directly to borrowers, the transaction costs as well as the risk would be significantly increased, to the point where these funds may not actually flow. Also, financial intermediaries lower the transaction costs of lending. This includes information gathering as well as monitoring costs. These lower transaction costs allow resources to be used to increase the output of goods and services in the economy.

The income velocity of money is defined as nominal GDP divided by the money supply. In the first quarter of 2013 the U.S. nominal GDP was estimated to be around $16 trillion annually and M2 was $10460.3 billion. Would the income velocity of M2 be equal to 1; < 1; or > 1? Explain.

Greater than one. If you divide nominal GDP of $16 trillion (or $14,500 billion) by $10460.3 billion the result is 1.53.

Suppose that you have a winning lottery ticket for $100,000. The State of California doesn't pay this amount up front - this is the amount you will receive over time. The State offers you two options. The first pays you $80,000 up front and that will be the entire amount. The second pays you winnings over a three year period. The last option pays you a large payment today with small payments in the future. The payment options are detailed in the table below: Option 1 2 3 Amount today $80k $22K $50K After 1 year $22K $12K 2 $22K $22K 3 $22K $22K Compute the present value of each payment option, assuming the interest rate is 12%. Now, compute the present values based on an interest rate of 5%. Compare your answers, explaining why they are different when the interest rate changes. When the interest rate is 5%, the present values are as follows: Present Values (i- 5^n n ) 1 2 3 Today $80K $22K $50K 1 $20,952 $11,429 2 $19,955 $10,884 3 $19,004 $10,366 Total Present Value $80K $81,911 $82,679 When the interest rate is 12%, the present values are as follows: Present Values (i- 5^n n ) 1 2 3 Today $80K $22K $50K 1 $19,643 $10,714 2 $17,538 $9,566 3 $15,659 $8,541 Total Present Value $80K $81,911 $82,679

From the computations above, when the interest rate is 5%, Option #3 has the highest present value. When the interest rate is 12%, Option #1 has the highest present value. When the interest rate increases from 5% to 12%, the opportunity cost of foregoing future payments is higher. That is, while the winner is waiting to receive his/her future payments, he/she is forgoing interest that could be earned on a bank deposit or other investment. When the interest rate is low, this opportunity cost is relatively low, making Option #3 (with larger fixed payments similar to coupon payments on a bond) more attractive. When the interest rate is relatively high, these future fixed payments have less value, making Option #1 more attractive

Explain why insurance companies may find themselves at times having to refuse business.

Insurance companies accept risk from individuals and then spread this risk, a form of diversification. As an example, an insurance company that provides home insurance accepts the risk from an individual and pools these risks in a portfolio of policies. One situation the insurance company must be aware of is accepting too many risks from one area so that the portfolio is not diversified as well as it may be. If the company finds that it has too many homes insured in Florida, say, and not enough in other parts of the country it may leave itself exposed to larger losses due to hurricanes. As a result, the company may deny any more policies from Florida until the percentage of homes in Florida represents the percentage the company predicted in determining its expected return. Also, value at risk issues come into play in these situations. A hurricane or other natural disaster can have a very large impact on one concentrated area and insurance companies must always be aware of the value at risk. If this becomes too large for a certain area or possible event, the company may not accept any additional business from that area, (this is one reason why insurance companies purchase re-insurance).

Is the characteristic that distinguishes money from other assets its ability to be a store of value?

No; there are many assets that fall into the category of financial assets that are good stores of value, these include bonds and stocks. What distinguishes money is that it is liquid, meaning it can immediately serve as a means of payment. This is not true of other assets, which must be converted to spendable form. Moreover, it can be costly to turn a bond or stock into a means of payment, especially if it must be done on short notice.

Suppose that an internet-based program, Novus, wants to raise $10 million to expand its business operations. Describe how Novus can raise these funds directly through each of the follow options: issuing stock, issuing bonds, or obtaining a bank loan. Compare and contrast these three options.

Novus can issue new stock worth $10 million. Alternatively, it can issue $10 million in bonds. In either of these two cases, Novus will seek out an investment bank to serve as an underwriter (to bring the shares from the primary to the secondary market). If Novus issues stock, it is not obligated to pay dividends to its new stock holders, but if it doesn't it risks reducing the value of its stock. If Novus issues bonds, it must pay interest in regular payments. If Novus goes to a bank for a loan, it will make regular payments that include interest (and possibly parts of the principal amount owed), similar to a bond issue.

If the U.S. Supreme Court ruled that states could no longer require people to have auto insurance, do you think most people would cancel their policies? Explain.

Probably not. Auto insurance falls under the principle that risk requires compensation. For most people the additional risk they would face of driving without insurance exceeds the cost of the insurance, so they are better off purchasing auto insurance to reduce their risk.

What evidence is there that the transaction costs involved with the buying and selling of stocks is low?

Probably the best evidence is the volume of trading that occurs on an average day. As an example, on an average day billions of shares of stock may trade in the U.S. alone, and while most of these trades are undertaken using brokers, the fee the broker requires is usually a very small percentage of the overall value of the instruments traded. The volume of trades and the low fees for these trades would not result if transaction costs were high.

What is the difference between standard deviation and value at risk? Consider the difference between purchasing a one-year bank CD compared with purchasing a homeowner's insurance policy. Which scenario do you believe is more likely to consider value at risk over standard deviation? Explain.

Standard deviation measures the uncertainty about a payoff's expected return, whereas the value at risk is the worst possible scenario. The decision to purchase an insurance policy is more likely to consider value at risk. When people decide to purchase insurance, they are more likely to consider the worst-case scenario because the time horizon is an individual's lifetime. For a one-year bank CD, the worst-case scenario is less likely to occur simply because the time horizon is shorter.

How has the Bureau of Labor Statistics (BLS) changed the calculation of the CPI in order to take substitution bias into account?

Substitution bias is an overstatement of inflation by the CPI that comes from the fact that the calculation of the index is based on the assumption of an unchanging market basket of goods and services. Since prices do not all rise at the same rate (and some may not rise or may even fall), people can avoid some inflation by changing their spending pattern, that is, substituting lower-priced goods in place of those whose prices have risen. In order to take this into account, the BLS now changes the weights used in the CPI every two years, and today's CPI is a much more accurate measure of inflation than the one published a decade ago.

As we saw in the chapter, some financial instruments are used primarily to transfer risk. Explain how a bread maker can use a financial instrument to transfer the following risk: the bread maker has the opportunity to provide bread to a local army base. The base figures they will need 10,000 loaves of bread each week, or roughly 500,000 for a year. The problem is the baker must quote a price for the entire year. The baker would really like to have this contract but he realizes that fluctuating input prices (specifically wheat) could result in significant losses.

The baker could quote a price for bread based on today's price and then purchase wheat a futures contract for wheat at today's price, for delivery one year from now. If actual wheat prices do increase the baker will lose money on the actual baking operations but these losses will be offset by the profits he will earn on the wheat futures contract. If wheat prices end up decreasing, he will suffer losses on the futures contract but will offset these by having higher profits from baking. In this case the futures contract accomplishes exactly what it was supposed to do. It transferred the risk of volatile wheat prices from the baker, who otherwise wouldn't accept the opportunity to provide bread at a guaranteed price for a year, to someone who was more willing to accept this risk.

Suppose that IBM considers expanding its operations. The expansion will require $400 million for two new factories which the corporation plans to raise by selling stock and bonds. Which of the core principles will come into play as investors decide whether or not to buy the stock and the bonds?

The five core principles are: #1) Time has value; #2) Risk requires compensation; #3) Information is the basis for decisions; #4) Markets determine prices and allocate resources; #5) Stability improves welfare. Investors considering buying IBM's stock and bonds would surely have principle #2 in mind; they would assess the risk involved in IBM's expansion and want to be compensated for it. This would clearly involve information (principle #3). Principle #1 would come into play with the bonds; are they 1-year bonds? 5-year bonds? The longer the time period involved, everything else constant, the greater the return investors would require. Principles #4 and #5 are not totally irrelevant here, as investors will rely on markets to price the stocks and bonds and will judge IBM's expansion based on the outlook for the economy as a whole (stability).

What are the four fundamental characteristics that determine the value of a financial instrument?

The four fundamental characteristics that determine the value of a financial instrument are (1) The size of the payment that is promised; (2) When the promised payment is to be made; (3) the likelihood that the payment will be made; (4) The conditions under which the payment is to be made.

Suppose there is an economy that has 100 people each of whom makes a different good, and that they use a barter system for exchange. How many relative prices will there be?

The general formula for the number of prices is n(n - 1)/2; where n = the number of goods. Since we have 100 people each producing one good, we have 100 goods, so n = 100. Plugging this into our formula, we obtain: 100(99)/2 = 4950; so there will be 4,950 relative prices.

In the data, we observe that countries with high inflation rates tend to have high nominal interest rates. What does this imply, if anything, about real interest rates in countries with very high inflation rates?

The higher nominal interest rates are simply a reflection of high inflation rates. The real interest rates in these countries could be equal to (or even less than) those in low-inflation countries.

Why might a life insurance company insist on an individual having a physical exam before agreeing to provide life insurance to the individual?

The life insurance policy is a contract that transfers risk from the buyer to the seller, in this case from the individual to the company. The price of the contract is based upon certain assumptions regarding the general health of the individual and specific information such as gender, age, etc. The company wants to make sure there is not any information hidden (information asymmetry) or other problem that would significantly alter its decision to provide the coverage or the price of the coverage.

What is the primary distinction between debt/equity markets and derivative markets?

The market for equities (stocks) and debt (mainly bonds) are markets where the actual claims are purchased or sold for immediate cash payment. On the other hand, in derivative markets, parties and counterparties make agreements that are settled at a later date.

There are three goods produced in an economy by three individuals: Good: Oranges, Bread, Chocolate Producer: Orchard owner, baker, candy maker If the orchard owner likes only bread, the baker likes only chocolate, and the candy maker likes only oranges, will any trade between these three persons take place in a barter economy? Explain.

Yes, but this is a good example of the high transaction costs that can occur in a barter economy due to the double coincidence of wants problem. Any one of the individuals will have to make two trades to get what he/she wants; for example, the baker will have to trade bread with the orchard owner to get oranges, to then be able to trade with the candy maker to obtain the chocolate that he/she really wants.

All of the following are true about electronic funds transfers except: A. sometimes involve the Federal Reserve sending electronic images of checks to banks. B. occur when banks or individuals deposit/withdraw from one bank account to another electronically. C. include automated clearinghouse transactions (ACH). D. include credit card payments made online.

A

An automobile is an asset, but it is not liquid because: A. the transactions costs for turning it into money are high. B. the owner may still be making payments on the loan. C. the automobile may not be in good repair. D. the automobile cannot be sold without a loss in value.

A

As an economy produces more different types of goods: A. it is more difficult to quote prices if the economy does not use money. B. the number of relative prices decreases. C. money becomes less useful as a unit of account. D. money becomes less useful as a standard of value.

A

Changes in general economic conditions usually produce: A. systematic risk. B. idiosyncratic risk. C. risk reduction. D. lower risk premiums.

A

Compare two economies: a barter economy versus an economy that uses money. In order to exchange goods and services: A. a double coincidence of wants is necessary in the barter economy. B. a double coincidence of wants is more likely to occur in the barter economy. C. transactions are likely to be smoother in the barter economy because goods and services are exchanged directly. D. the money economy requires that sellers have more information about buyers' wants.

A

Consider a bond that costs $1000 today and promises a one-time future payment of $1080 in four years. What is the approximate interest rate on this bond? A. 2% B. 4% C. 8% D. 10.8%

A

Financial instruments are used to channel funds from: A. savers to borrowers in financial markets and via financial institutions. B. savers to borrowers in financial markets but not through financial institutions. C. borrowers to savers in financial markets but not through financial institutions. D. borrowers to savers through financial institutions, but not in financial markets.

A

Financial instruments used primarily as stores of value would not include: A. a car insurance policy. B. a U.S. Treasury bond. C. shares of General Motors stock. D. a home mortgage.

A

Financial intermediaries include each of the following, except: A. the New York Stock Exchange. B. credit unions. C. savings banks. D. commercial banks.

A

If the internal rate of return from an investment is more than the opportunity cost of funds the firm should: A. make the investment. B. not make the investment. C. only make the investment using retained earnings. D. only make part of the investment and wait to see if interest rates decrease.

A

In 2010, regulators of many nations agreed on a major update of internationally active banks known as: A. Basel III. B. the Fred-Bob Act. C. the Gramm-Leach-Bliley Act. D. the Dodd-Frank Act.

A

The amount of currency in the hands of the public is approximately what percentage of M1? A. 45% B. 25% C. 30% D. 90%

A

The coupon rate for a coupon bond is equal to the: A. annual coupon payment divided by the face value of the bond. B. annual coupon payment divided by the purchase price of the bond. C. purchase price of the bond divided by the coupon payment. D. annual coupon payment divided by the selling price of the bond.

A

The decimal equivalent of a basis point is: A. 0.0001 B. 1.00 C. 0.001 D. 0.01

A

We should expect a country that experiences volatile inflation to also have: A. volatile nominal interest rates. B. volatile real interest rates but stable nominal rates. C. stable nominal interest rates. D. volatile real interest rates.

A

What is the present value of $500 promised four years from now at 5% annual interest? A. $411.35 B. $400.00 C. $607.75 D. $520.00

A

When measuring the risk of an asset: A. one must measure the uncertainty about the size of future payoffs. B. it is necessary to incorporate uncertainties that are not quantifiable. C. one must remember that the concept of risk applies only to financial markets, not to financial intermediaries. D. one cannot use other investments to evaluate the asset's risk.

A

When the Continental Congress issued currency to finance the Revolutionary War, the Continental Congress: A. issued too many "continentals," eventually making the currency worthless. B. tied the value of the "continental" to gold. C. tied the value of the "continental" to gold to French "assignats." D. made "continentals" legal tender.

A

When the home construction industry does poorly due to a recession, this is an example of: A. systematic risk. B. idiosyncratic risk. C. risk premium. D. unique risk.

A

Which of the following are depository institutions? A. Credit unions B. Mutual funds C. Pension funds D. Insurance companies

A

Which of the following statements is most correct? A. All banks are financial intermediaries, but not all financial intermediaries are banks. B. Financial intermediaries must be public corporations. C. All financial intermediaries are insurance companies. D. Financial intermediaries are government agencies.

A

Which of the following assets is the most liquid? A. Art B. Demand deposits C. Houses D. Stocks

B

A promise of a $100 payment to be received one year from today is: A. more valuable than receiving the payment today. B. less valuable than receiving the payment two years from now. C. equally valuable as a payment received today if the interest rate is zero. D. not enough information is provided to answer the question.

C

Which of the following statements is not true? A. For most of history gold has been the most common commodity money. B. The most common form of money in the U.S. is not a commodity money. C. Gold is an example of a fiat money. D. U.S. currency is legal tender.

C

How useful is M2 in tracking inflation? Explain.

Empirical research mentioned in the chapter shows that across many countries, high rates of growth in M2 were associated with high rates of inflation and relatively low growth rates in M2 in many countries also were associated with low rates of inflation. For this reason many economists believe that, at least for moderate inflation rates, controlling inflation means controlling the money growth.

How do financial markets pool and communicate the information regarding issuers of financial instruments in a convenient way?

Financial markets pool and communicate information about the issuers of financial instruments and summarize this information in the form of a price. For example, any information that says an issuer of a financial instrument is less likely to honor its payment would have the price of the instrument decrease or the required return increases. Any information that places the issuer in a more favorable light would have the opposite effect.

After the Revolutionary War, the U.S. monetary system was based on gold. Historically, why did the U.S. adopt the use of gold as a currency? How does this compare with the currency used today?

Historically, the U.S. adopted the use of gold as a currency (or as a way to back paper notes) because people had grown suspicious of the use of fiat money. During the Revolutionary War, the Continental Congress issued continentals that became worthless with rising inflation. Using gold to back currency gave the public trust in the government's ability and desire to protect its value (e.g., to prevent rising inflation). Today, the currency printed by the U.S. Treasury Bureau of Engraving and Printing is fiat money. That is, it has little or no intrinsic value. The general public is willing to use this fiat money because it trusts the government's promise to protect its value. People have an expectation that they will be able to use the existing currency to pay for goods and services.

Explain why returns on assets compensate for systematic risk but not for idiosyncratic risk.

Idiosyncratic risk can be reduced through diversification. Systematic risk cannot since it affects all assets.

What is the probability of tossing a pair of dice once and getting a 1? How about a 7?

It is impossible to toss two dice and get a 1, since the smallest number you can roll is a 2. So the probability of getting a 1 is 0. On the other hand a seven can be obtained a 6 different ways, and since there are 36 possible outcomes from a single roll of a pair of dice, the answer is 6/36 or 1/6 or 16.7%.

Explain why the following statement is true, "money is an asset but not all assets are money."

Money is an asset because it represents something of value to the owner. But not all assets can be used as an immediate means of payment.

An individual faces two alternatives for an investment. Asset 'A' has the following probability of return schedule: Prob of return Return (yield) % .25 11 .2 10.5 .2 9.5 .15 9 .1 6.5 .1 -1.0 Asset 'B' has a certain return of 10.25%. If this individual selects asset 'A' does it imply she is risk averse? Explain.

Since both assets provide the same expected return, they would be equally attractive to an investor who is risk neutral. An investor who is risk averse would prefer Asset B, which provides the same expected return but with less risk than Asset A.

What is included in M2 that is not included in M1?

Small denomination time deposits, plus Savings Deposits and Money Market Deposit Accounts and Retail Money Market Mutual Fund Shares.

Historically, some governments have relied on the revenue generated from printing currency to finance government spending. Give two examples of government's relying on paper currency to finance wartime expenditures. What do you expect happened to inflation rates during these historical episodes?

The Continental Congress issued continentals in 1775 to finance the Revolutionary War. The French Revolutionary Government issued assignats in 1793. The inflation rates during both historical episodes increased. The money supply is linked to the economy's inflation rate. As the money supply grows at a faster rate, the inflation rate rises.

During the early 1980s, the U.S. economy experienced an increase in interest rates quoted on U.S. Treasury debt, business loans, and mortgages. At the same time the inflation rate gradually declined more than expected. What happened to ex ante versus ex post real interest rates during this period? Use the Fisher equation to support your answer.

The Fisher equation is: i = r + πe. The Fisher equation can be used to compute the ex ante real interest rate. The ex post real interest rate is computed using actual inflation in place of expected inflation. If nominal interest rates increase and the inflation rate decreased, this implies the ex post real interest rate must have decreased. If inflation declined more than expected, this would imply that the ex post real interest rate exceeded the ex ante real interest rate.

Describe what is likely to happen to the average price of a share of stock if the stock markets decide to close every Friday and Monday to provide workers at the exchanges with longer weekends.

The average price of stocks would decrease. The fact that the markets are open less decreases the liquidity of stocks and, as a result, their prices would have to be lower in order to entice savers to hold these instruments.

Explain the rapid rise in popularity of mutual funds.

The chapter covered the topic of spreading risk and one of the ways for an individual investor to spread risk is to purchase many different financial assets. The problem for any one individual is it could be expensive, both in terms of absolute dollars but also in transaction costs to purchase many different assets. Mutual funds allow individuals to pool their funds and purchase many different assets, thereby achieving most of the benefits of diversification without requiring a lot of funds to invest or high transaction costs.

How are the decisions of government policy makers, such as the Federal Reserve, related to risk and an individual investor's portfolio?

The decisions of government policy makers, such as the Federal Reserve, affect macroeconomic conditions, which in turn, affect the degree of systematic risk in the financial system. When the economy has low GDP growth and/or high inflation, this creates systematic risk that cannot be eliminated through diversification.

Calculate the expected value of an investment that has the following payoff frequency: a quarter of the time it will pay $2,000, half of the time it will pay $1,000 and the remaining time it will pay $0.

The expected value = ¼($2000) + ½($1000) + ¼($0) = $1000

During what period was money a better store of value: 1960-1980 or 1990-2009? Explain.

The period 1990-2009. During the period 1960-1980, inflation often rose to more than 5 percent; during the period 1990-2000, it rarely did.

What will be the amount owed at the end of one year if a borrower charges $100 on his/her credit card and doesn't make any payments during the year (assume the interest rate is 1.5% per month)?

$119.56. While it is tempting to multiply 1.5 times 12, obtaining 18% and the multiplying this by $100 to determine the interest charge, it would be incorrect since we would be ignoring compounding. The correct answer can be determined by using the following: FV = PV(1 + im)12. This will be FV = $100(1.015)12 or $119.56.

Which investment plan will provide the highest future value: $500 invested at 5 percent annually for four years and then that balance invested at 7 percent annually for an additional three years, or $500 invested at 6 percent annually for seven years?

$500 invested for four years at 5 percent interest and then that balance invested at 7% for three additional years will produce a balance of $744.52 at the end of seven years. The future value of $500 invested for seven years at 6 percent interest is $751.82.

Explain the difference(s) between a debit card and a credit card.

93. Explain the difference(s) between a debit card and a credit card. A debit card works the same way as a check, in that it provides the bank with instructions to transfer funds from the cardholder's account to the merchant's account. The debit card-holder must have adequate funds in his/her checking account to cover the purchase. A credit card is a promise by a bank to lend the cardholder money with which to make purchases. The store supplying the goods being purchased receives money, but the money that is used does not belong to the buyer, the credit card provides the cardholder with access to someone else's money.

A $500 investment has the following payoff frequency: half of the time it will pay $350 and the other half of the time it will pay $900. Its standard deviation and value at risk respectively are: A. $275; $150 B. $625; $275 C. $275; $350 D. $125; $500

A

A cross-country analysis of money growth shows that the growth rate in the money supply was: A. lower in countries with lower inflation rates. B. higher in countries with lower inflation rates. C. lower in countries with higher inflation rates. D. the same whether the countries had high or low inflation rates.

A

A futures contract is an example of: A. a derivative instrument. B. an instrument used solely by financial institutions. C. a high-risk security that will only have value if certain events occur. D. a contract that is traded but is not a financial instrument.

A

Economists study the link between money and inflation because: A. they want to understand how to keep inflation low and stable. B. economists believe that inflation in the 3-6% range is healthy for an economy. C. as prices increase money becomes more valuable. D. the Fed needs to increase the money supply as prices increase.

A

Financial instruments and money share which of the following characteristics? A. Both can function as a means of payment and a store of value. B. Both can function as a store of value and allow for trading of risk. C. Both can function by acting as a means of payment and allow for trading of risk. D. Both can function as a store of value even though they do not allow for trading of risk.

A

Juan purchases automobile insurance; the insurance contract is a: A. financial instrument. B. form of money. C. transfer of risk from the insurance company to Juan. D. financial intermediary.

A

M1 is: A. less than 25% of GDP. B. equal to GDP. C. about four times larger than GDP. D. about one fourth the amount of GDP.

A

Money aggregates can best be defined as a set of measures of the amount of: A. money that exists at a particular point in time. B. money the Federal Reserve has on deposit as reserves. C. money available to the economy over a year. D. U.S. currency the Bureau of Printing and Engraving has produced.

A

Money eliminates the need for: A. a search for a double coincidence of wants. B. government regulation. C. specialization of labor. D. financial Intermediaries.

A

Newly issued U.S. Treasury Securities are sold in: A. the primary financial market. B. only to the Federal Reserve who then resells them. C. the secondary market since bonds cannot be sold in the primary market. D. secondary markets but only using registered bond dealers.

A

One major difference between a debit and credit card is: A. you can build a credit history with the credit card but not with the debit card. B. you have to pay interest on your purchases if you use a credit card. C. credit cards are money and the debit card is not. D. debit cards charge late fees.

A

Roles served by financial markets include the following, except: A. eliminating risk. B. providing liquidity. C. pooling and communicating information. D. sharing of risk.

A

Sometimes spreading has an advantage over hedging to lower risk because: A. it can be difficult to find assets that move predictably in opposite directions. B. it is cheaper to spread than hedge. C. spreading increases expected returns, hedging does not. D. spreading does not affect expected returns.

A

Suppose Paul borrows $4,000 for one year from his grandfather who charges Paul 7% interest. At the end of the year Paul will have to repay his grandfather: A. $4,280 B. $4,290 C. $4,350 D. $4,820

A

Suppose the nominal interest rate on a one-year car loan is 8% and the inflation rate is expected to be 3% over the next year. Based on this information, we know: A. the ex ante real interest rate is 5%. B. the lender benefits more than the borrower because of the difference in the nominal versus real interest rates. C. at the end of the year, the borrower pays only 5% in nominal interest. D. the ex post real interest rate 11%.

A

The Russian wheat crop fails, driving up wheat prices in the U.S. This is an example of: A. idiosyncratic risk. B. diversification. C. systematic risk. D. quantifiable risk.

A

The introduction of money market substitutes for basic checking accounts was fueled partially by the: A. relatively high rates of inflation that existed in the late 1970s and early 1980s. B. reluctance of many retailers to accept checks. C. high number of bank failures that were occurring in the 1970s. D. higher interest rates banks had to pay on checking accounts.

A

The shorter the time until a payment the: A. higher the present value. B. lower the present value because time is valuable. C. lower must be the interest rate. D. higher must be the interest rate.

A

The variance of a portfolio of assets: A. decreases as the number of assets increases. B. increases as the number of assets increase. C. approaches 0 as the number of assets decreases. D. approaches 1 as the number of assets increases.

A

Which best describes money as a means of payment? A. Money provides an immediate double coincidence of wants. B. Money makes sure a double coincidence of wants never occurs. C. Money requires at least two transactions to obtain the double coincidence of wants. D. To obtain a double coincidence of wants without money is impossible.

A

Which of the following expresses 4.85%? A. 0.0485 B. 4.850 C. 0.00485 D. 0.485

A

Which of the following is an example of a financial market? A. A local coffeehouse where people regularly buy and sell financial instruments. B. A bank that only accepts deposits and issues loans. C. An electronic network used for buying and selling textbooks. D. A central bank used for raising taxes and borrowing on behalf of the government.

A

Explain the suggestion that people may have their own "personal discount rate" and how that may affect decisions about borrowing and other financial matters.

A good illustration of this comes from the story of the downsizing by the Defense Department in the 1990s. Military personnel were offered a choice between an annual payment and a lump sum, and were given information about how to calculate the present value of the annual payment using a 7 percent discount rate. The evidence suggests that most people put excessive weight on a "bird in the hand," meaning the "sure thing" of the lump-sum payment, suggesting that for most people their "personal discount rate" is higher. For the military personnel, it seemed to be much higher than 7 percent. This explains why people are more likely to choose lump-sum payments and to borrow at high rates of interest (for example, the rates on credit card balances). Most people seem to be extremely impatient, even to their own financial detriment.

If a borrower and a lender agree on a long-term loan at a nominal interest rate that is fixed over the duration of the loan, how will a higher-than-expected rate of inflation impact the parties if at all?

A higher-than-expected rate of inflation will benefit the borrower who will end up paying a lower real interest rate than planned, and so will be better off. The lender, on the other hand, will end up receiving a real interest rate that is less than what was planned so the lender will be harmed.

An individual faces two alternatives for an investment: Asset A has the following probability return schedule: Prob of return Return (yield) % .25 11 .2 10.5 .2 9.5 .15 9 .1 6.5 .1 -1.0 Asset B has a certain return of 8.0%. If the individual selects asset A does she violate the principle of risk aversion? Explain.

Asset A provides an expected return of 8.65%. For the investor the 0.65% premium may be a large enough differential to compensate for the additional risk, so she may still be "risk averse".

A risk-averse investor will: A. never prefer an investment with a lower expected return. B. always prefer an investment with a certain return to one with the same expected return but that has any amount of uncertainty. C. always require a certain return. D. always focus exclusively on the expected return.

B

Financial markets enable the transfer of risk by: A. requiring that risk-averse investors have access to U.S. Treasury bond markets. B. allowing individuals and firms less willing to bear risk to transfer risk to other individuals and firms more willing to bear risk. C. making sure that higher default risk is offset by greater liquidity. D. enabling even unsophisticated investors to purchase highly complex financial instruments.

B

High oil prices tend to harm the auto industry and benefit oil companies; therefore, high oil prices are an example of: A. systematic risk. B. idiosyncratic risk. C. neither systematic nor idiosyncratic risk. D. both systematic and idiosyncratic risk.

B

One hundred basis points could be expressed as: A. 0.01% B. 1.00% C. 100.0% D. 0.10%

B

Suppose that Ray Allen, a basketball player for the Miami Heat, will become a free agent at the end of this NBA season. Suppose that Allen is considering two possible contracts from different teams. Note that the salaries are paid at the end of EACH year. Contract 1 (Seattle) Contract 2 (Portland) Signing Bonus (Paid Today): 1M 1M First year salary: 2M 4M second year salary: 4M 4M third year salary: 5M 3M The interest rate is 10%. Based on this information, which of the following is true? A. Allen should take the Seattle contract because it has a higher present value. B. Allen should take the Portland contract because it has a higher present value. C. Allen is indifferent between the two contracts because they are both worth $12 million. D. Allen is indifferent between the two contracts because they are both worth $10.9 million.

B

The Consumer Price Index (CPI): A. tends to understate the impact of price changes. B. tends to overstate the impact of price changes due to substitution bias. C. is more accurate than the GDP deflator. D. assumes that consumers substitute away from cheaper goods.

B

The Consumer Price Index (CPI): A. is calculated using a basket of goods and services adjusted annually by government statisticians. B. answers the question, "How much more does it cost today to buy the same basket of goods and services that were purchased at some fixed time in the past?" C. does not suffer from substitution bias because the basket used to measure prices changes every year. D. understates the impact of price changes.

B

The New York Stock Exchange (NYSE) originated as: A. a decentralized electronic market made up of dealers all over the world. B. an example of a centralized exchange. C. a financial market where nearly 100 million shares of stock are traded every business day. D. the only centralized stock exchange in the world.

B

The value of a financial instrument rises as: A. the size of the payment promised decreases. B. the promised payment is made sooner rather than later. C. it is less likely the payment will be made. D. the payments are made when the prospective investor needs them least.

B

The variance of a portfolio containing n assets with independent returns: A. increases as n increases. B. decreases as n increases. C. is constant for any n greater than two. D. does not change in a predictable way when n increases.

B

To say an asset is liquid implies that: A. we are focusing on a category of assets that are in a physically liquid form, like oil. B. we are considering assets that may be readily converted into a means of payment. C. we are considering any asset that can be sold. D. we are only considering U.S. currency.

B

Tom deposits funds in his savings account at the bank which is paying 3.5% interest. If he keeps his funds in the bank for one year he will have $155.25. What amount is Tom depositing? A. $151.75 B. $150.00 C. $148.75 D. $147.50

B

U.S. currency is: A. A commodity money B. Fiat money C. Tied to the value of gold at a fixed rate D. The only store of value

B

When considering different investments, a risk-averse investor is most likely to focus on purchasing: A. investments with the greatest spread in the expected rate of return. B. investments that offer the lowest standard deviation in the investments' expected rates of return for any given expected rate of return. C. only risk-free investments. D. investments with the lowest risk premium, regardless of the expected rate of return.

B

Which of the following best expresses the payment a lender receives for lending money for three years? A. 3PV B. PV(1 + i)3 C. PV/(1 + i)3 D. FV/(1 + i)3

B

Which of the following is incorrect? A. Money is wealth but not all wealth is money. B. Money is a means of payment but is not part of wealth. C. An asset doesn't have to be a means of payment to be a part of a person's wealth. D. All items considered wealth can eventually be converted to a means of payment.

B

Which of the following is not an example of bartering? A. Sue trading candles with Tom for his bread. B. Mary paying for her new shoes with her credit card. C. John cutting his neighbor's grass in return for his neighbor washing John's car. D. Mrs. Smith treating the neighbor children to pizza after they helped clean up her yard.

B

Which of the following statements is false? A. Diversification can reduce risk. B. Diversification can reduce risk but only by reducing the expected return. C. Diversification reduces idiosyncratic risk. D. Diversification allocates savings across more than one asset.

B

Which of the following statements is most correct? A. Financial intermediaries are banks. B. A bank is a financial intermediary. C. Financial intermediaries are insurance companies. D. Financial intermediaries are essential to direct finance.

B

Which of the following statements is most correct? A. When a risk is difficult to predict, financial instruments are created to transfer these risks. B. Financial instruments are created to transfer risks that are relatively easy to predict. C. Financial instruments require certainty of an event to be able to transfer risk. D. Financial instruments eliminate the risk from uncertainty, they do not transfer it.

B

Which of the following statements is true? A. Leverage increases expected return while lowering risk. B. Leverage increases risk. C. Leverage lowers the expected return and lowers risk. D. Leverage lowers the expected return and increases risk.

B

Financial instruments used primarily as stores of value

Bank loans, Bonds, Home mortgages, stocks, asset backed securities

Why are electronic transactions increasingly taking the place of paper transactions?

Because efficient payments systems continue to evolve and seek easier and cheaper ways to pay for things.

A monthly growth rate of 0.5% is an annual growth rate of: A. 6.00% B. 5.00% C. 6.17% D. 6.50%

C

GDP

C + I + G + NX

A borrower who makes a $1000 loan for one year and earns interest in the amount of $75, earns what nominal interest rate and what real interest rate if inflation is two percent? A. A nominal rate of 5.5% and a real rate of 2.0%. B. A nominal rate of 7.5% and a real rate of 5.0%. C. A nominal rate of 7.5% and a real rate of 9.5%. D. A nominal rate of 7.5% and a real rate of 5.5%.

D

A monthly growth rate of 0.6% is an annual growth rate of: A. 7.20% B. 6.00% C. 7.60% D. 7.44%

D

Explain why most financial instruments are fairly complex, while at the same time quite standardized.

Most financial instruments are complex in the sense that many possible contingencies are identified and both buyer and seller want to avoid problems that can arise from unforeseen events. To write a complete contract, however, would be very time consuming and expensive. As a result, most financial instruments are standardized because over time many common problems have been identified and worked into the contract, and standardization makes it easier to compare contracts and makes the instruments more liquid.

Standard & Poor's sells information to investors; this is their primary business. Is this an example of a financial intermediary? Explain.

No. A financial intermediary is involved indirectly in a financial transaction. It matches up the ultimate lenders (savers) with the ultimate spenders (borrowers). The funds flow through the intermediary which is acting as a "middleman." That is not the case with Standard & Poor's.