Bus 322 Exam 1

Explain why you would be more or less willing to buy a share of Polaroid stock in the following situations: a. Your wealth falls. b. You expect it to appreciate in value. c. The bond market becomes more liquid. d. You expect gold to appreciate in value. e. Prices in the bond market become more volatile.

(a) Less, because your wealth has declined; (b) more, because its relative expected return has risen; (c) less, because it has become less liquid relative to bonds; (d) less, because its expected return has fallen relative to gold; (e) more, because it has become less risky relative to bonds.

Explain why you would be more or less willing to buy a house under the following circumstances: a. You just inherited $100,000. b. Real estate commissions fall from 6% of the sales price to 4% of the sales price. c. You expect Polaroid stock to double in value next year. d. Prices in the stock market become more volatile. e. You expect housing prices to fall.

(a) More, because your wealth has increased; (b) more, because it has become more liquid; (c) less, because its expected return has fallen relative to Polaroid stock; (d) more, because it has become less risky relative to stocks; (e) less, because its expected return has fallen.

How can a change in interest rates affect the profitability to financial institutions?

A change in interest rates affects the cost of acquiring funds for financial institution as well as changes the income on assets such as loans, both of which affect profits. In addition, changes in interest rates affect the price of assets such as stock and bonds that the financial institution owns which can lead to profits or losses.

Why are financial markets important to the health of the economy?

Because they channel funds from those who do not have a productive use for them to those who do, thereby resulting in higher economic efficiency.

How can the adverse selection problem explain why you are more likely to make a loan to a family member than to a stranger?

Because you know your family member better than a stranger, you know more about the borrower's honesty, propensity for risk taking, and other traits. There is less asymmetric information that with a stranger and less likelihood of an adverse selection problem, with the result that you are more likely to lend to the family member.

When interest rates rise, how might business and consumers change their economic behavior?

Businesses would cut investment spending because the cost of financing this spending is now higher, and consumers would be less likely to purchase a house or a car because the cost of financing their purchase is higher.

What effect might a rise in stock prices have on consumers' decisions to spend?

Higher stock prices mean that consumers' wealth is higher and so they will be more likely to increase their spending.

How does a decline in the value of the pound sterling affect British consumers?

It makes foreign goods more expensive and so British consumers will buy less foreign goods and more domestic goods.

Is everybody worse off when interest rate rise?

No. People who borrow to purchase a house or a car are worse off because it costs them more to finance their purchase; however, savers benefit because they can earn higher interest rates on their savings.

I own a professional football team, and I plan to diversify by purchasing shares in either a company that owns a pro basketball team or a pharmaceutical company. Which of these two investments is more likely to reduce the overall risk I face? Why?

Purchasing shares in the pharmaceutical company is more likely to reduce my overall risk because the correlation of returns on my investment in a football team with the returns on the pharmaceutical company shares should be low. By contrast, the correlation of returns on an investment in a football team and an investment in a basketball team are probably pretty high, so in this case there would be little risk reduction if I invested in both.

What effect might a fall in stock prices have on business investment?

The lower price for a firm's shares means that it can raise a smaller amount of funds, and so investment in plant and equipment will fall.

The U.S. economy borrowed heavily from the British in the nineteenth century to build a railroad system. What was the principal debt instrument used? Why did this make both countries better off?

The principal debt instruments used were foreign bonds which were sold in Britain and denominated in pounds. The British gained because they were able to earn higher interest rates as a result of lending to Americans, while the Americans gained because they now had access to capital to start up profitable businesses such as railroads.

Why is a share of Microsoft common stock an asset for its owner and a liability for Microsoft?

The share of Microsoft stock is an asset for its owner because it entitles the owner to a share of the earnings and assets of Microsoft. The share is a liability for Microsoft because it is a claim on its earnings and assets by the owner of the share.

"Because corporations do not actually raise any funds in secondary markets, they are less important to the economy than primary markets."

This statement is false. Prices in secondary markets determine the prices that firms issuing securities receive in primary markets. In addition, secondary markets make securities more liquid and thus easier to sell in the primary markets. Therefore, secondary markets are, if anything, more important than primary markets.

"No one who is risk-averse will ever buy a security that has a lower expected return, more risk, and less liquidity than another security," Is this statement true, false, or uncertain? Explain your answer.

True, because for a risk averse person, more risk, a lower expected return and less liquidity make a security less desirable.

"The more risk-averse people are, the more likely they are to diversify." Is this statement true, false, or uncertain? Explain your answer.

True, because the benefits to diversification are greater for a person who cares more about reducing risk.

Some economists suspect that one of the reasons that economies in developing countries grow so slowly is that they do not have well-developed financial markets. Does this argument make sense?

Yes, because the absence of financial markets means that funds cannot be channeled to people who have the most productive use for them. Entrepreneurs then cannot acquire funds to set up businesses that would help the economy grow rapidly.

If you suspect that a company will go bankrupt next year, which would you rather hold, bonds issued by the company or equities issued by the company? Why?

You would rather hold bonds, because bondholders are paid off before equity holders, who are the residual claimants.