Chapter 9 Questions, Chapter 10, CHAPTER 12, Fin Exam 2 Ch. 6, 9, 11, 12, 13, 17, 20, 22

"Foreign exchange rates, like stock prices, should follow a random walk." Is this statement true, false, or uncertain? Explain your answer.

"Foreign exchange rates, like stock prices, should follow a random walk." Is this statement true, false, or uncertain? Explain your answer. True in principle. Foreign exchange rates are a random walk over a short interval such as a week because changes in the exchange rate are unpredictable. If a change were predictable, large unexploited profit opportunities would exist in the foreign exchange market. If the foreign exchange market is efficient, these unexploited profit opportunities cannot exist, and so the foreign exchange rate will approximately follow a random walk.

100 asset 4 years 90 liabilities 6 year 2 percentage

(100 x(-2%) x 4 years) 8 assets fall in value (90 x(-2%) x 6 years) 10.8 liabilities Net worth increases by 2.8

8. What are Fed Funds? Does the Federal Reserve directly set the Fed funds rate? How does the Fed influence this rate?

- Are short-term funds transferred between financial institutions at the US interbank market, usually for a period of one day and can have maturities to 7 days. - Banks often use fed funds to meet the reserve requirements imposed by the government. They keep a certain percentage of their total deposits with the Federal Reserve - The Central Banks cannot directly control fed funds rates. The influence is indirect, i.e., by buying or selling securities (e.g. T-bills).

13. What kinds of risk is an investor exposed to when she buys a corporate bond?

- Corporate bonds are issued by corporations and usually pay interest semi-annually. - The degree of risk varies with each bond, even from the same issuer. The degree of risk ranges from low-risk (AAA) to higher risk (BBB). Any bond rated below BBB is considered sub-investment grade debt.

6. A bond makes an annual $80 interest payment (8% coupon). The bond has 5 years before it matures, at which time it will pay $1,000. Assuming a discount rate of 10%, what should be the price of the bond?

- Bond with 8% annual coupon, Face or Par Value = $1,000, n = 5 years, Discount rate: 10% - Price = 80/(1+0.1) + 80/(1.1)²...+ 80/1.1^4 + (1,000 + (1,000x0.08))/1.1^5 = $924.18

4. Calculate the price of a 180-day T-bill purchased at a 5% discount rate if the T-bill has a face value of $5,000.

- P = F (1 - iDisc x n / 360) = 5,000 x (1 - 0.05 x 180/360) =

4. Why do businesses use money markets?

- To invest excess cash or borrow money for a relatively short period with high liquidity. - Securities they buy issue are Repurchase Agreements and Commercial papers - Securities they buy are Repurchase Agreements, Negotiable certificates of deposit, Commercial papers, Banker's acceptance and Eurodollar deposits

2. What would be your annualized discount rate % and your annualized investment rate % if a Treasury bill was purchased for $9,360 maturing in 270 days for $10,000?

- i Disc = ((F-P) / F) x 360/n = ((10,000-9,360) / 10,000) x 360/270 = 0.0853 = 8.53% Discount rate gives me the price of the treasury bill - I Inv = ((F-P) / P) x 365/n = ((10,000-9,360) / 10,000) x 365/270 = 0.0866 = 8.66% Annualized interest rates is around 8.6%

Rank the following bank assets from most liquid to least liquid

1. Reserves 2.Securities 3.Commercial loans 4.Physical capital

A bank has 200,000 of checkable deposts, a required reserve ratio of 20 percent. The bank currently hold 160,000 in reserves. How much of these reserves are excess reserves

120,000

100 asset 4 year 85 liablities 3 year 2 pervent

2.9

When 50,000 10 percent

45,000

When 150000 is deposited at a bank, the required reserve ration is 5 percent, and the bank chooses not to hold any excess reserves makes loans instead, total reserves are equal to

7500

Suppose that you are the manager of a bank whose 100 billion

8billion 10.8 billion 2.8 billion

Why has noninterest income been growing as a source of bank operating income?

Because the off-balance sheet activities that generate fees have become a more important part of a bank's business.

Why might a bank be more willing to borrow funds from other banks rather than borrow from the Fed

Borrowing from the Fed might invite greater supervisory scrutiny from the central bank

Which of the following management strategies will reduce bank capital relative to assets and rasise the equity multiplier

Buy back bank stock

The small-firm effect refers to the observation that small firms' stocks A) follow a random walk but large firms' stocks do not. B) have earned abnormally low returns given their greater risk. C) have earned abnormally high returns even taking into account their greater risk. D) sell for lower prices than do large firms' stocks.

C) have earned abnormally high returns even taking into account their greater risk.

Federal Reserve independence is thought to A) introduce a short-term bias to monetary policymaking. B) lead to better fiscal and monetary policy coordination. C) introduce longer-run considerations to monetary policymaking. D) do both A and B of the above.

C) introduce longer-run considerations to monetary policymaking.

Bonds with relatively low risk of default are called A) zero coupon bonds. B) junk bonds. C) investment-grade bonds. D) none of the above.

C) investment-grade bonds.

A bank almost always insists that the firms it lends to keep compensating balances at the bank. Why?

Compensating balances can act as collateral. They also help establish long-term customer relationships, which make it easier for the bank to collect information about prospective borrowers, thus reducing the adverse selection problem. Compensating balances help the bank monitor the activities of a borrowing firm so that it can prevent the firm from taking on too much risk, thereby not acting in the interest of the bank

A bank almost always insists that the firms it lends to keep compensating balances

Compensating balances help establish Compensating balnces help the bank Compensating balnces can act as collateral

The free-rider problem A) occurs when people who do not pay for information take advantage of the information other people have to pay for. B) suggests that the private sale of information will only be a partial solution to the lemons problem. C) prevents the private market from producing enough information to eliminate all the asymmetric information that leads to adverse selection. D) all of the above.

D) all of the above.

Which of the following is an element of the Federal Reserve System? A) The Federal Reserve banks B) The Board of Governors C) The FDIC D) All of the above E) Only A and B of the above

E) Only A and B of the above

When faced with capital shortfall, banks can raise new capital or restrict lending. In 2008

False Make fewer loans

How can the existence of asymmetric information provide a rationale for government regulation of financial markets?

How can the existence of asymmetric information provide a rationale for government regulation of financial markets? Because there is asymmetric information and the free-rider problem, there is not enough information available in financial markets. This provides a rationale for government to regulate to markets to encourage information production to better screen out good and bad borrowers. They can also reduce morale hazard and improve performance of markets by enforcing standard accounting principles and prosecuting fraud.

How does the free-rider problem aggravate adverse selection and moral hazard problems in financial markets?

How does the free-rider problem aggravate adverse selection and moral hazard problems in financial markets? The free-rider problem means that private producers of information will not obtain the full benefit of their information producing activities, and so less information will be produced. This means that there will be less information collected to screen out good from bad risks, making adverse selection problems worse, and that there will be less monitoring of borrowers, increasing the moral hazard problem.

If I read the Wall Street Journal that the "smart money" on Wall Street expects stock prices to fall, should I follow that lead and sell all my stocks?

If I read the Wall Street Journal that the "smart money" on Wall Street expects stock prices to fall, should I follow that lead and sell all my stocks? No, because this is publicly available information and is already reflected in stock prices. The optimal forecast of stock returns will equal the equilibrium return, so there is no benefit from selling your stocks.

Why is being nosy a good trait for a banker?

In order for a banker to reduce adverse selection she must screen out good from bad credit risks by learning all she can about potential borrowers. Similarly in order to minimize moral hazard, she must continually monitor borrowers to ensure that they are complying with restrictive loan covenants. Hence it pays for the banker to be nosy

If a bank is falling short of meeting its capital requirements by 1 million

Issure stock Decrease dividend payments to increase retained earnings Call in existing loans in an attempt to decrease

Which of the following may not be used as a backup line of credit

Mortgages

The portion of checkable deposits that banks are required to hold is called

Required Reserves

What happens to reserves at the First National Bank if one person withdraws 900 of cash and another person deposits 600 of cash

Reserves -300 Checkable -300

Why has the developement of overnight loan markets made it more likely that banks will hold fewer excess reserves

The presence of overnight loan markets thus reduces the costs associated with deposit outflows

what is a sinking fund? do investors like bonds that contain this feature?

a sinking fund contains funds set aside by the issuer of the bond to pay for the redemption of the bond when it matures. because a sinking fund increases the likelihood that a firm will have the funds to pay off the bonds as required, investors like the feature. as a result, interest rates are lower on securities with sinking funds.

distinguish between competitive bidding and non-competitive bidding for treasury securities

a treasury auction will sell a certain face amount of securities. the non-competitive bids will all settle at the yield dictated by the auction. thus, the face amount of non-competitive bids are removed from the total amount to be auctioned by competitive bid. the competitive bids are ranked according to yield and the auction is settled at the lowest yield for which there are enough bids at a lower yield to clear the remaining auction amount. winning competitive and non-competitive bids are settled at this yield.

what is the document called that lists the terms of a bond?

bond indenture

who issues commercial paper and for what purpose?

large businesses with very good credit standings sell commercial paper to raise short term funds. the most common use of these funds is to extend short term funds. the most common use of these funds is to extend short-term loans to customers for the purchase of the firm;s products.

A bank with excess reserves can economize on these reserves by

lending reserves in the federal funds market

14. What are the benefits and costs for a bank when it decides to increase the amount of its bank capital?

the benefit is that the bank now has a larger cushion of bank capital and so is less likely to go broke if there are losses on its loans or other assets. The cost is that for the same ROA, it will have a lower ROE, return on equity.

is a treasury bond issued 29 years ago with 6 months remaining before it matures a money market instrument?

the bond would not be considered a money market security because money market securities have an original maturity of less than a year.

does the federal reserve directly set the federal funds interest rate? how does the fed influence this rate?

the federal reserve cannot directly set the federal funds rate of interest. it can influence the interest rate by adding funds to or withdrawing reserves from the economy.

which of the money market securities is the most liquid and considered the most risk-free? why?

treasury bills are usually viewed as the most liquid and least risky of securities because they're backed by the strength of the US government and trade in extremely large volumes

the US treasury issues bills, notes, and bonds. how do these three securities differ?

treasury bills mature in less than 1 year, treasury notes mature in 1 to 10 years, and treasury bonds mature in 10 to 30 years.

10. Explain what is a bond and what are the main characteristics of a simple bond, namely the par value, the coupon interest rate, and the maturity.

- Definition: Long term debt security, with maturity greater than one year. It is used by issuers as a way to borrow funds for long-term financing or investments. They are issued by US Treasury, Federal and local governments, corporations and bought by Institutional investors (most often has they are expensive). Characteristics: - Annual or semi-annual interest payments in the form of coupons - At maturity, the issuer pays the par value to the bond holder - Both the par value and coupons are specified when the bond is issued - Very often, the coupon of a bond is constant and the bond holder receives the same coupon every year (or every six months) Frequency of coupon payments - However, some bonds have coupons which are variable-rate coupons (floating-rate bond) or indexed to inflation. - Issued to the primary capital market (Investors), Secondary market private transaction from investor who bought the bond from the primary market to another investor - Some bond contracts can include: Protective covenants (on dividend policy), A call provision: the issuer has the right to force the buyer to sell back the bond before maturity, Convertibility: the bond holder has the right, under certain conditions, to convert the bond into shares of the corporation

3. Why does the U.S. government use money markets?

- For example, to do Cash Management with Treasury Bills. For instance, debt securities are issued by the US Treasury to cover government budget shortfalls (deficits) Cash Management. - Moreover, Fed Funds which are a market for lending and borrowing between banks are ruled by the government. The US government manipulates them for monetary policy purposes. The Federal Reserves (like the European Central Bank in Europe) has set minimum reserves requirements that all banks must maintain Because many clients may withdraw their money at the same time and they must, of course, fulfil the clients' demands

11. How are bonds different from money market securities? Discuss the difference between money markets and capital markets.

- From the issuer or seller's standpoint, both markets provide a necessary business function: maintaining adequate levels of funding. - The goal for which sellers access each market varies depending on their liquidity needs (money market securities more liquid) and time horizon (money market shorter maturities). - Capital markets offer higher-risk investments, while money markets offer safer assets - Money market returns are often low but steady, while capital markets offer higher returns. The magnitude of capital market returns often has a direct correlation to the level of risk, but that is not always the case.

5. Suppose the Pound sterling overnight LIBOR rate today is 0.22574%. Bank A borrows $50,000,000 from Bank B for a period of one day at this rate. What is the amount of interest owed (assume 365 days convention)?

- Interest = 50,000,000 x 0.0022574 x 1/365 = 309.23

1. What characteristics define the money markets?

- Is the market for short-term debt (less than one year maturity) - The securities traded in the money markets have high liquidity, low default risk and low expected returns Can easily be bought and sold and are considered as money - Benefit: Invest excess cash, Cash outflows (payments) and cash inflows (income) are not perfectly synchronized which can lead to cash shortages "a-synchronization problem" (eg. When I have to produce goods first (cost for inputs and employees) and get paid after a couple of weeks) Money markets provide a way to solve these cash timing problems.

7. Who are the major parties issuing and investing in money market securities?

- Issuers are mainly U.S. government, banks, businesses and finance companies - Investors are mainly consumers, companies, banks, governments and businesses

5. What is meant by the Eurodollar market? Why is it an important source of funding?

- It is an active interbank market in Eurodollars. This market is used by banks around the world as a source of overnight funding, therefore, it is an alternative to fed funds - It is an important market because it allows to benefit from exchange rate fluctuations

9. What is a LIBOR rate? What is the market convention to quote LIBOR rates?

- LIBOR is the abbreviation for London Interbank Offer Rate, a type of Eurodollars. - It is the rate at which a bank is prepared to lend to another one (eg. Loans Libor + charge) - It is quoted every day for different maturities ranging for one day to one year. - Bank must satisfy certain creditworthiness criteria to qualify for receiving LIBOR (time) deposits. - It must typically be rated (at least) AA, AAA being the best rating - It turns out that LIBOR is quoted for various, currencies and not only for the dollar - ICE LIBOR (formerly known as BBA LIBOR) is a benchmark rate produced for five currencies with seven maturities quoted for each - ranging from overnight to 12 months; All ICE LIBOR rates are quoted as an annualized interest rate. This is a market convention - The US Dollar LIBOR interest rate is the average interbank interest rate at which a large number of banks on the London money market are prepared to lend one another (unsecured) funds denominated in US Dollars. - The Euro LIBOR interest rate is the average interbank interest rate at which a large number of banks on the London money market are prepared to lend one another (unsecured) funds denominated in European euros. - LIBOR provides an indication of the average rate at which a LIBOR contributor bank can obtain (unsecured) funding in the London interbank market for a given period in a given currency

2. If a 15-year bond is supposed to mature in 3 months, is it considered to be a money market instrument?

- No, it remains a capital market instrument due to its characteristics (higher interest rates, often tax exempt, higher risk...)

3. Suppose you want to earn an annualized discount rate of 2.5%. What would be the most you would be willing to pay for a 182-day Treasury bill that pays $10,000 at maturity?

- P = F (1 - iDisc x n / 360) = 10,000 x (1 - 0.025 x 182/360) = 9873.61

14. What is the yield to maturity of a bond, and what are the main factors that affect it?

- Since the cash flows of a bond are known in advance, the valuation of a bond is simple: The present value of a bond is equal to the present value of all its future cash flows. - The future cash flows are discounted at the required rate of return/yield. ++++++

6. Which of the money market securities is the most liquid and considered to be the most risk-free? Why?

- Treasury Bills that are used by the government. They are very liquid (issued for terms of 4, 13, 26, and 52 weeks and are auctioned on a regular schedule) and are Virtually default-risk free (because it is short term and very liquid Risk that government can't pay back after 4 weeks is minor)

1. What would be your annualized discount rate % and your annualized investment rate % on the purchase of a 182-day Treasury bill for $4,925 that pays $5,000 at maturity?

- i Disc = ((F-P) / F) x 360/n = ((5000-4925) / 5000) x 360/182 = 0.0297 = 2.96% Discount rate gives me the price of the treasury bill - I Inv = ((F-P) / P) x 365/n = ((5000-4925) / 4925) x 360/182 = 0.0305 = 3.05% Annualized interest rates is around 3%

If the bank you own has no excess reserves and a sound customer comes in asking for a loan, should you automatically turn the customer down, explaining that you don't have any excess reserves to loan out? Why or why not? What options are available for you to provide the funds your customer needs?

-No. When you turn a customer down, you may lose that customer's business forever, which is extremely costly. Instead, you might go out and borrow from other banks, corporations, or the Fed to obtain funds so that you can make the customer's loan. Alternatively, you might sell negotiable CDs or some of your securities to acquire the necessary funds.

What does it mean if a bank has never incurred costs due to a deposit outflow? Should you invest stock?

-The fact that the bank has never incurred costs as a result of a deposit outflow means that the bank is holding a lot of reserves that do not earn any interest. Thus the bank's profits are low, and stock in the bank is not a good investment.

Suppose that you are the manager of a bank 30 rate-asset 20rate-liabilities 5 percent

.5

A bank has 25,000 checkable 25 percent 18750 reserve

12500

When 25,000 is deposited at a bank the required reserve ratio is 10 percent, and the bank chooses not to hold any excess recerives

22500

100 million asset 4 years 90 lil 3 years 5 percentage

6.5

100 asset 5 years 85 liabilities 2 years 2 percentage

6.6 percent

Suppose First National hold 100 million in assets with an average duration of 4 years, it holds 90 million liabilities 2 year. 3 percent A 3- percentage-point increase in interest rates decreases First National's net worth by 6.6 percent

6.6percent

Although it enjoys a high degree of autonomy, the Fed is still subject to the influence of Congress because A) Congress can pass legislation that would restrict the Fed's independence. B) Congress can withhold the Fed's budget requests. C) Congress can remove members of the Board of Governors whose views on policy differ from those of key members of Congress. D) All of the above.

A) Congress can pass legislation that would restrict the Fed's independence.

Which of the following are duties of the Board of Governors of the Federal Reserve System? A) Setting margin requirements, the fraction of the purchase price of securities that has to be paid for with cash. B) Setting the maximum interest rates payable on certain types of time deposits under Regulation Q. C) Regulating credit with the approval of the President under the Credit Control Act of 1969. D) None of the above has been a duty of the Board since the mid-1980s.

A) Setting margin requirements, the fraction of the purchase price of securities that has to be paid for with cash.

Rules used to predict movements in stock prices based on past patterns are, according to the efficient markets theory, A) a waste of time. B) profitably employed by all financial analysts. C) the most efficient rules to employ. D) consistent with the random walk hypothesis.

A) a waste of time.

The problem created by asymmetric information before the transaction occurs is called ________, while the problem created after the transaction occurs is called ________. A) adverse selection; moral hazard B) moral hazard; adverse selection C) costly state verification; free-riding D) free-riding; costly state verification

A) adverse selection; moral hazard

The efficient market hypothesis applies to A) both the stock market and the foreign exchange market. B) the stock market but not the foreign exchange market. C) the foreign exchange market but not the stock market. D) neither the stock market nor the foreign exchange market.

A) both the stock market and the foreign exchange market.

Conflicts of interest in the Arthur Andersen accounting firm intensified when ________ became the firm's largest source of profits and large clients pressured ________ office managers to give favorable audits. A) consulting; regional B) consulting; national C) auditing; regional D) auditing; national

A) consulting; regional

According to the January effect, stock prices A) experience an abnormal price rise from December to January. B) experience an abnormal price decline from December to January. C) follow a random walk during January. D) set the pattern for the entire year in January.

A) experience an abnormal price rise from December to January.

Corporate bonds are not as liquid as government bonds because A) fewer bonds for any one corporation are traded, making them more costly to sell. B) the corporate bond rating must be calculated each time they are traded. C) corporate bonds are not callable. D) all of the above. E) only A and B of the above.

A) fewer bonds for any one corporation are traded, making them more costly to sell.

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

A) gently upward-sloping.

Since firms issuing new securities pay to have these securities rated, the credit-rating agencies have incentive to ________ to attract more business. A) give favorable ratings B) give impartial ratings C) lower the fees they charge D) practice spinning

A) give favorable ratings

A trend in recent years is that more and more governments A) have been granting greater independence to their central banks. B) have been reducing the independence of their central banks to make them more accountable for poor economic performance. C) have mandated that their central banks give up multiple policy goals to focus strictly on inflation. D) have required their central banks to coordinate policies with their ministers of finance.

A) have been granting greater independence to their central banks.

A conflict of interest between providing impartial research about companies issuing securities and selling those same securities arises in A) investment banking. B) commercial banking. C) accounting firms. D) mutual funds.

A) investment banking.

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

A) long-term interest rates are above short-term interest rates.

Financial intermediaries (banks in particular) have the ability to avoid the free-rider problem as long as they primarily A) make private loans. B) acquire a diversified portfolio of stocks. C) buy junk bonds. D) do a balanced combination of A and B of the above.

A) make private loans.

A moderately upward-sloping yield curve indicates that short-term interest rates are expected to A) neither rise nor fall in the near future. B) remain relatively unchanged, but that long-term rates are expected to fall. C) neither rise nor fall, but that long-term rates are expected to rise moderately. D) rise moderately in the near future.

A) neither rise nor fall in the near future.

The advantage of a "buy and hold strategy" is that A) net profits will tend to be higher because there will be fewer brokerage commissions. B) losses will eventually be eliminated. C) the longer a stock is held, the higher its price will be. D) only B and C of the above are true.

A) net profits will tend to be higher because there will be fewer brokerage commissions.

Moral hazard in equity contracts is known as the ________ problem because the manager of the firm has fewer incentives to maximize profits than the stockholders might ideally prefer. A) principal-agent B) adverse selection C) free-rider D) debt deflation

A) principal-agent

Adverse selection is a problem associated with equity and debt contracts arising from A) the lender's relative lack of information about the borrower's potential returns and risks of his investment activities. B) the lender's inability to legally require sufficient collateral to cover a 100 percent loss if the borrower defaults. C) the borrower's lack of incentive to seek a loan for highly risky investments. D) none of the above.

A) the lender's relative lack of information about the borrower's potential returns and risks of his investment activities.

Another way to state the efficient market condition is that in an efficient market, A) unexploited profit opportunities will be quickly eliminated. B) unexploited profit opportunities will never exist. C) arbitrageurs guarantee that unexploited profit opportunities never exist. D) both A and C of the above occur.

A) unexploited profit opportunities will be quickly eliminated.

According to the expectations theory of the term structure, A) when the yield curve is steeply upward-sloping, short-term interest rates are expected to rise in the future. B) when the yield curve is downward-sloping, short-term interest rates are expected to remain relatively stable in the future. C) investors have strong preferences for short-term relative to long-term bonds, explaining why yield curves typically slope upward. D) all of the above. E) only A and B of the above.

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

The problem of adverse selection helps to explain A) which firms are more likely to obtain funds from banks and other financial intermediaries, rather than from securities markets. B) why collateral is an important feature of consumer, but not business, debt contracts. C) why direct finance is more important than indirect finance as a source of business finance. D) only A and B of the above.

A) which firms are more likely to obtain funds from banks and other financial intermediaries, rather than from securities markets.

If borrowers with the most risky investment projects are more likely to seek bank loans as compared to those borrowers with the safest investment projects, banks are said to face the problem of

Adverse selction

Which of the following actions will reduce interest-rate risk faced by banks

All of the above

Why is being nosy a desirable trait for a banker

All of the above

If the bank suffers a deposit outflow of 50 million with a requrid reserve ratio on deposits of 10 percent. Reserves 75, Loans 525, Deposits 500, Bank capital 100

Any combination of the above

The Federal Reserve entity that determines monetary policy strategy is the A) Board of Governors. B) Federal Open Market Committee. C) Chairman of the Board of Governors. D) Shadow Open Market Committee.

B) Federal Open Market Committee.

Which Federal Reserve Bank president always has a vote in the Federal Open Market Committee? A) Philadelphia B) New York C) Boston D) San Francisco

B) New York

A situation in which the price of an asset differs from its fundamental market value is called A) an unexploited profit opportunity. B) a bubble. C) a correction. D) a mean reversion.

B) a bubble.

The Sarbanes-Oxley Act of 2002 dealt with conflicts of interest in A) investment banks. B) accounting firms. C) credit-rating agencies. D) all of the above.

B) accounting firms.

If bad credit risks are the ones who most actively seek loans and, therefore, receive them from financial intermediaries, then financial intermediaries face the problem of A) moral hazard. B) adverse selection. C) free-riding. D) costly state verification.

B) adverse selection.

Adverse selection A) is a problem created by asymmetrical information after the transaction. B) can be solved by eliminating asymmetrical information. C) occurs when people who do not pay for information take advantage of the information other people have to pay for. D) all of the above.

B) can be solved by eliminating asymmetrical information.

As a result of the subprime collapse, the demand for low -quality corporate bonds ________, the demand for high-quality Treasury bonds ________, and the risk spread ________. A) increased; decreased; was unchanged B) decreased; increased; increased C) increased; decreased; decreased D) decreased; increased; was unchanged

B) decreased; increased; increased

If Moody's or Standard and Poor's downgrades its rating on a corporate bond, the demand for the bond ________ and its yield ________. A) increases; decreases B) decreases; increases C) increases; increases D) decreases; decreases

B) decreases; increases

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

B) expectations theory.

Because of the lemons problem in the used car market, the average quality of the used cars offered for sale will be ________, which gives rise to the problem of ________. A) low; moral hazard B) low; adverse selection C) high; moral hazard D) high; adverse selection

B) low; adverse selection

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

B) raising the default risk and causing the demand for its bonds to fall.

When the default risk on corporate bonds decreases, other things equal, the demand curve for corporate bonds shifts to the ________ and the demand curve for Treasury bonds shifts to the ________. A) right; right B) right; left C) left; left D) left; right

B) right; left

The conflict of interest in credit-rating agencies arises because ________ pay to have securities rated and, as a result, the agencies' ratings may be biased ________. A) security issuers; downward B) security issuers; upward C) investors; downward D) regulators; upward

B) security issuers; upward

Evidence against market efficiency does not include A) the small-firm effect. B) technical analysis. C) excessive volatility. D) mean reversion.

B) technical analysis.

According to the liquidity premium theory of the term structure, A) because buyers of bonds may prefer bonds of one maturity over another, interest rates on bonds of different maturities do not move together over time. B) the interest rate on long-term bonds will equal an average of short-term interest rates that people expect to occur over the life of the long-term bonds plus a term premium. C) because of the positive term premium, the yield curve cannot be downward-sloping. D) all of the above. E) only A and B of the above.

B) the interest rate on long-term bonds will equal an average of short-term interest rates that people expect to occur over the life of the long-term bonds plus a term premium.

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

B) the relationship among interest rates of different bonds with the same maturity.

The principal-agent problem A) occurs when managers have more incentive to maximize profits than the stockholders-owners do. B) would not arise if the owners of the firm had complete information about the activities of the managers. C) in financial markets helps to explain why equity is a relatively important source of finance for American businesses. D) all of the above. E) only A and B of the above.

B) would not arise if the owners of the firm had complete information about the activities of the managers.

Banks Sheet A Reserves75, Loans 535 Deposits 500, BC 100 Bank Sheet B Reserves 100, Loans 500 Depostis 500, BC 100

Balance Sheet B because the excess reserves are adequate to cover the depost outflow without habing to alter its balnace sheet

Measuring the sensitivity of bank profits to changes in interest rates by calculating the product of the gap and the change in the interest rate is caled

Basic gap analysis

10. Why do equity holders care more about ROE than ROA?

Because ROE, the return on equity, tells stock holders how much they are earning on their equity investment, while ROA, the return on assets, only provides an indication how well the bank's assets are being managed.

Each member of the seven-member Board of Governors is appointed by the president and confirmed by the Senate to serve A) 4-year terms. B) 6-year terms. C) 14-year terms. D) as long as the appointing president remains in office.

C) 14-year terms.

In the United States, the government agency requiring that firms, which sell securities in public markets, adhere to standard accounting principles and disclose information about their sales, assets, and earnings is the A) Federal Corporate Securities Commission. B) Federal Trade Commission. C) Securities and Exchange Commission. D) U.S. Treasury Department. E) Federal Reserve System.

C) Securities and Exchange Commission.

Which of the following functions are not performed by any of the twelve regional Federal Reserve banks? A) Check clearing B) Conducting economic research C) Setting interest rates payable on time deposits D) Issuing new currency

C) Setting interest rates payable on time deposits

If the yield curve slope is flat, the liquidity premium theory indicates that the market is predicting A) a mild rise in short-term interest rates in the near future and a mild decline further out in the future. B) constant short-term interest rates in the near future and further out in the future. C) a mild decline in short-term interest rates in the near future and a continuing mild decline further out in the future. D) constant short-term interest rates in the near future and a mild decline further out in the future.

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

Members of the Board of Governors are A) chosen by the Federal Reserve Bank presidents. B) appointed by the newly elected president of the United States, as are cabinet positions. C) appointed by the president of the United States and confirmed by the Senate as members resign. D) never allowed to serve more than seven-year terms.

C) appointed by the president of the United States and confirmed by the Senate as members resign.

The elimination of a riskless profit opportunity in a market is called A) the efficient market hypothesis. B) random walk. C) arbitrage. D) market fundamentals.

C) arbitrage.

The efficient market hypothesis A) is based on the assumption that prices of securities fully reflect all available information. B) holds that the expected return on a security equals the equilibrium return. C) both A and B. D) neither A nor B.

C) both A and B.

The majority of household debt in the United States consists of A) credit card debt. B) consumer installment debt. C) collateralized loans. D) unsecured loans, such as student loans.

C) collateralized loans.

According to the efficient market hypothesis, the current price of a financial security A) is the discounted net present value of future interest payments. B) is determined by the highest successful bidder. C) fully reflects all available relevant information. D) is a result of none of the above.

C) fully reflects all available relevant information.

The efficient market hypothesis suggests that allocating your funds in the financial markets on the advice of a financial analyst A) will certainly mean higher returns than if you had made selections by throwing darts at the financial page. B) will always mean lower returns than if you had made selections by throwing darts at the financial page. C) is not likely to prove superior to a strategy of making selections by throwing darts at the financial page. D) is good for the economy.

C) is not likely to prove superior to a strategy of making selections by throwing darts at the financial page.

If borrowers take on big risks after obtaining a loan, then lenders face the problem of A) free-riding. B) adverse selection. C) moral hazard. D) costly state verification.

C) moral hazard.

Moody's and Standard and Poor's are agencies that A) help investors collect when corporations default on their bonds. B) advise municipal bond issuers on the tax exempt status of their bonds. C) produce information about the probability of default on corporate bonds. D) maintain liquid markets for corporate bonds.

C) produce information about the probability of default on corporate bonds.

In the used car market, asymmetric information leads to the lemons problem because the price that buyers are willing to pay will A) reflect the highest quality of used cars in the market. B) reflect the lowest quality of used cars in the market. C) reflect the average quality of used cars in the market. D) none of the above.

C) reflect the average quality of used cars in the market.

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

C) short-term interest rates to stay near their current levels.

Mean reversion refers to the observation that A) stock prices overact to news announcements. B) stocks prices are more volatile than fluctuations in their fundamental value would predict. C) stocks with low returns are likely to have high returns in the future. D) stocks with low returns are likely to have even lower returns in the future.

C) stocks with low returns are likely to have high returns in the future.

Tests used to rate the performance of rules developed in technical analysis conclude that A) technical analysis outperforms the overall market. B) technical analysis far outperforms the overall market, suggesting that stockbrokers provide valuable services. C) technical analysis does not outperform the overall market. D) technical analysis does not outperform the overall market, suggesting that stockbrokers do not provide services of any value.

C) technical analysis does not outperform the overall market.

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

C) the interest rate on municipal bonds would rise.

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

C) widened significantly

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

C) yield curve.

Which of the following is not an asset on a banks balnace sheet

Checkable deposits

Assets of value promised to the lender as compensation if the borrower defaults are called ---

Collateral

Which of the following statements are true? A) Because coupon payments on municipal bonds are exempt from federal income tax, the expected after-tax return on them will be higher for individuals in higher income tax brackets. B) An increase in tax rates will increase the demand for municipal bonds, lowering their interest rates. C) Interest rates on municipal bonds will be lower than on comparable bonds without the tax exemption. D) All of the above are true statements. E) Only A and B are true statements.

D) All of the above are true statements.

________ bonds are exempt from federal income taxes. A) Corporate Aaa B) U.S. Treasury C) Corporate Baa D) Municipal

D) Municipal

Because managers (________) have less incentive to maximize profits than the stockholders-owners (________) do, stockholders find it costly to monitor managers; thus, stockholders are reluctant to purchase equities. A) principals; agents B) principals; principals C) agents; agents D) agents; principals

D) agents; principals

According to the market segmentation theory of the term structure, A) the interest rate for bonds of one maturity is determined by the supply and demand for bonds of that maturity. B) bonds of one maturity are not substitutes for bonds of other maturities; therefore, interest rates on bonds of different maturities do not move together over time. C) investors' strong preference for short-term relative to long-term bonds explains why yield curves typically slope upward. D) all of the above. E) none of the above.

D) all of the above.

Holding everything else the same, if a corporation's earnings rise, then the default risk on its bonds will ________ and the expected return on those bonds will ________. A) increase; decrease B) decrease; decrease C) increase; increase D) decrease; increase

D) decrease; increase

That most used cars are sold by intermediaries (i.e., used car dealers) provides evidence that these intermediaries A) provide information that is valued by consumers of used cars. B) are able to prevent others from free-riding off the information that they provide. C) can profit by becoming experts in determining whether an automobile is a good car or a lemon. D) do all of the above.

D) do all of the above.

The liquidity premium theory of the term structure A) indicates that today's long-term interest rate equals the average of short-term interest rates that people expect to occur over the life of the long-term bond. B) assumes that bonds of different maturities are perfect substitutes. C) suggests that markets for bonds of different maturities are completely separate because people have different preferences. D) does none of the above.

D) does none of the above.

The Bush tax cut passed in 2001 reduces the top income tax bracket from 39 percent to 35 percent over the next ten years. As a result of this tax cut, the demand for municipal bonds should shift to the ________ and the interest rate on municipal bonds should ________. A) right; decline B) right; increase C) left; decline D) left; increase

D) left; increase

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

D) left; right

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

D) none of the above.

If the optimal forecast of the return on a security exceeds the equilibrium return, then A) the market is inefficient. B) an unexploited profit opportunity exists. C) the market is in equilibrium. D) only A and B of the above are true. E) only B and C of the above are true.

D) only A and B of the above are true.

A conflict of interest occurs when A) a financial firm sells a service to its customers for a price that exceeds the cost of producing the service. B) lenders prefer higher interest rates and borrowers prefer lower interest rates. C) riskier borrowers are the ones who are more likely to apply for loans. D) people expected to provide reliable information to the public have incentives not to do so.

D) people expected to provide reliable information to the public have incentives not to do so.

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

D) rightward; fall

To say that stock prices follow a "random walk" is to argue that A) stock prices rise, then fall. B) stock prices rise, then fall in a predictable fashion. C) stock prices tend to follow trends. D) stock prices are, for all practical purposes, unpredictable.

D) stock prices are, for all practical purposes, unpredictable.

Evidence in favor of market efficiency does not include A) random-walk behavior. B) technical analysis. C) performance of investment analysts and mutual funds. D) the January effect.

D) the January effect.

The term structure of interest rates is A) the relationship among interest rates of different bonds with the same risk and maturity. B) the structure of how interest rates move over time. C) the relationship among the terms to maturity of different bonds from different issuers. D) the relationship among interest rates on bonds with different maturities but similar risk.

D) the relationship among interest rates on bonds with different maturities but similar risk.

Studies of mutual fund performance indicate that mutual funds that outperformed the market in one time period A) usually beat the market in the next time period. B) usually beat the market in the next two subsequent time periods. C) usually beat the market in the next three subsequent time periods. D) usually do not beat the market in the next time period.

D) usually do not beat the market in the next time period.

The volume of checkable deposits relative to total bank liabilities has

Declined over time

Bank loans from the Federal Reserve are called ----- and represent a source of new funds for financial intermediaries

Discount loans

Which of the following are true statements? A) The FOMC usually meets every six weeks to set monetary policy. B) The FOMC issues directives to the trading desk at the New York Fed. C) Designers of the Federal Reserve Act did not envision the use of discount lending as a monetary policy tool. D) All of the above are true statements. E) Only A and B of the above are true statements.

E) Only A and B of the above are true statements.

Since yield curves are usually upward sloping, the ________ indicates that, on average, people tend to prefer holding short-term bonds to long-term bonds. A) market segmentation theory B) expectations theory C) liquidity premium theory D) both A and B of the above E) both A and C of the above

E) both A and C of the above

The risk premium on corporate bonds becomes smaller if A) the riskiness of corporate bonds increases. B) the liquidity of corporate bonds increases. C) the liquidity of corporate bonds decreases. D) the riskiness of corporate bonds decreases. E) either B or D of the above occur.

E) either B or D of the above occur.

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

E) five years.

Because of the moral hazard problem, A) lenders will write debt contracts that restrict certain activities of borrowers. B) lenders will more readily lend to borrowers with high net worth. C) debt contracts are used less frequently to raise capital than equity contracts. D) all of the above. E) only A and B of the above.

E) only A and B of the above.

Factors that provide the Federal Reserve with a high degree of independence include A) 14-year terms for members of the Board of Governors. B) a four-year term for the chairman of the Board of Governors that is not coincident with the president's term of office. C) constitutional independence from Congress and the president. D) all of the above. E) only A and B of the above.

E) only A and B of the above.

Moral hazard is a problem associated with debt and equity contracts arising from A) the borrower's incentive to undertake highly risky investments. B) the owners' inability to ensure that managers will act in the owners' interest. C) the difficulty lenders have in sorting out good credit risks from bad credit risks. D) all of the above. E) only A and B of the above.

E) only A and B of the above.

The unusual structure of the Federal Reserve System is perhaps best explained by A) Americans' fear of centralized power. B) the traditional American distrust of moneyed interests. C) Americans' desire to remove control of the money supply from the U.S. Treasury. D) all of the above. E) only A and B of the above.

E) only A and B of the above.

Why might eliminating the Fed's independence lead to a more pronounced political business cycle?

Eliminating the Fed's independence might make it more shortsighted and subject to political influence. Thus, when political gains could be achieved by expansionary policy before an election, the Fed might be more likely to engage in this activity. As a result, more pronounced political business cycles might result.

Because diversification is a desirable strategy for aboiding risk, it never makes sense for a bank to specialize in making specific types of loans

False because a bank may have developed expertise in screening and monitoring a particular kind of loan, thus improving its ability to handle problems of adverse selection and moral hazard

"Because diversification is a desirable strategy for avoiding risk, it never makes sense for a bank to specialize in making specific types of loans." Is this statement true, false, or uncertain? Explain your answer.

False. Although diversification is a desirable strategy for a bank, it may still make sense for a bank to specialize in certain types of lending. For example, a bank may have developed expertise in screening and monitoring borrowers for a particular kind of loan, thus improving its ability to handle problems of adverse selection and moral hazard

Bank managers should always seek the highest return possible on their assets." Is this statement true, false or uncertain? Explain your answer.

False. If an asset has a lot of risk, a bank manager might not want to hold it even if it has a higher return than other assets. Thus a bank manager has to consider risk as well as the expected return when deciding to hold an asset.

"An efficient market is one in which no one ever profits from having better information than the rest." Is this statement true, false, or uncertain? Explain your answer.

False. The people with better information are exactly those who make the market more efficient by eliminating unexploited profit opportunities. These people can profit from their better information.

Using the T-account of the First National Bank and the Second National Bank, describe what happens when Jane Brown writes a 95 check on her account at the First National Bank to pay her friend Joe Green

First National -95. -95 Second National 95, 95

in addition to treasury securities, some agencies of the government issue bonds. list 3 such agencies, and state what the funds raised by the bond issues are used for.

Ginny Mae (Government National Mortgage Association), Federal Housing Administration, the Veteran Administration, the Fannie Mae (Federal National Mortgage Association), and Sallie Mae (Student Loan Marketing Association). The first 4 fund mortgage loans and the last funds college student loans.

If the public expects a corporation to lose $5 a share this quarter and it actually loses $4, which is still the largest loss in the history of the company, what does the efficient market hypothesis say will happen to the price of the stock when the $4 loss is announced?

If the public expects a corporation to lose $5 a share this quarter and it actually loses $4, which is still the largest loss in the history of the company, what does the efficient market hypothesis say will happen to the price of the stock when the $4 loss is announced? The stock price will rise. Even though the company is suffering a loss, the price of the stock reflects an even larger expected loss. When the loss is less than expected, efficient markets theory then indicates that the stock price will rise.

If yield curves, on average, were flat, what would this say about the liquidity premiums in the term structure? Would you be more or less willing to accept the pure expectations theory?

If yield curves, on average, were flat, what would this say about the liquidity premiums in the term structure? Would you be more or less willing to accept the pure expectations theory? If yield curves on average were flat, this would suggest that the risk premium on long-term relative to short-term bonds would equal zero and we would be more willing to accept the pure expectations theory.

Risk that is related to the uncertainty about future interest rate movemtns is called

Interest-rate risk

15. If a bank is falling shore of meeting its capital requirements by $1m, what three things can it do to rectify the situation?

It can raise $1 million of capital by issuing new stock. It can cut its dividend payments by $1 million, thereby increasing its retained earnings by $1 million. It can decrease the amount of its assets so that the amount of its capital relative to its assets increases, thereby meeting the capital requirements.

A bank finds that its ROE is too low because it has too much bank capital.

It can sell part of its holdings of securitites and hold more excess reserves

Which of the following is a main responsibility of the bank manager

Mainting reserves at a level to minimize the cost to the bank of deposit outflow

what purpose initially motivated Merrill Lynch to offer money market mutual funds to its customers?

Merrill Lynch initially felt is could better service its regular customers by making it easier to buy and sell securities from an account held at the brokerage house. The brokerage could offer a market interest rate on these funds by investing them in the money markets.

In order to reduce the ----- problem in loan markets, bankers often insist on collateral from potential borrowers

Moral hazard

Can we expect the value of the dollar to rise by 2% next week if our expectations are optimal?

No, because this expected change in the value of the dollar would imply that there is a huge unexploited profit opportunity (over a 100% expected return at an annual rate). Since the rational expectations theory rules out unexploited profit opportunities, such a big expected change in the exchange rate could not exist.

If the bank you own has no excess reserves and a sound customer comes in asking for a loan should you automatically turn the customer down

No. There are several ways that reserves

Predict what will happen to interest rates on a corporation's bonds if the federal government guarantees today that it will pay creditors if the corporation goes bankrupt in the future. What will happen to the interest rates on Treasury securities?

Predict what will happen to interest rates on a corporation's bonds if the federal government guarantees today that it will pay creditors if the corporation goes bankrupt in the future. What will happen to the interest rates on Treasury securities? The government guarantee will reduce the default risk on corporate bonds, making them more desirable relative to Treasury securities. The increased demand for corporate bonds and decreased demand for Treasury securities will lower interest rates on corporate bonds and raise them on Treasury bonds.

Provisions in loan contracts designed to mmitigate the moral hazard problem are called

Restrictive covenants

Risk premiums on corporate bonds are usually anti-cyclical; that is, they decrease during business cycle expansions and increase during recessions. Why is this so?

Risk premiums on corporate bonds are usually anti-cyclical; that is, they decrease during business cycle expansions and increase during recessions. Why is this so? During business cycle booms, fewer corporations go bankrupt and there is less default risk on corporate bonds, which lowers their risk premium. Similarly, during recessions, default risk on corporate bonds increases and their risk premium increases. The risk premium on corporate bonds is thus anticyclical, rising during recessions and falling during booms.

Examples of off balance sheet activities include

Selling loan portfolios

The share of checkable deposits in toatl bank liabilities has

Shrunk over time

When investors are involved in trading activities in an attempt to outguess markets they are

Speculating

The Fed is the most independent of all U.S. government agencies. What is the main difference between it and other government agencies that explains the Fed's greater independence?

The Fed is the most independent of all U.S. government agencies. What is the main difference between it and other government agencies that explains the Fed's greater independence? The Fed is more independent because its substantial revenue from securities and discount loans allows it to control its own budget.

The Fed promotes secrecy by not releasing the minutes of the FOMC meetings to Congress or the public immediately. Discuss the pros and cons of this policy.

The Fed promotes secrecy by not releasing the minutes of the FOMC meetings to Congress or the public immediately. Discuss the pros and cons of this policy. The argument for not releasing the FOMC directives immediately is that it keeps Congress off the Fed's back, thus enabling the Fed to pursue an independent monetary policy that is less subject to inflation and political business cycles. The argument for releasing the directive immediately is that it would make the Fed more accountable.

Do you think the lemons problem would be more sever for stocks traded on the New York Stock Exchange or those traded over the counter? Explain.

The lemons problem would be less severe for firms listed on the New York Stock Exchange because they are typically larger corporations which are better known in the marketplace. Therefore it is easier for investors to get information about them and figure out whether the firm is of good quality or is a lemon. This makes the adverse selection-lemons problem less severe.

The principal agent problem that exists for bank trading activities can be reduced through

The physical separation of trading activities from bookkeeping activites

13. If a bank finds its ROE is too low because it has too much bank capital, what can it do to raise its ROE?

To lower capital and raise ROE, holding its assets constant, it can pay out more dividends or buy back some of its shares. Alternatively, it can keep its capital constant but increase the amount of its assets by acquiring new funds and then seeking out new loan business or purchasing more securities with these new funds.

"If stock prices did not follow a random walk, there would be unexploited profit opportunities in the market." Is this statement true, false, or uncertain? Explain your answer.

True, as an approximation. If large changes in a stock price could be predicted, then the optimal forecast of the stock return would not equal the equilibrium return for that stock. In this case, there would be unexploited profit opportunities in the market and expectations would not be rational. Very small changes in stock prices could be predictable, however, and the optimal forecast of returns would equal the equilibrium return. In this case, an unexploited profit opportunity would not exist.

"Banking has become a more dynamic industry because of more active liability management." Is this statement true, false or uncertain?

True. Banks can now pursue new loan business much more aggressively than in the past because when they see profitable loan opportunities, they can use liability management to acquire new funds and expand the bank's business.

What effect would reducing income tax rates have on the interest rates of municipal bonds? Would interest rates of Treasury securities be affected and, if so, how?

What effect would reducing income tax rates have on the interest rates of municipal bonds? Would interest rates of Treasury securities be affected and, if so, how? The reduction in income tax rates would make the tax-exempt privilege for municipal bonds less valuable, and they would be less desirable than taxable Treasury bonds. The resulting decline in the demand for municipal bonds and increase in demand for Treasury bonds would raise interest rates on municipal bonds while causing interest rates on Treasury bonds to fall.

Which entities in the Federal Reserve System control the discount rate? Reserve requirement? Open market operations?

Which entities in the Federal Reserve System control the discount rate? Reserve requirement? Open market operations? The Board of Governors sets reserve requirements and the discount rate; the FOMC directs open market operations. In practice, however, the FOMC helps make decisions about reserve requirements and the discount rate.

If you are a banker and expect interest rates to rise in the future, would you want to make short-term or long-term loans?

You should want to make short-term loans. Then, when these loans mature, you will be able to make loans at higher interest rates, which will generate more income for the bank.

Describe two conflicts of interest that occur when underwriting and research are provided by a single investment firm.

a. Research analysts in investment banks might distort their research to please issuers of securities so underwriters in the investment bank can get their business. b. Investment banks might engage in spinning, a form of kickback in which they allocate hot, but underpriced, IPOs to executives in return for their companies' future business.

why are banker;s acceptances so popular for international transactions?

banker's acceptances substitute the credit worthiness of a bank for that of a business. when a company sells a product to a company it is unfamiliar with, it often prefers to have the promise of a bank that payment will be made.

why do banks not eliminate the need for money markets?

banks have higher costs than the money market owing to the need to maintain reserve requirements. the lower cost structure of the money markets, coupled with the economies of scale resulting from high volume and large-denomination securities, allows for higher interest rates.

Transformation of assets can be accomplished by

borrowing short and lending long

why do businesses use the money market?

businesses both invest and borrow in the money markets. they borrow to meet short-term cash flow needs, often by issuing commercial paper. they invest in all types of money market securities as an alternative to holding idle cash balances

what characteristics define the money markets?

can be characterized as having securities that trade in one year or less, are one of large denomination, and are very liquid

describe the two ways whereby capital market securities pass from the issuer to the public?

capital market securities may be sold in a public offering or in a private placement. in a public offering, investment bankers register the security with the SEC and market it through a network of brokerage houses. in a private placement, the firm or an investment bankers sells the securities to a very large number of investors, who each buy a large quantity.

who issues federal funds, and what is the usual purpose of these funds?

federal funds are sold by banks to other banks. they're used to invest excess reserves and to raise reserves is a bank is short

a call provision on a bond allows the issuer to redeem the bond at will. investors don't like call provisions and so require higher interest on callable bonds. who do issuers continue to issue callable bonds anyway?

firms like having the flexibility to adjust their capital structure by paying off debt they no longer need. they also need to pay off debt to remove restrictive covenants. call provisions permit both these actions at the issuers discretion.

what motivates regulators to impose interest ceilings on bank savings accounts? what effect did this eventually have on the money markets?

following the great depression, regulators were primarily concerned with stopping banks from failing. by removing interest-rate competition, bank risk was substantially reduced. the problem with these regulations was that when market interest rates rose above the established interest-rate ceiling, investors withdrew their funds from banks.

contrast investors use of capital markets with their use of money markets

investors use capital markets for long-term investment purposes. they use money markets, which have lower yields, primarily for temporary or transaction purposes.

why are more funds from property and casualty insurance companies than funds from life insurance companies invested in the money markets?

life insurance companies can invest for the long term because the timing for their liabilities is known with reasonable accuracy. property and casualty insurance companies cannot predict the natural disasters that cause large payouts on policies.

Banks generate profits by earning higher returns on their ----- than the pay in interest on -----

loans, deposits

Large-denomination CDs are ------, so that like a bond, they have a ------- degree of liquidity and can be sold in secondary markets

negotibale, greater

Gap analysis measures the difference between a banks

rate-sensitive

what are primary capital market securities, and who are the primary purchasers of these securities?

stocks and bonds. most of these are purchased by and owned by households

distinguish between a term security and a demand security.

term securities have a specific maturity date. demand securities can be redeemed at any time. a six-month certificate of deposit is a term security. a checking account is a demand security.

why does the US government use the money market?

the US government sells large numbers of securities in the money markets to support government spending. over the past several decades, the government has spent more each year than it has received in tax revenues. it makes up the difference by borrowing. part of what it borrows comes from the money markets.

a bond provides info abut its par value, coupon interest rate, and maturity date. define each of these.

the par value is the amount the issuer will pay the holder when the bond matures. the coupon interest rate is multiplied times the the par value to determine the interest payment the issuer must make each year. the maturity date is when the issuer must bay the holder the par value.

distinguish between the primary market and the secondary market for securities

the primary market is for securities being issued for the very first time, and the issuer receives the funds paid for the security. the secondary market is for securities that have been issued previously but are being traded smong investors.

as interest rates in the market change over time, the market price of bonds rises and falls. the change in the value of bonds due to change in interest rates is a risk incurred by bond investors. what is this risk called?

the risk that a bond's price will change due to changes in market interest rates is called INTEREST RISK RATE.