ECO 029 Test 1 HW/Quiz Answers

Using the numbers 1, 2, 3, 4, rank the following four assets from most liquid (1) to least liquid (4): A 10,000-square-foot-office building $2,000 in cash A $10,000 Treasury bill 100 shares of Google stock

4 1 2 3

Asset A: Pays a return of $2,000 20% of the time and $500 80% of the time. Asset B: Pays a return of $1,000 50% of the time and $600 50% of the time. If both assets can be acquired for the same price, as a risk-averse investor, you would prefer

Asset B

If you suspect that an airline will go bankrupt next week, which would you rather hold, bonds or equities issued by the company?

Bonds

Identify the cash flow available to an investor in stock.

Dividends and capital gains.

Retired persons often have much of their wealth placed in savings accounts and other interest-bearing investments, and complain whenever interest rates are low. Which of the following, if true, would be a valid complaint?

Expected inflation is falling at a slower rate than nominal interest rates.

"According to the expectations theory of the term structure, is it better to invest in one-year bonds, reinvested over two years, than to invest in a two-year bond, if interest rates on one-year bonds are expected to be the same in both years." Is this statement true, false, or uncertain?

False: These investments are almost of the same profitability.

If a forecaster spends hours every day studying data to forecast interest rates, but his expectations are not as accurate as predicting that tomorrow's interest rates will be identical to today's interest rate, which of the following is true?

He could improve the accuracy of his forecasts.

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?

Interest rates on corporate bonds will decrease

What will happen to interest rates if the public suddenly expects a large increase in stock prices?

Interest rates will rise because the expected increase in stock prices raises the expected return on stocks relative to bonds and so the demand for bonds decreases.

What would happen to the risk premium on corporate bonds if brokerage commissions were lowered in the corporate bond market?

Lower brokerage commissions for corporate bonds would make them more liquid and thus increase demand, which would lower the risk premium.

As a bank, you make a loan to an individual seeking funds to open a coffee shop. When the loan is made, the borrower uses the funds to take a vacation to Greenland. This is an example of

Moral hazard.

Would you be more or less willing to buy long-term AT&T bonds under the following circumstances: Trading in these bonds increases, making them easier to sell. You expect a bear market in stocks (stock prices are expected to decline). Brokerage commissions on stocks fall. You expect interest rates to rise. Brokerage commissions on bonds fall.

More willing More willing Less willing Less willing More willing

Would you be more or less willing to buy a house under the following circumstances: You just inherited $100,000 Real estate commissions fall from 6% of the sales price to 5% of the sales price You expect Microsoft stock to double in value next year Prices in the stock market become more volatile You expect housing prices to fall

More willing More willing Less willing More willing Less willing

A financial adviser has just given you the following advice: "Long-term bonds are a great investment because their interest rate is over 20%." Is the financial adviser necessarily right?

No. If the interest rates rise sharply in the future, long-term bonds may suffer a sharp fall in price causing their return to be quite low.

Assuming the terms of issuance to be the same for different types of loans, a government would choose to issue a:

Perpetuity

What basic principle of finance can be applied to the valuation of any investment asset?

Present value

If monetary policy becomes more transparent about the future course of interest rates, how would that affect stock prices, if at all?

Stock prices will increase, as the risk and required return on the investment will be reduced.

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

The channel funds from savers to investors.

M1 money growth in the U.S. was about 16% in 2008, 7% in 2009, and 9% in 2010. Over the same period, the yield on 3-month Treasury bills fell from almost 3% to close to 0%. Given these high rates of money growth, why did interest rates fall, rather than increase?

The income, price-level, and expected-inflation effects were small relative to the liquidity effect.

During 2008, the difference in the yield between 3-month AA-rated financial commercial paper and 3-month AA-rated non-financial commercial paper steadily increased from its usual level of close to zero, spiking to over a full percentage point at its peak in October 2008. Which of the following explains this sudden increase?

The increase in the yield spread was a result of the decrease in demand for financial commercial paper due to the uncertainty and soundness of financial companies and banks.

If expectations of future short-term interest rates suddenly fall, what would happen to the slope of the yield curve?

The yield curve would become flatter.

When interest rates decrease, how might businesses and consumers change their economic behavior?

There will be more consumption spending on interest-sensitive items and more investment by businesses.

To pay for college, you have just taken out a $1,000 government loan that makes you pay $126 per year for 25 years. However, you don't have to start making these payments until you graduate from college two years from now. Why is the yield to maturity necessarily less than 12% (this is the yield to maturity on a normal $1,000 fixed-payment loan in which you pay $126 per year for 25 years)?

This is the case because the first payment due begins at a future date.

Foreign exchange rates, like stock prices, should follow a random walk because changes in the exchange rate are unpredictable.

True

"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?

True because for a risk-averse person, those characteristics 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?

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

True or False: With a discount bond, the return on a bond is equal to the rate of capital gain.

True: a discount bond has no coupon payments so the return on the bond is equal to the rate of capital gain

What will happen to interest rates if prices in the bond market become more volatile?

When bond prices become more volatile, bonds become riskier and the demand for bonds will fall, which causes interest rates to rise.

A share of Microsoft common stock is

an asset for its owner and a liability for Microsoft

The effect of a shock of downward revision of inflation expectations causes bond yields to

decrease

Is it better for bondholders when the yield to maturity increases or decreases? Bondholders are better off when the yield to maturity:

decreases, since this represents an increase in the price of the bond and a decrease in potential capital losses.

The provision of several types of financial services by one firm may be beneficial because of

economies of scope and problematic because of conflicts of interest

If the income tax exemption on municipal bonds were abolished, the interest rates on these bonds would

increase

You would be (blank) willing to buy gold if prices in the gold market become more volatile because

less gold has become relatively more risky

You would be (blank) willing to buy a share of Microsoft stock if you expect gold to appreciate in value because

less the return on gold relative to stocks has improved

You would be (blank) willing to buy a share of Microsoft stock if the bond market becomes more liquid because

less you can now sell bonds easier than stocks

You would be (blank) willing to buy a share of Microsoft stock if your wealth falls because

less you have less money to spend on all of your potential assets

You would be (blank) willing to buy gold if gold again becomes acceptable as a medium of exchange because

more gold has become relatively more liquid

You would be (blank) willing to buy gold if you expect interest rates to rise because

more now gold has a better expected return than bonds

You would be (blank) willing to buy a share of Microsoft stock if prices in the bond market become more volatile because

more stocks have become relatively safer than bonds

You would be (blank) willing to buy gold if you expect inflation to rise, and gold prices tend to move with the aggregate price level because

more the value of gold will offset the rising prices to keep your real value the same

You would be (blank) wiling to buy a share of Microsoft stock if you expect the stock to appreciate in value because

more you believe the amount of return on your investment will be positive

If bond investors decide that 30-year bonds are no longer as desirable an investment, the yield curve would:

steepen at the end of the yield curve and flatten somewhere along the rest of the curve

If the yield curve suddenly becomes steeper, how would you revise your predictions of interest rates in the future?

you would raise your predictions of future interest rates