ECON308 Chapter 2

5) If Microsoft sells a bond in London and it is denominated in dollars, the bond is a A) Eurobond. B) foreign bond. C) British bond. D) currency bond.

Answer: A

18) Secondary markets make financial instruments more A) solid. B) vapid. C) liquid. D) risky.

Answer: C

6) ________ are short-term loans in which Treasury bills serve as collateral. A) Repurchase agreements B) Negotiable certificates of deposit C) Federal funds D) U.S. government agency securities

Answer: A

11) Risk sharing is profitable for financial institutions due to A) low transactions costs. B) asymmetric information. C) adverse selection. D) moral hazard.

Answer: A

13) Which of the following instruments is not traded in a money market? A) Residential mortgages B) U.S. Treasury Bills C) Negotiable bank certificates of deposit D) Commercial paper

Answer: A

15) 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% loss if the borrower defaults. C) the borrower's lack of incentive to seek a loan for highly risky investments. D) the borrower's lack of good options for obtaining funds.

Answer: A

18) Which of the following instruments are traded in a capital market? A) Corporate bonds B) U.S. Treasury bills C) Negotiable bank CDs D) Repurchase agreements

Answer: A

27) Because these securities are more liquid and generally have smaller price fluctuations, corporations and banks use the ________ securities to earn interest on temporary surplus funds. A) money market B) capital market C) bond market D) stock market

Answer: A

1) Prices of money market instruments undergo the least price fluctuations because of A) the short terms to maturity for the securities. B) the heavy regulations in the industry. C) the price ceiling imposed by government regulators. D) the lack of competition in the market.

Answer: A

10) Which of the following are short-term financial instruments? A) A repurchase agreement B) A share of Walt Disney Corporation stock C) A Treasury note with a maturity of four years D) A residential mortgage

Answer: A

10) Which of the following can be described as involving direct finance? A) A corporation issues new shares of stock. B) People buy shares in a mutual fund. C) A pension fund manager buys a short-term corporate security in the secondary market. D) An insurance company buys shares of common stock in the over-the-counter markets.

Answer: A

11) An important financial institution that assists in the initial sale of securities in the primary market is the A) investment bank. B) commercial bank. C) stock exchange. D) brokerage house.

Answer: A

12) When an investment bank ________ securities, it guarantees a price for a corporation's securities and then sells them to the public. A) underwrites B) undertakes C) overwrites D) overtakes

Answer: A

14) Securities are ________ for the person who buys them, but are ________ for the individual or firm that issues them. A) assets; liabilities B) liabilities; assets C) negotiable; nonnegotiable D) nonnegotiable; negotiable

Answer: A

14) 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

Answer: A

15) A corporation acquires new funds only when its securities are sold in the A) primary market by an investment bank. B) primary market by a stock exchange broker. C) secondary market by a securities dealer. D) secondary market by a commercial bank.

Answer: A

15) Equity and debt instruments with maturities greater than one year are called ________ market instruments. A) capital B) money C) federal D) benchmark

Answer: A

16) With direct finance, funds are channeled through the financial market from the ________ directly to the ________. A) savers, spenders B) spenders, investors C) borrowers, savers D) investors, savers

Answer: A

17) An important function of secondary markets is to A) make it easier to sell financial instruments to raise funds. B) raise funds for corporations through the sale of securities. C) make it easier for governments to raise taxes. D) create a market for newly constructed houses.

Answer: A

17) Which of the following instruments are traded in a capital market? A) U.S. Government agency securities B) Negotiable bank CDs C) Repurchase agreements D) U.S. Treasury bills

Answer: A

19) A liquid asset is A) an asset that can easily and quickly be sold to raise cash. B) a share of an ocean resort. C) difficult to resell. D) always sold in an over-the-counter market.

Answer: A

2) Financial markets have the basic function of A) getting people with funds to lend together with people who want to borrow funds. B) assuring that the swings in the business cycle are less pronounced. C) assuring that governments need never resort to printing money. D) providing a risk-free repository of spending power.

Answer: A

2) Which of the following statements about the characteristics of debt and equities is true? A) They can both be long-term financial instruments. B) Bond holders are residual claimants. C) The income from bonds is typically more variable than that from equities. D) Bonds pay dividends.

Answer: A

20) The countries that have made the least use of securities markets are ________ and ________; in these two countries finance from financial intermediaries has been almost ten times greater than that from securities markets. A) Germany; Japan B) Germany; Great Britain C) Great Britain; Canada D) Canada; Japan

Answer: A

20) The higher a security's price in the secondary market the ________ funds a firm can raise by selling securities in the ________ market. A) more; primary B) more; secondary C) less; primary D) less; secondary

Answer: A

21) Although the dominance of ________ over ________ is clear in all countries, the relative importance of bond versus stock markets differs widely. A) financial intermediaries; securities markets B) financial intermediaries; government agencies C) government agencies; financial intermediaries D) government agencies; securities markets

Answer: A

21) When secondary market buyers and sellers of securities meet in one central location to conduct trades the market is called a(n) A) exchange. B) over-the-counter market. C) common market. D) barter market.

Answer: A

24) Which of the following statements about financial markets and securities is true? A) Many common stocks are traded over-the-counter, although the largest corporations usually have their shares traded at organized stock exchanges such as the New York Stock Exchange. B) As a corporation gets a share of the broker's commission, a corporation acquires new funds whenever its securities are sold. C) Capital market securities are usually more widely traded than shorter-term securities and so tend to be more liquid. D) Because of their short-terms to maturity, the prices of money market instruments tend to fluctuate wildly.

Answer: A

3) Bonds that are sold in a foreign country and are denominated in the country's currency in which they are sold are known as A) foreign bonds. B) Eurobonds. C) equity bonds. D) country bonds.

Answer: A

4) Economies of scale enable financial institutions to A) reduce transactions costs. B) avoid the asymmetric information problem. C) avoid adverse selection problems. D) reduce moral hazard.

Answer: A

5) A short-term debt instrument issued by well-known corporations is called A) commercial paper. B) corporate bonds. C) municipal bonds. D) commercial mortgages.

Answer: A

5) If the maturity of a debt instrument is less than one year, the debt is called A) short-term. B) intermediate-term. C) long-term. D) prima-term.

Answer: A

6) Financial intermediaries provide customers with liquidity services. Liquidity services A) make it easier for customers to conduct transactions. B) allow customers to have a cup of coffee while waiting in the lobby. C) are a result of the asymmetric information problem. D) are another term for asset transformation.

Answer: A

7) The process where financial intermediaries create and sell low-risk assets and use the proceeds to purchase riskier assets is known as A) risk sharing. B) risk aversion. C) risk neutrality. D) risk selling.

Answer: A

9) Reducing risk through the purchase of assets whose returns do not always move together is A) diversification. B) intermediation. C) intervention. D) discounting.

Answer: A

9) The British Banker's Association average of interbank rates for dollar deposits in the London market is called the A) Libor rate. B) federal funds rate. C) prime rate. D) Treasury Bill rate.

Answer: A

7) Distinguish between a foreign bond and a Eurobond.

Answer: A foreign bond is sold in a foreign country and priced in that country's currency. A Eurobond is sold in a foreign country and priced in a currency that is not that country's currency.

29) Describe the two methods of organizing a secondary market.

Answer: A secondary market can be organized as an exchange where buyers and sellers meet in one central location to conduct trades. An example of an exchange is the New York Stock Exchange. A secondary market can also be organized as an over-the-counter market. In this type of market, dealers in different locations buy and sell securities to anyone who comes to them and is willing to accept their prices. An example of an over-the-counter market is the federal funds market.

22) Because there is an imbalance of information in a lending situation, we must deal with the problems of adverse selection and moral hazard. Define these terms and explain how financial intermediaries can reduce these problems.

Answer: Adverse selection is the asymmetric information problem that exists before the transaction occurs. For lenders, it is the difficulty in judging a good credit risk from a bad credit risk. Moral hazard is the asymmetric information problem that exists after the transaction occurs. For lenders, it is the difficulty in making sure the borrower uses the funds appropriately. Financial intermediaries can reduce adverse selection through intensive screening and can reduce moral hazard by monitoring the borrower.

1) The process of indirect finance using financial intermediaries is called A) direct lending. B) financial intermediation. C) resource allocation. D) financial liquidation.

Answer: B

1) Which of the following statements about the characteristics of debt and equity is false? A) They can both be long-term financial instruments. B) They can both be short-term financial instruments. C) They both involve a claim on the issuer's income. D) They both enable a corporation to raise funds.

Answer: B

10) A financial market in which previously issued securities can be resold is called a ________ market. A) primary B) secondary C) tertiary D) used securities

Answer: B

10) The concept of diversification is captured by the statement A) don't look a gift horse in the mouth. B) don't put all your eggs in one basket. C) it never rains, but it pours. D) make hay while the sun shines.

Answer: B

11) Which of the following instruments are traded in a money market? A) State and local government bonds B) U.S. Treasury bills C) Corporate bonds D) U.S. government agency securities

Answer: B

12) Which of the following instruments are traded in a money market? A) Bank commercial loans B) Commercial paper C) State and local government bonds D) Residential mortgages

Answer: B

13) 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.

Answer: B

13) Which of the following can be described as involving indirect finance? A) You make a loan to your neighbor. B) You buy shares in a mutual fund. C) You buy a U.S. Treasury bill from the U.S. Treasury. D) A corporation buys a short-term security issued by another corporation in the primary market.

Answer: B

16) A corporation acquires new funds only when its securities are sold in the A) secondary market by an investment bank. B) primary market by an investment bank. C) secondary market by a stock exchange broker. D) secondary market by a commercial bank.

Answer: B

16) An example of the problem of ________ is when a corporation uses the funds raised from selling bonds to fund corporate expansion to pay for Caribbean cruises for all of its employees and their families. A) adverse selection B) moral hazard C) risk sharing D) credit risk

Answer: B

2) One reason for the extraordinary growth of foreign financial markets is A) decreased trade. B) increases in the pool of savings in foreign countries. C) the recent introduction of the foreign bond. D) slower technological innovation in foreign markets.

Answer: B

2) Thrift institutions include A) banks, mutual funds, and insurance companies. B) savings and loan associations, mutual savings banks, and credit unions. C) finance companies, mutual funds, and money market funds. D) pension funds, mutual funds, and banks.

Answer: B

22) In a(n) ________ market, dealers in different locations buy and sell securities to anyone who comes to them and is willing to accept their prices. A) exchange B) over-the-counter C) common D) barter

Answer: B

25) A financial market in which only short-term debt instruments are traded is called the ________ market. A) bond B) money C) capital D) stock

Answer: B

3) Financial markets improve economic welfare because A) they channel funds from investors to savers. B) they allow consumers to time their purchase better. C) they weed out inefficient firms. D) eliminate the need for indirect finance.

Answer: B

3) U.S. Treasury bills are considered the safest of all money market instruments because there is almost no risk of A) defeat. B) default. C) desertion. D) demarcation.

Answer: B

3) Which of the following is a depository institution? A) A life insurance company B) A credit union C) A pension fund D) A mutual fund

Answer: B

4) A debt instrument sold by a bank to its depositors that pays annual interest of a given amount and at maturity pays back the original purchase price is called A) commercial paper. B) a negotiable certificate of deposit. C) a municipal bond. D) federal funds.

Answer: B

4) Bonds that are sold in a foreign country and are denominated in a currency other than that of the country in which it is sold are known as A) foreign bonds. B) Eurobonds. C) equity bonds. D) country bonds.

Answer: B

4) Which of the following is a depository institution? A) A life insurance company B) A mutual savings bank C) A pension fund D) A finance company

Answer: B

4) Which of the following is an example of an intermediate-term debt? A) A thirty-year mortgage. B) A sixty-month car loan. C) A six month loan from a finance company. D) A Treasury bond.

Answer: B

6) U.S. dollar deposits in foreign banks outside the U.S. or in foreign branches of U.S. banks are called A) Atlantic dollars. B) Eurodollars. C) foreign dollars. D) outside dollars.

Answer: B

7) Collateral is ________ the lender receives if the borrower does not pay back the loan. A) a liability B) an asset C) a present D) an offering

Answer: B

7) Which of the following can be described as direct finance? A) You take out a mortgage from your local bank. B) You borrow $2500 from a friend. C) You buy shares of common stock in the secondary market. D) You buy shares in a mutual fund.

Answer: B

8) Assume that you borrow $2000 at 10% annual interest to finance a new business project. For this loan to be profitable, the minimum amount this project must generate in annual earnings is A) $400. B) $201. C) $200. D) $199.

Answer: B

19) Studies of the major developed countries show that when businesses go looking for funds to finance their activities they usually obtain these funds from A) government agencies. B) equities markets. C) financial intermediaries. D) bond markets.

Answer: C

5) A breakdown of financial markets can result in A) financial stability. B) rapid economic growth. C) political instability. D) stable prices.

Answer: C

1) Equity of U.S. companies can be purchased by A) U.S. citizens only. B) foreign citizens only. C) U.S. citizens and foreign citizens. D) U.S. mutual funds only.

Answer: C

1) Financial institutions that accept deposits and make loans are called ________ institutions. A) investment B) contractual savings C) depository D) underwriting

Answer: C

12) Typically, borrowers have superior information relative to lenders about the potential returns and risks associated with an investment project. The difference in information is called A) moral selection. B) risk sharing. C) asymmetric information. D) adverse hazard

Answer: C

14) Bonds issued by state and local governments are called ________ bonds. A) corporate B) Treasury C) municipal D) commercial

Answer: C

14) ________ work in the secondary markets matching buyers with sellers of securities. A) Dealers B) Underwriters C) Brokers D) Claimants

Answer: C

16) Which of the following is a long-term financial instrument? A) A negotiable certificate of deposit B) A repurchase agreement C) A U.S. Treasury bond D) A U.S. Treasury bill

Answer: C

17) Banks can lower the cost of information production by applying one information resource to many different services. This process is called A) economies of scale. B) asset transformation. C) economies of scope. D) asymmetric information.

Answer: C

19) Which of the following are not traded in a capital market? A) U.S. government agency securities B) State and local government bonds C) Repurchase agreements D) Corporate bonds

Answer: C

2) In the United States, loans from ________ are far ________ important for corporate finance than are securities markets. A) government agencies; more B) government agencies; less C) financial intermediaries; more D) financial intermediaries; less

Answer: C

20) The most liquid securities traded in the capital market are A) corporate bonds. B) municipal bonds. C) U.S. Treasury bonds. D) mortgage-backed securities.

Answer: C

23) Forty or so dealers establish a "market" in these securities by standing ready to buy and sell them. A) Secondary stocks B) Surplus stocks C) U.S. government bonds D) Common stocks

Answer: C

26) Equity instruments are traded in the ________ market. A) money B) bond C) capital D) commodities

Answer: C

6) The principal lender-savers are A) governments. B) businesses. C) households. D) foreigners.

Answer: C

8) Equity holders are a corporation's ________. That means the corporation must pay all of its debt holders before it pays its equity holders. A) debtors B) brokers C) residual claimants D) underwriters

Answer: C

8) The process of asset transformation refers to the conversion of A) safer assets into risky assets. B) safer assets into safer liabilities. C) risky assets into safer assets. D) risky assets into risky liabilities.

Answer: C

9) Which of the following benefit directly from any increase in the corporation's profitability? A) a bond holder B) a commercial paper holder C) a shareholder D) a T-bill holder

Answer: C

13) Which of the following is not a secondary market? A) foreign exchange market B) futures market C) options market D) IPO market

Answer: D

1) Every financial market has the following characteristic: A) It determines the level of interest rates. B) It allows common stock to be traded. C) It allows loans to be made. D) It channels funds from lenders-savers to borrowers-spenders.

Answer: D

11) Which of the following can be described as involving direct finance? A) A corporation takes out loans from a bank. B) People buy shares in a mutual fund. C) A corporation buys a short-term corporate security in a secondary market. D) People buy shares of common stock in the primary markets.

Answer: D

12) Which of the following can be described as involving indirect finance? A) You make a loan to your neighbor. B) A corporation buys a share of common stock issued by another corporation in the primary market. C) You buy a U.S. Treasury bill from the U.S. Treasury. D) You make a deposit at a bank.

Answer: D

15) With ________ finance, borrowers obtain funds from lenders by selling them securities in the financial markets. A) active B) determined C) indirect D) direct

Answer: D

18) Conflicts of interest are a type of ________ problem that can happen when an institution provides multiple services. A) adverse selection B) free-riding C) discounting D) moral hazard

Answer: D

2) U.S. Treasury bills pay no interest but are sold at a ________. That is, you will pay a lower purchase price than the amount you receive at maturity. A) premium B) collateral C) default D) discount

Answer: D

3) The time and money spent in carrying out financial transactions are called A) economies of scale. B) financial intermediation. C) liquidity services. D) transaction costs.

Answer: D

3) Which of the following statements about financial markets and securities is true? A) A bond is a long-term security that promises to make periodic payments called dividends to the firm's residual claimants. B) A debt instrument is intermediate term if its maturity is less than one year. C) A debt instrument is intermediate term if its maturity is ten years or longer. D) The maturity of a debt instrument is the number of years (term) to that instrument's expiration date.

Answer: D

4) Well-functioning financial markets A) cause inflation. B) eliminate the need for indirect finance. C) cause financial crises. D) produce an efficient allocation of capital.

Answer: D

5) An example of economies of scale in the provision of financial services is A) investing in a diversified collection of assets. B) providing depositors with a variety of savings certificates. C) spreading the cost of borrowed funds over many customers. D) spreading the cost of writing a standardized contract over many borrowers.

Answer: D

5) Which of the following financial intermediaries is not a depository institution? A) A savings and loan association B) A commercial bank C) A credit union D) A finance company

Answer: D

6) Long-term debt has a maturity that is A) between one and ten years. B) less than a year. C) between five and ten years. D) ten years or longer.

Answer: D

7) When I purchase ________, I own a portion of a firm and have the right to vote on issues important to the firm and to elect its directors. A) bonds B) bills C) notes D) stock

Answer: D

8) Federal funds are A) funds raised by the federal government in the bond market. B) loans made by the Federal Reserve System to banks. C) loans made by banks to the Federal Reserve System. D) loans made by banks to each other.

Answer: D

9) You can borrow $5000 to finance a new business venture. This new venture will generate annual earnings of $251. The maximum interest rate that you would pay on the borrowed funds and still increase your income is A) 25%. B) 12.5%. C) 10%. D) 5%.

Answer: D

28) Corporations receive funds when their stock is sold in the primary market. Why do corporations pay attention to what is happening to their stock in the secondary market?

Answer: The existence of the secondary market makes their stock more liquid and the price in the secondary market sets the price that the corporation would receive if they choose to sell more stock in the primary market.

17) Distinguish between direct finance and indirect finance. Which of these is the most important source of funds for corporations in the United States?

Answer: With direct finance, funds flow directly from the lender/saver to the borrower. With indirect finance, funds flow from the lender/saver to a financial intermediary who then channels the funds to the borrower/investor. Financial intermediaries (indirect finance) are the major source of funds for corporations in the U.S.