Fin 340

Suppose the nominal interest rate is 2% and the expected rate of inflation is 3%. Then the real interest rate is approximately ____%. Because this measure uses expected rather than actual inflation, it is sometimes referred to as the ____ real interest rate,

-1; ex ante

Most economists believe that the Fed and other central banks should enjoy ____ independence from the rest of government to ensure that they ____.

. substantial; can resist political pressures to adopt overly easy monetary policies

At one time, the only publicly issued bonds rated below investment-grade were those whose ratings had been reduced from when the bonds were first issued ("fallen angels"). This situation changed in the 1980s when the investment bank Drexel Burnham Lambert did which of the following? 1. Made a market for already issued low-rated bonds. 2. Purchased large amounts of low-rated bonds to hold as long-run investments in its portfolio. 3. Served as underwriter for new issues of low-rated bonds.

1 and 3

Q30 Which of the following are reasons why a borrower might prepay her mortgage? 1. Mortgage rates have decreased. 2. Mortgage rates have increased. 3. She wants to move to a bigger house.

1 and 3

Q24 A tension or conflict of interest exists between a firm's bondholders and shareholders in that the firms' managers may be able to benefit shareholders at the expense of bondholders by doing which of the following? 1. Increase leverage. 2. Decrease leverage. 3. Shift to investment projects with the same risk and lower expected payoffs. 4. Shift to investment projects with the same expected payoffs and higher risk.

1 and 4

Which of the following are other differences between debt and equity as forms of external financing? 1. Equity usually comes with more control over management. 2.Debt usually comes with more control over management. 3. Dividends are tax-deductible, while interest expense is not. 4. Interest expense is tax-deductible, while dividends are not.

1 and 4

The diagram below shows aggregate expenditure as a function of the real interest rate, r. Which of the following are reasons why the curve is downward sloping? 1. An increase in the real interest rate increases the cost to businesses of financing investment projects. 2. An increase in the real interest rate causes people to save more and thus consume less. 3. An increase in the real interest rate causes capital to flow into the U.S., leading to an appreciation of the dollar and a decrease in demand for U.S. exports.

1 only

Q11 Suppose the current market yield is 5% for a one-year zero-coupon bond and 8% for a two-year zero coupon bond. Then the implicit one-year forward rate for one year from now is ___%.

11.09

Q15 Suppose an investor has a marginal tax rate of 25%. She is trying to choose between a municipal bond with a promised yield of 9% and a corporate bond with the same maturity, default risk, and liquidity. For the investor to be just indifferent between the two bonds, the yield on the corporate bond must be _____%.

12.0

Q08 Suppose the interest rate on a 1-year zero-coupon bond is currently 10% and is expected to rise to 15% in one year and then stay there for a long time. Then according to the pure expectations hypothesis of the term structure, the current interest rate on a 2-year zero-coupon bond should be approximately ____ and the current interest rate on a 3-year zero coupon bond should be approximately ____.

12.5; 13.3

An entrepreneur needs $1,000 to finance a one-year risky project. He can raise the money from an outside investor either by issuing equity or by issuing debt. The relationship of the payoff to the outside investor to the final project outcome is shown below for each of the two cases. If the project is financed with equity, the payoff to the investor will be given by line ____ and her ownership share will be ___.

Line X; 80%

The diagram below shows reserve demand and reserve supply as functions of the federal funds rate when the Fed implements monetary policy as described in the textbook and class. The reason the supply curve becomes horizontal at a federal funds rate of 10% is that ____. The reason the demand curve becomes horizontal at a federal funds rate of 5% is that _____.

banks can borrow reserves from the Fed at a rate of 10%; banks can earn interest of 5% on excess reserves held at the Fed

The difference between direct and indirect finance is that ____ in direct finance, while ____ in indirect finance.

funds flow directly from suppliers of funds to users of funds; funds flow through financial intermediaries that hold claims on the users

Q01 If you hold a zero-coupon bond to maturity, the holding-period yield _____ the yield to maturity at the time you bought it.

is aways the same

Q03 Suppose an investor needs her money back in five years and is uncertain about future interest rates. She will face ____risk if she buys a 30-year zero coupon bond with the intention of selling it in five years; she will face ____ risk if she buys a 1-year bond with the intention of rolling it over each year until the five years are up; and she will face ____risk if she buys a 5-year zero coupon bond with the intention of holding it to maturity.

price; reinvestment; neither

Ball argues that rapid financial development _____, while Bartlett suggests that it _____

promotes economic growth by encouraging saving and investment; may hurt economic growth by drawing skilled workers from more productive sectors and encouraging excessive speculation

Q02 The price of a bond promising multiple payments can be calculated as the ____ of the payments.

sum of the prices

One limit to the independence of the Fed is that ____.

ts high-level monetary goals have been set by Congress through the dual mandate

Indirect finance provides liquidity to investors mainly by ___, while direct finance does it mainly by _____.

using pooling to reduce uncertainty about withdrawals; enabling securities to be quickly and easily sold to others

A mortgage-backed security in which the cash flow from the underlying mortgages is split among tranches with different timing or seniority of payments is called a _____. The purpose of such securities is to ______.

collateralized mortgage obligation; create securities tailored to investors' differing risk preferences

Q05 The diagram below shows the relationship between price and interest rate for two different debt instruments. One of them is a 10-year annual coupon bond and the other is a 10-year annuity. The debt instrument with the greater price risk is represented by _____. Based on what you have learned in the course about duration, it is the ____.

curve X; coupon bond

The Federal Reserve differs from central banks in other countries in that it has a relatively ____ structure. The Fed is more ___ today than when it was founded due to changes made in response to the Fed's performance during the Great Depression of the 1930s.

decentralized; centralized

The type of equilibrium represented by point A in the diagram in the next-to-last question is the type that existed ____ the 2007-2009 financial crisis. The reason the reserves market was in this position was that ____.

during and after; the Fed had sharply increased the supply of reserves as part of its easing of monetary policy

The most important thing about securitization is that it separates the origination of the loans from the _____ of the loans. The model of mortgage lending made possible by securitization is called the _____ model.

funding; originate-to-distribute

Q22 From the point of view of investors, the most important feature of TIPS is that they _____.

guarantee a real rate of return over the life of the security

Which of the following are examples of financial institutions that facilitate direct finance by collecting information about issuers of debt and equity but are not financial intermediaries in the sense we have used that term? 1. An investment bank whose only business is underwriting new issues of stocks and bonds. 2. A commercial bank that accepts deposits and makes loans. 3. A credit rating agency like Standard & Poor's that rates bonds.

1 and 3

For adverse selection to arise in debt financing, which of the following conditions must be met? 1. Lenders have a hard time telling risky borrowers from safe borrowers. 2. Lenders can easily distinguish risky borrowers from safe borrowers. 3. An increase in the interest rate causes more risky borrowers to drop out of the market than safe borrowers. 4. An increase in the interest rate causes more safe borrowers to drop out of the market than risky borrowers.

1 and 4

In the previous question, suppose the mortgage rate has fallen 5 percentage points. On which of the following factors should George's decision to refinance depend? 1. How big the closing cost is. 2. How much his monthly payment would be reduced if he refinanced. 3. How likely he is to stay in the house till the end of the 5 years.

1, 2, and 3

Q25 Which of the following are provisions that bondholders often put into the bond contracts to protect themselves from the conflict of interest in the previous question? 1. Restrictions on dividend payments to shareholders. 2. Prohibitions against issuing additional debt. 3. First claim to specific assets of the firm in the event of default.

1, 2, and 3

Which of the following are potential benefits to a financial intermediary of securitizing the loans that it originates. 1. Can reduce its interest rate risk if the loans have longer maturity than its liabilities. 2. Can help it diversify its assets if its main expertise is lending to a single industry or area. 3. Can reduce the amount of capital it needs to meet regulatory requirements.

1, 2, and 3

Which of the following are reasons why external financing occurs in an economy? 1. People like to consume the same amount they earn each year, even if their earnings vary over their lifetimes. 2. Some entrepreneurs do not have enough money to fund their investment projects, while some individuals have more than enough money to fund their current consumption. 3. Some entrepreneurs who have enough money to fund their own projects would prefer not to "put all their eggs in one basket."

1, 2, and 3

Suppose mortgages are self-amortizing with annual payments due at the end of each year. Two years ago, George took out a 5-year mortgage for $5,000. (Houses are cheap!) At that time, the mortgage rate was 20%. His annual payment is approximately____, and his current balance due is approximately_____. To answer the question, you can use the annuity table below, a financial calculator, or Excel.

1,672; 3,522

Q12 The Shaky Industries Corporation has decided to raise money by issuing one-year bonds. Investors consider the bonds to have a 10% probability of default and a 60% recovery rate in the event of default (the investor loses the interest on her investment and 40% of the amount invested). The risk-free rate is 6%. If investors were risk-neutral, the promised yield on the bond would have to be ____ %. If investors were risk-averse and required a risk premium of 3% on the bonds, the promised yield would have to be _____%.

11.1; 14.4

Alice has formed an LLC (limited liability corporation) in order to finance a one-period investment project. The project requires an investment of 1,000 and has a probability of 0.8 of yielding 2,200 and a probability of 0.2 of yielding 700. If Bob decides to lend the money to Alice at an interest rate of 25%, his expected rate of return will be ____ %.

14

Suppose a bank has either 100 or 200 depositors, each of whom holds the same amount of deposits. A depositor has a 10 percent chance of having to withdraw her funds. The bank wants to hold just enough liquid reserves to keep the probability of being unable to meet withdrawals below 1%. The bank's probability distribution of deposit withdrawals for the two possible numbers of depositors is given by the table below. The table implies that the bank's minimum reserve ratio is ___ % with 100 depositors and ___ % with 200 depositors.

18; 15

Which of the following are examples of indirect finance, as that term has been used in the course? 1. You buy stocks through a broker. 2. A mutual fund buys stocks. 3. A venture capital fund makes an equity investment in a startup. 4. A wealthy individual makes an equity investment in a startup.

2 and 3

In which of the following cases is a borrower likely to choose a mortgage with points and a low interest rate over a mortgage with no points and a high interest rate? 1. The difference in interest rates is small. 2. The difference in interest rate is large. 3. She expects to keep the mortgage a short time. 4. She expects to keep the mortgage a long time.

2 and 4

Suppose the Aggregate Expenditure curve is the same as in Question 27 and the Phillips curve is the same as in Question 28. If the Fed wants inflation to be 5% this year, its target for nominal interest rates should be _____%.

27.5

Bob is trying to finance a one-period investment project that requires an investment of 1,000 and has a ½ probability of yielding 2,200 and a ½ probability of yielding 800. Alice is considering funding the project with an equity investment. If she is given 70% ownership, her expected rate of return will be ____%.

5

Suppose the Phillips curve is the same as in the previous question. If the Fed wants inflation to be 5% this year, its target for output should be ____ . If output remains at this level for an extended period of time, expected inflation will eventually _____, causing the Phillips curve to shift _____.

500; fall; downward

Q13 In the previous question, if the capital-asset pricing model holds, the risk premium that investors require on the bond will _____ the beta of the bond.

be higher, the higher is the

If Alice uses the banking system to pay Bob, the end result is likely to be an increase in ____ and a decrease in ____.

both Bob's bank account and the reserve account of Bob's bank at the Fed; both Alice's bank account and the reserve account of Alice's bank at the Fed

Q16 In Treasury auctions, competitive bidders indicate ______, while noncompetitive bidders indicate ______.

both a desired quantity and a desired price; only a desired quantity

Q20 Originally, commercial paper was issued by _____. This changed in the 2000s, when large amounts of commercial paper began to be issued by _____

both nonfinancial and financial corporations; special entities set up by big banks to offload their long-term mortgage-related assets

Q06 The yield curve shows how market yields on bonds vary _____. While the curve can take on different shapes, it is normally _____.

by maturity at a given point in time; upward-sloping

By "potential output," economists mean the level of output (real GDP) that ____. While the Fed normally sets monetary policy to try to achieve this level of output, it may sometimes aims for a lower level of output to ____.

can be produced when unemployment is at the natural rate, with no upward or downward pressure on inflation; decrease inflation when it has become too high

Moral hazard arises in external financing only when the user of the funds____.

cannot be easily monitored by the supplier of the funds

In the diagram in the previous question, suppose the reserves market is initially in equilibrium at point A with a federal funds rate of 5%. If the equilibrium funds rate changes to 7.5%, it could be either because the Fed ____ or because the Fed ____.

conducts open market sales of 200; raises interest on excess reserves by 2.5 points

Indirect finance facilitates diversification by ____, while direct finance does it by ____.

financial intermediaries investing customers' funds in a wide array of loans or securities; enabling investors of moderate wealth to buy a wide array of securities

The diagram below shows the output Phillips curve relating inflation to total output when expected inflation is 7.5%. A major reason that the curve slopes upward is that ______. The curve implies that potential output in the economy is ____.

higher output implies lower unemployment, which causes workers to be more aggressive in demanding wage increases; 750

Q29 In an amortizing mortgage, the monthly principal payments ____ over the life of the mortgage, and the monthly interest payments _____.

increase; decrease

In the previous question, the difference in probabilities between the two columns suggests that deposit withdrawals are ____. The benefit to the bank of increasing the number of depositors from 100 to 200 in this case is that it can invest a higher percentage of its funds in ____.

independent risks; high-yielding illiquid assets

Q17 Treasury auctions are called _____ auctions because winning bidders pay _____.

ingle-price; the lowest bid accepted by the Treasury

Fannie Mae and Freddie Mac are government sponsored agencies (GSEs) that sought to improve the mortgage finance system mainly by ____.

issuing and guaranteeing mortgage-backed securities

Compared to selling bonds in an IPO, the advantage to a firm of selling bonds through direct placement is that ____. The disadvantage is that ___.

it can avoid registering the bonds with the SEC; it cannot sell the bonds to as large a pool of investors

In the previous question, the outside investor will bear ____ risk, and the entrepreneur will bear ____ risk, if the project is financed with debt than if the project is financed with equity.

less; more

When moral hazard arises in equity financing, the supplier of funds is mainly worried that the user will ____. When moral hazard arises in debt financing, the supplier of funds is mainly worried that the user will ____.

loaf or waste money on perks; choose risky projects

Q23 Bonds issued by Fannie Mae and Freddie Mac to finance their mortgage holdings have always had a ____ yield than corporate bonds of the same maturity because investors have viewed the bonds as enjoying an ____ government guarantee.

lower; implicit

Q04 The duration of a bond promising multiple future payments bond can be viewed as a weighted average of the _____, weighting each one by the ____.

maturities of the payments; share of the present value of the payment in the total price

The Fed is said to conduct countercyclical monetary policy when it adjusts its interest rate target to ______. This policy implies that it would respond to a decrease in business and consumer confidence by _____ its interest rate target.

offset both positive and negative expenditure shocks and keep output close to potential; decreasing

Just before the pandemic, the unemployment rate had fallen to a historic low of 3.5%. Suppose that after the pandemic ends, the economy recovers and the unemployment rate falls even lower. The new monetary strategy announced by the Fed in August suggests that the Fed would react to such unusually low unemployment by raising its nominal interest rate target _____.

only if the inflation rate had exceeded the Fed's target of 2% for long enough for the average inflation rate over several years to exceed 2%

In the U.S., the secondary market for bonds is an _____.

over-the-counter dealer market both for corporate bonds and for government bonds

A mortgage-backed security in which the investor receives a pro-rated share of all the principal and interest payments on the underlying mortgages is called a _____. For investors, it has the advantage over a whole mortgage loan that it _____.

pass-through security; has greater diversification and liquidity

Q10 Suppose that investors believe the Fed will keep short-term interest rates unchanged for the foreseeable future. Then a decision by the Fed to start buying lots of long-term bonds would be most likely to ____ the yield on long-term bonds if the _____ theory of the term structure holds.

reduce; preferred habitat

Q21 Banks with temporary liquidity needs often meet those needs in the money market by borrowing on the ____ market or selling some of their holdings of Treasury____.

repo; bills

Q27 Municipal revenue bonds are payable out of _____ and as a result generally have _____ default risk than general obligation bonds

revenue from a specific project; higher

Q18 When a bond dealer does a repurchase agreement, she ____ another party and agrees to ____ the next day. For the bond dealer, such a transaction can be viewed as ____ funds for one day, with the security serving as collateral.

sells a security to; buy the security back; borrowing

One of the main reasons the Federal Reserve was created in 1913 was to _____. Only later did the Federal Reserve begin to _____.

serve as a lender of last resort to banks having liquidity problems; conduct monetary policy to benefit the overall economy

Q19 Commercial paper is debt that usually has _____ maturity and _____ default risk. One of its attractions to issuers is that because of these features, it does not have to be _____.

short; low; registered with the SEC

Q07 The pure expectations hypothesis of the term structure assumes that investors care about _____. According to this theory, the slope of the yield curve depends on investors' _____.

their expected return only; forecasts of future short-term yields

Q09 Suppose investors expect short-term interest rates to remain unchanged over the next 10 years but are highly uncertain that will turn out to be the case. According to the liquidity premium hypothesis of the term structure, the yield curve will slope ____. The reason is that investors will be willing to hold longer-term bonds only if compensated for the greater ____ risk of such bonds.

upward; price

Q14 The spread between the promised yields on speculative-grade (junk) bonds and Treasury securities of the same maturity tends to ____in recessions because investors become ____ concerned that low-rated firms will default on their debt.

widen; more