MBCM Quiz 2

Using the one-period valuation model, assuming a year-end dividend of $0.50, an expected sales price of $50, and a required rate of return of 10%, the current price of the stock would be

$45.91

The efficient markets hypothesis

(a)is an application of rational expectations to the pricing of financial securities. (b) is based on the assumption that prices of securities fully reflect all available information. (c) holds that the expected return on a security equals the equilibrium return.

Assume that a customer deposits $1000 in her bank. Show in a T-account the effect of this deposit. If the bank is subject to reserve requirements, show in a second T-account the banks balance sheet indicating required and excess reserve. In a third T-account, show the change in the bank's balance sheet when the bank makes loans with the excess reserves.

-------------------------------------------------------------------- Reserves $1000 | Checkable deposits $1000 -------------------------------------------------------------------- Required reserves $100 | Checkable deposits $1000 Excess reserves $900 | -------------------------------------------------------------------- Required reserves $100 | Checkable deposits $1000 Loans | $900

Assume a bank has $200 million of assets with a duration of 2.5, and $190 million of liabilities with a duration of 1.05. The duration gap for this bank is

1.5

According to the liquidity premium theory

A) a steeply rising yield curve indicates that short-term interest rates are expected to rise in the future. B) a moderately rising yield curve indicates that short-term interest rates are not expected to change much in the future. C) a flat yield curve indicates that short-term interest rates are expected to fall moderately in the future.

It cannot explain the empirical fact that interest rates on bonds of different maturities tend to move together. A) segmented markets theory B) expectations theory C) liquidity premium theory D) both (a) and (b) of the above E) both (a) and (c) of the above

A) segmented markets theory

Which of the following are reported as assets on a bank's balance sheet? A. Cash items in the process of collection B. Checkable deposits C. Borrowings D. Bank capital

A. Cash items in the process of collections

Which of the following statements are true? A. Checkable deposits are usually the lowest cost source of bank funds. B. Checkable deposits are payable on demand. C. Checkable deposits include NOW accounts. D. All of the above are true.

All of the Above

A bank's balance sheet A. shows that total assets equals total liabilities plus equity capital. B. lists sources and uses of bank funds. C. indicates whether or not the bank is solvent. D. does all of the above.

All of the above

Yield curves can be A) steeply upward sloping. B) moderately upward sloping. C) downward sloping.

All of the above

Which of the following statements are true? A. A risk premium is sometimes mistakenly called a "liquidity premium." B. The demand for a bond declines when it becomes less liquid, increasing the interest rate spread between it and relatively more liquid bonds. C. The differences in bond interest rates reflect differences in both default risk and liquidity.

B and C

Bank reserves A. equal bank deposits at the Fed. B. include holdings of U.S. government securities. C. can be divided up into required and excess reserves.

C. can be divided up into required and excess reserves

Which of the following are reported as liabilities on a bank's balance sheet? A. Reserves B. Checkable deposits C. Loans D. Deposits with other banks

Checkable deposits

Individuals purchasing homes for the first time might prefer financing the purchase with a fixed-rate mortgage A) they have limited incomes that would make it difficult for them to make ends meet during periods of rising interest rates. B) if they would rather not be subject to the interest-rate risk due to rising rates. C) if they believed that interest rates would be likely to rise and remain at a level higher than the current rate. D) for any of the above reasons. E) for none of the above reasons.

D. all of the above

The First National Bank gains reserves when A. a check written on an account at another bank is deposited in First National. B. it receives a discount loan from the Federal Reserve. C. it pays back a discount loan from the Federal Reserve. D. both (a) and (b) of the above occur. E. both (a) and (c) of the above occur.

D. both a and b

From the standpoint of _____, specialization in lending is surprising but makes perfect sense when one considers the _____ problem.

Diversification; adverse selection

Payments of net earnings to shareholders are called

Dividends

Bank reserves include A. deposits at the Fed and short-term treasury securities. B. vault cash and short-term Treasury securities. C. short-term Treasury securities and municipal securities .D. deposits at other banks and deposits at the Fed. E. vault cash and deposits at the Fed.

E. Vault cash and deposits at the Fed

16. Which of the following statements are accurate descriptions of modern liability management? A. Greater flexibility in liability management has allowed banks to increase the proportion of their assets held in loans. B. New financial instruments enable banks to acquire funds quickly. C. The introduction of negotiable CDs has significantly reduced the percentage of funds that banks borrow from one another to finance loans. D. All of the above have occurred since 1960. E. Only (a) and (b) of the above have occurred since 1960.

E. a and b

A number of companies exist that specialize in "payday loans." Payday loans are small loans — often for a few hundred dollars or less — that are made to low-income borrowers. Often these borrowers have poor credit histories and few assets and would have difficulty in qualifying for loans from other sources. The interest rates on these loans are often very high and some commentators have suggested that ceilings should be enforced on these loans. If such interest rate ceilings were imposed, what would be the likely effect?

Given the severe adverse selection problems and high default rates in this market, regulations that reduced the interest rates on these loans to the levels paid by more creditworthy borrowers would be likely to drastically curtail the volume of lending in this market.

What are two ways in which an FI can offset the liquidity effects of a net deposit drain of funds? How do the two methods differ? What are the operational benefits and costs of each method?

If the bank has a net deposit drain, it needs to either increase its liabilities (by borrowing funds or issuing equity) or reduce its assets. An institution can reduce its assets by drawing down on its cash reserves, selling securities, or calling back (or not renewing) its loans. It can increase liabilities by issuing more Federal funds, long-term debt, or new issues of equity. If a bank offsets the drain by increasing liabilities, the size of the firm remains the same. However, if it offsets the drain by reducing its assets, the size of the firm is reduced. If it has a net negative deposit drain, then it needs to follow the opposite strategy. The operational benefit of addressing a net deposit drain is to restore the financial stability and health of the FI. However, this process does not come without costs. On the asset side, liquidating assets may occur only at fire-sale prices that will result in realized losses of value, or asset-mix instability. Further, not renewing loans may result in the loss of profitable relationships that could have negative affects on profitability in the future. On the liability side, entering the borrowed funds market normally requires paying market interest rates that are above those rates that it had been paying on low interest deposits.

The interest rate on municipal bonds rises relative to the interest rate on Treasury securities when

Income tax rates are lowered

What are the two reasons that liquidity risk arises? How does liquidity risk arising from the liability side of the balance sheet differ from liquidity risk arising from the asset side of the balance sheet? What is meant by fire-sale prices?

Liquidity risk occurs because of situations that develop from economic and financial transactions that are reflected on either the asset side of the balance sheet or the liability side of the balance sheet of an FI. Asset-side risk arises from transactions that result in a transfer of cash to some other asset, such as the exercise of a loan commitment or a line of credit. Liability-side risk arises from transactions whereby a creditor, depositor, or 8other claim holder demands cash in exchange for the claim. The withdrawal of funds from a bank is an example of such a transaction. A fire-sale price refers to the price of an asset that is less than the normal market price because of the need or desire to sell the asset immediately under conditions of financial distress.

Which of the following is the primary source of external funds used by American businesses to finance their activities?

Loans

he most important category of assets on a bank's balance sheet is A. discount loans. B. securities .C. loans. D. cash items in the process of collection.

Loans

The existence of rating agencies has

Lowered returns on corporate bonds.

Following the risk premium theory what is the shape of the yield curve with the expectation of constant future short-term interest rates?

Moderately upward sloping

If the expectations theory of the term structure is correct, would a reduction in the supply of 30-year Treasury bonds affect their yields?

No. According to the expectations theory, Treasury bonds of different maturities are perfect substitutes. If expectations of the future path of short-term rates remain unchanged, then a reduction in the supply of 30-year bonds will not affect their yields.

hen the default risk in 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 _____

Right, left

Which firms are most likely to use bank financing rather than to issue bonds or stocks to finance their activities? Why?

Smaller firms that are not well known are the most likely to use bank financing. Since it is harder for investors to acquire information about these firms, it will be harder for the firms to sell securities in the financial markets. Banks that specialize in collecting information about smaller firms will then be the only outlet these firms have for financing their activities.

What is the most important contrast between the segmented markets theory and the expectations theory?

The expectation theory states that investors view similar assets that differ only with respect to maturity as perfect substitutes.

Recent economic news indicates that the economy is growing at a healthier pace than originally was projected. What effects should this growth have on spreads between AAA and B rated bonds? Why?

The spread should narrow. The decrease in default risk will cause funds to be shifted from AAA to B rated Bonds, raising the rate on the low-risk AAA bonds relative to the high-risk B bonds.

Is there a connection between market liquidity and market efficiency? Why or why not?

Yes, prices in liquid markets reflect information better

Which of the following statements concerning external sources of financing for nonfinancial businesses in the United States are true? A) Bonds are a far more important source of finance than are stocks. B) Stocks and bonds, combined, supply less than one-third of the external funds. C) Financial intermediaries such as banks are the most important source of external funds.

a

Equity contracts account for a small fraction of external funds raised by American businesses because A) costly state verification makes the equity contract less desirable than the debt contract. B) of the greater scope for moral hazard problems under equity contracts, as compared to debt contracts. C) equity contracts do not permit borrowing firms to raise additional funds by issuing debt.

a and b

One way for a bank to assure depositors that it is not taking on too much risk, and so obtain their deposits, is for it to A) diversify its loan portfolio. B) increase its equity capital. C) lengthen the maturity of its assets. D) do both (a) and (b) of the above.

a and b

That only large, well-established corporations have access to securities markets A) explains why indirect finance is such an important source of external funds for businesses. B) can be explained by the problem of adverse selection. C) can be explained by government regulations that prohibit small firms from acquiring funds in securities markets.

a and b

The author's analysis of adverse selection indicates that financial intermediaries in general, and banks in particular because they hold a large fraction of non-traded loans, A) have advantages in overcoming the free-rider problem, helping to explain why indirect finance is a more important source of business finance than is direct finance. B) play a greater role in moving funds to corporations than do securities markets as a result of their ability to overcome the free-rider problem. C) provide better-known and larger corporations a higher percentage of their external funds than they do to newer and smaller corporations, which rely to a greater extent on the new issues market for funds.

a and b

When a bank sells all or part of the cash stream from a specific loan, A. it thereby removes the loan from its balance sheet. B. it usually does so at a loss. C. it usually does so at a profit. D. both (a) and (b) of the above. E. both (a) and (c) of the above.

a and c

According to the liquidity premium theory

a downward sloping yield curve indicates that short-term interest rates are expected to fall sharply in the future.

If expectations of the future inflation rate are formed solely on the basis of a weighted average of past inflation rates, then economics would say that expectation formation is

adaptive

The problem created by asymmetric information before the transaction occurs is called _____, while the problem created after the transaction occurs is called _____.

adverse selection; moral hazard

Factors that lead to worsening conditions in financial markets include A) increases in interest rates. B) declining stock prices. C) increasing uncertainty in financial markets.

all of the above

The principal-agent problem arises because A) agents have more information about their activities than do the principals. B) monitoring agents' activities is costly. C) principals have incentives to free-ride off the monitoring expenditures of other principals.

all of the above

Debt-deflation occurs when

an economic downturn causes the price level to fall and a deterioration in firms' net worth because of the increased burden of indebtedness.

Duration analysis involves comparing the average duration of the bank's _____ to the average duration of its _____.

assets; liabilities

A borrower who takes out a loan usually has better information about the potential returns and risk of the investment projects he plans to undertake than does the lender. This inequality of information is called

asymmetric information

The number and availability of discount brokers has grown rapidly since the mid-1970s. The efficient markets hypothesis predicts that people who use discount brokers (a) will likely earn lower returns than those who use full-service brokers. (b) will likely earn about the same as those who use full-service brokers, but will net more after brokerage commissions. (c) are going against evidence suggesting that full-service brokers can help outperform the market. (d) are likely to be poor. (e) are likely to outperform the market by a wide margin.

b

Measuring the sensitivity of bank profits to changes in interest rates by multiplying the gap times the change in the interest rate is called

basic gap analysis

Asset transformation can be described as

borrowing short and lending long

The default risk premium

brings the expected yield on a security into equality with the expected yield on a default-free security

If market participants notice that a variable behaves differently now than in the past, then, according to rational expectations theory, we can expect market participants to

change the way they form expectations about future values of the variable.

Credit risk management tools include:

collateral; credit rationing

The value of any investment is found by

computing the present value of all future cash flows

Assume a stock's price falls after higher quarterly profits are announced. This occurrence is

consistent with the efficient market hypothesis

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

creation of internal controls that separate trading activities from bookkeeping

In actual practice, short-term interest rates are just as likely to fall as to rise; this is the major shortcoming of the

expectations theory

Under the preferred habitat theory, a flat yield curve indicates that investors expect future short-term rates to

fall

The theory of asset demand predicts that because the expected return on corporate bonds falls as their relative riskiness rises, the demand for corporate bonds will _____ and the demand for default-free bonds will _____.

fall; rise

Loophole mining refers to

financial innovation designed to get around regulations

Because of their _____ liquidity, _____ U.S. government securities are called secondary reserves.

high; short-term

The interest rate on municipal bonds falls relative to the interest rate on Treasury securities when

income tax rates are raised

If the preferred habitat theory is correct, a reduction by the Treasury in the supply of 30-year bonds should

increase their price and lower their yield

A monetary expansion _____ stock prices due to a decrease in the _____ and an increase in the ____.

increases; required rate of return; dividend growth rate

Bonds with relatively low risk of default are called

investment grade bonds

Holding large amounts of bank capital helps prevent bank failures because A. it means that the bank has a higher income. B. it makes loans easier to sell. C. it can be used to absorb the losses resulting from a deposit outflow. D. it makes it easier to call in loans.

it can be used to absorb the losses resulting from a deposit outflow

Everything else equal, a bank will hold less excess reserves when

it expects to have a deposit inflow in the near future.

The efficient markets hypothesis suggests that if an unexploited profit opportunity arises in an efficient market,

it will quickly be eliminated

A bank is insolvent when

its liabilities exceed its assets

Because of the adverse selection problem,

lenders are reluctant to make loans that are not secured by collateral.

Examples of off-balance-sheet activities include

loan sales

Examples of off-balance-sheet activities include

loan sales, foreign exchange market transactions, and trading in financial futures

High net worth helps to diminish the problem of moral hazard problem by

making the debt contract incentive compatible

You observe that both short-term and long-term interest rates fall after an announcement by the Federal Reserve that the money supply has expanded over the past week. You might speculate that

market participants do not expect a big surge in inflation in the next few months

Which of the following would a bank not hold as insurance against the highest cost of deposit outflow -- bank failure?

mortgages

Large-denomination CDs are _____, so that like a bond they can be resold in a _____ market before they mature.

negotiable; secondary

Because _____ are less liquid for the depositor than _____, they earn higher interest rates.

passbook savings; checkable deposits

Moral hazard in equity contracts is known as the _____ problem because the manager of the firm may shirk his responsibility to maximize profits for the shareholders.

principal-agent

Because larger loans create greater incentives for borrowers to engage in undesirable activities that make it less likely they will repay the loans, banks

ration credit, granting borrowers smaller loans than they have requested

A change in perceived risk of a stock changes

required rate of return

A clause in a mortgage loan contract requiring the borrower to purchase homeowner's insurance is an example of a

restrictive covenant

Mean reversion refers to the fact that

stocks that have had low returns in the past are more likely to do well in the future

Tests used to rate the performance of rules developed in technical analysis conclude that

technical analysis does not outperform the overall market.

If a corporation begins to suffer large losses, then

the default risk on the corporate bond will increase and the bond's return will become more uncertain, meaning the expected return on the corporate bond will fall.

Using the Gordon growth model, a stock's price will increase if

the dividend growth rate increases

U.S. government bonds have no default risk because

the federal government can increase taxes or print money to pay its obligations.

For a given return on assets,

the lower is bank capital, the higher is the returns for the owners of the bank

The risk structure of interest rates is

the relationship among interest rates of different bonds with the same maturity

The term structure of interest rates is

the relationship among interest rates on bonds with different maturities.

Poor people have difficulty getting loans because

they typically have little collateral

If a banker expects interest rates to fall in the future, the her best strategy for the present is

to increase the duration of the bank's assets

One financial intermediary in our financial structure that helps to reduce the moral hazard from arising from the principal-agent problem is the

venture capital firm