11.

1 Multiple Choice
1) Activity in money markets increased significantly in the late 1970s and early 1980s because of
A) rising short-term interest rates.
B) regulations that limited what banks could pay for deposits.
C) both A and B of the above.
D) neither A nor B of the above.
Answer: C
2) Money market securities have all the following characteristics except they are not
A) short term.
B) money.
C) low risk.
D) very liquid.
Answer: B
3) Money market instruments
A) are usually sold in large denominations.
B) have low default risk.
C) mature in one year or less.
D) are characterized by all of the above.
E) are characterized by only A and B of the above.
Answer: D
4) The banking industry
A) should have an efficiency advantage in gathering information that would eliminate the need
for the money markets.
B) exists primarily to mediate the asymmetric information problem between saver-lenders and
borrower spenders.
C) is subject to more regulations and governmental costs than the money markets.
D) all of the above are true.
E) only A and B of the above are true.
Answer: D
5) In situations where asymmetric information problems are not severe,
A) the money markets have a distinct cost advantage over banks in providing short-term funds.
B) the money markets have a distinct cost advantage over banks in providing long-term funds.
C) banks have a distinct cost advantage over the money markets in providing short-term funds.
D) the money markets cannot allocate short-term funds as efficiently as banks can.
Answer: A
6) Brokerage firms that offered money market security accounts in the 1970s had a cost
advantage over banks in attracting funds because the brokerage firms
A) were not subject to deposit reserve requirements.
B) were not subject to the deposit interest rate ceilings.
C) were not limited in how much they could borrow from depositors.
D) had the advantage of all the above.
E) had the advantage of only A and B of the above.
Answer: E

7) Which of the following statements about the money markets are true?
A) Not all commercial banks deal for their customers in the secondary market.
B) Money markets are used extensively by businesses both to warehouse surplus funds and to
raise
short-term funds.
C) The single most influential participant in the U.S. money market is the U.S. Treasury
Department.
D) All of the above are true.
E) Only A and B of the above are true.
Answer: E
8) Which of the following statements about the money markets are true?
A) Most money market securities do not pay interest. Instead, the investor pays less for the
security than it will be worth when it matures.
B) Pension funds invest a portion of their assets in the money market to have sufficient liquidity
to meet their obligations.
C) Unlike most participants in the money market, the U.S. Treasury Department is always a
demander of money market funds and never a supplier.
D) All of the above are true.
E) Only A and B of the above are true.
Answer: D
9) Which of the following are true statements about participants in the money markets?
A) Large banks participate in the money markets by selling large negotiable CDs.
B) The U.S. government and corporations borrow in the money markets because cash inflows and
outflows are rarely synchronized.
C) The Federal Reserve is the single most influential participant in the U.S. money market.
D) All of the above are true.
E) Only A and B of the above are true.
Answer: D
10) The most influential participant(s) in the U.S. money market
A) is the Federal Reserve.
B) is the U.S. Treasury Department.
C) are the large money center banks.
D) are the investment banks that underwrite securities.
Answer: A
11) The Fed is an active participant in money markets mainly because of its responsibility to
A) lower borrowing costs to encourage capital investment.
B) control the money supply.
C) increase the interest income of retirees holding money market instruments.
D) assist the Securities and Exchange Commission in regulating the behavior of other money
market participants.
Answer: B
12) Commercial banks are large holders of ________ and are the major issuer of ________.
A) negotiable certificates of deposit; U.S. government securities
B) U.S. government securities; negotiable certificates of deposit
C) commercial paper; Eurodollars
D) Eurodollars; commercial paper Answer: B
13) The primary function of large diversified brokerage firms in the money market is to
A) sell money market securities to the Federal Reserve for its open market operations.
B) make a market for money market securities by maintaining an inventory from which to buy or
sell.
C) buy money market securities from corporations that need liquidity.
D) buy T-bills from the U.S. Treasury Department.
Answer: B

14) Finance companies raise funds in the money market by selling

A) commercial paper.
B) federal funds.
C) negotiable certificates of deposit.
D) Eurodollars.
Answer: A
15) Finance companies play a unique role in money markets by
A) giving consumers indirect access to money markets.
B) combining consumers' investments to purchase money market securities on their behalf.
C) borrowing in capital markets to finance purchases of money market securities.
D) assisting the government in its sales of U.S. Treasury securities.
Answer: A
16) When inflation rose in the late 1970s,
A) consumers moved money out of money market mutual funds because their returns did not
keep pace with inflation.
B) banks solidified their advantage over money markets by offering higher deposit rates.
C) brokerage houses introduced highly popular money market mutual funds, which drew
significant
amounts of money out of bank deposits.
D) consumers were unable to take advantage of higher rates in money markets because of the
requirement of large transaction sizes.
Answer: C

17) Which of the following is the largest borrower in the money markets?
A) commercial banks
B) large corporations
C) the U.S. Treasury
D) U.S. firms engaged in foreign trade
Answer: C

18) Money market instruments issued by the U.S. Treasury are called
A) Treasury bills.
B) Treasury notes.
C) Treasury bonds.
D) Treasury strips.
Answer: A

19) Which of the following statements are true of Treasury bills?

A) The market for Treasury bills is extremely deep and liquid.
B) Occasionally, investors find that earnings on T-bills do not compensate them for changes in
purchasing power due to inflation.
C) By volume, most Treasury bills are sold to individuals who submit noncompetitive bids.
D) All of the above are true.
E) Only A and B of the above are true.
Answer: E
.
20) Suppose that you purchase a 91-day Treasury bill for $9,850 that is worth $10,000 when it
matures.
The security's annualized yield if held to maturity is about
A) 4 percent.
B) 5 percent.
C) 6 percent.
D) 7 percent.
Answer: C

21) Suppose that you purchase a 182-day Treasury bill for $9,850 that is worth $10,000 when it
matures.
The security's annualized yield if held to maturity is about
A) 1.5%.
B) 2%.
C) 3%.
D) 6%.
Answer: C
22) Treasury bills do not
A) pay interest.
B) have a maturity date.
C) have a face amount.
D) have an active secondary market.
Answer: A
23) If your competitive bid for a Treasury bill is successful, then you will
A) certainly pay less than if you had submitted a noncompetitive bid.
B) probably pay more than if you had submitted a noncompetitive bid.
C) pay the average of prices offered in other successful competitive bids.
D) pay the same as other successful competitive bidders.
Answer: B

24) If your noncompetitive bid for a Treasury bill is successful, then you will
A) certainly pay less than if you had submitted a competitive bid.
B) certainly pay more than if you had submitted a competitive bid.
C) pay the average of prices offered in other noncompetitive bids.
D) pay the same as other successful noncompetitive bidders.
Answer: D
25) Federal funds
A) are short-term funds transferred between financial institutions, usually for a period of one day.
B) actually have nothing to do with the federal government.
C) provide banks with an immediate infusion of reserves.
D) are all of the above.
E) are only A and B of the above.
Answer: D

26) Federal funds are

A) usually overnight investments.
B) borrowed by banks that have a deficit of reserves.
C) lent by banks that have an excess of reserves.
D) all of the above.
E) only A and B of the above.
Answer: D

27) The Fed can influence the federal funds interest rate by adjusting the level of reserves
available to banks. The Fed can
A) lower the federal funds interest rate by adding reserves.
B) raise the federal funds interest rate by removing reserves.
C) remove reserves by selling securities.
D) do all of the above.
E) do only A and B of the above.
Answer: D
28) The Federal Reserve can influence the federal funds interest rate by buying securities, which
________ reserves, thereby ________ the federal funds rate.
A) adds; raising
B) removes; lowering
C) adds; lowering
D) removes; raising
Answer: C

29) The Fed can lower the federal funds interest rate by ________ securities, thereby ________
reserves.
A) selling; adding
B) selling; lowering
C) buying; adding
D) buying; lowering
Answer: C
30) If the Fed wants to lower the federal funds interest rate, it will ________ the banking system
by
________ securities.
A) add reserves to; selling
B) add reserves to; buying
C) remove reserves from; selling
D) remove reserves from; buying
Answer: B
31) If the Fed wants to raise the federal funds interest rate, it will ________ securities to ________
the
banking system.
A) sell; add reserves to
B) sell; remove reserves from
C) buy; add reserves to
D) buy; remove reserves from
Answer: B
32) Government securities dealers frequently engage in repos to
A) manage liquidity.
B) take advantage of anticipated changes in interest rates.
C) lend or borrow for a day or two with what is essentially a collateralized loan.
D) do all of the above.
E) do only A and B of the above.
Answer: D
33) Repos are
A) usually low-risk loans.
B) usually collateralized with Treasury securities.
C) low interest rate loans.
D) all of the above.
E) only A and B of the above.
Answer: D
34) A negotiable certificate of deposit
A) is a term security because it has a specified maturity date.
B) is a bearer instrument, meaning whoever holds the certificate at maturity receives the
principal and interest.
C) can be bought and sold until maturity.
D) all of the above.
E) only A and B of the above.
Answer: D
35) Negotiable certificates of deposit
A) are bearer instruments because their holders earn the interest and principal at maturity.
B) typically have a maturity of one to four months.
C) are usually denominated at $100,000.
D) are all of the above.
E) are only A and B of the above.
Answer: E
36) Commercial paper securities
A) are issued only by the largest and most creditworthy corporations, as they are unsecured.
B) carry an interest rate that varies according to the firm's level of risk.
C) never have a term to maturity that exceeds 270 days.
D) all of the above.
E) only A and B of the above.
Answer: D
37) Unlike most money market securities, commercial paper
A) is not generally traded in a secondary market.
B) usually has a term to maturity that is longer than a year.
C) is not popular with most money market investors because of the high default risk.
D) all of the above.
E) only A and B of the above.
Answer: A
38) A banker's acceptance is
A) used to finance goods that have not yet been transferred from the seller to the buyer.
B) an order to pay a specified amount of money to the bearer on a given date.
C) a relatively new money market security that arose in the 1960s as international trade
expanded.
D) all of the above.
E) only A and B of the above.
Answer: E
39) Banker's acceptances
A) can be bought and sold until they mature.
B) are issued only by large money center banks.
C) carry low interest rates because of the very low default risk.
D) are all of the above.
E) are only A and B of the above.
Answer: D
40) Eurodollars
A) are time deposits with fixed maturities and are, therefore, somewhat illiquid.
B) may offer the borrower a lower interest rate than can be received in the domestic market.
C) are limited to London banks.
D) are all of the above.
E) are only A and B of the above.
Answer: E

41) Which of the following statements about money market securities are true?
A) The interest rates on all money market instruments move very closely together over time.
B) The secondary market for Treasury bills is extensive and well developed.
C) There is no well-developed secondary market for commercial paper.
D) All of the above are true.
E) Only A and B of the above are true.
Answer: D

42) Money market transactions

A) do not take place in any one particular location or building.
B) are usually arranged purchases and sales between participants over the phone by traders and
completed electronically.
C) are both A and B of the above.
D) are none the the above.
Answer: C

43) Two important characteristics of any financial market are flexibility and
A) risk.
B) innovation.
C) tolerance.
D) capital.
Answer: B

44) The main role of investment companies in the money market is to

A) trade on behalf of commercial accounts.
B) mediate the symmetric information problem between server-lender and borrower-spenders.
C) both A and B of the above.
D) neither A nor B of the above.
Answer: A

45) In a direct placement

A) the issuer bypasses the dealer and sells indirectly to the end investor.
B) the dealer sells directly to the end investor.
C) the issuer bypasses the dealer and sells directly to the end investor.
D) none of the above.
Answer: A
46) The advantage of mutual funds is that they
A) require no cash up front.
B) give investors with relatively small amounts of cash to invest access to large-denomination
securities.
C) always yield the highest returns.
D) both A and B of the above.
Answer: B

47) Asset-backed commercial paper differs from conventional commercial paper in that
A) it is backed (secured) by some bundle of assets.
B) its maturity usually extends well beyond 1 year.
C) both A and B of the above.
D) neither A nor B of the above.
Answer: A

11.2 True/False
1) Money market securities are short-term instruments with an original maturity of less than one
year.
Answer: TRUE

2) Money market securities include Treasury bills, commercial paper, federal funds, repurchase
agreements, negotiable certificates of deposit, banker's acceptances, and Eurodollars.
Answer: TRUE

3) The term money market is actually a misnomer, because liquid securities are traded in these
markets
rather than money.
Answer: TRUE

4) Money markets are referred to as retail markets because small individual investors are the
primary buyers of money market securities.
Answer: FALSE
5) The U.S. Treasury Department is the single most influential participant in the U.S. money
market.
Answer: FALSE

6) The U.S. Treasury Department is the single largest borrower in the U.S. money market.
Answer: TRUE

7) Banks are unusual participants in the money market because they buy, but do not sell, money
market instruments.
Answer: FALSE

8) Money markets are used extensively by businesses both to warehouse surplus funds and to
raise
short-term funds.
Answer: TRUE

9) The market for U.S. Treasury bills is a shallow market because so few individual investors buy
T-bills.
Answer: FALSE

10) The T-bill is not an investment to be used for anything but temporary storage of excess funds
because it barely keeps up with inflation.
Answer: TRUE

11) The main purpose of federal funds is to provide banks with an immediate infusion of reserves
should
they be short.
Answer: TRUE

12) The Fed can influence the federal funds rate by adjusting the level of reserves in the banking
system.
Answer: TRUE

13) Commercial paper securities are unsecured promissory notes, issued by corporations, that
mature in no more than 270 days.
Answer: TRUE

14) A banker's acceptance is an order to pay a specified amount of money to the bearer on a
given date. Banker's acceptances have been used since the twelfth century.
Answer: TRUE

15) Interest rates on banker's acceptances are low because the risk of default is very low.
Answer: TRUE

16) The size of the asset-backed commercial paper market nearly doubled between 2004 and
2007 to about $1 trillion.
Answer: TRUE

17) In general, money market instruments are low-risk, high-yield securities.

Answer: FALSE
18) Commercial paper has been used in various forms since the 1930s.
Answer: FALSE

19) The Treasury accepts noncompetitive bids in ascending order of yield until the accepted bids
reach the offering amount.
Answer: FALSE

20) Not all commercial banks deal in the secondary money market for their customers.
Answer: TRUE

11.3 Essay
1) Explain why banks, which would seem to have a comparative advantage in gathering
information,
have not eliminated the need for the money markets.

2) Explain how the Federal Reserve can influence the federal funds interest rate.

3) Explain why the money markets are referred to as wholesale markets.

4) Explain why money market interest rates move so closely together over time.

5) How are Treasury bills sold? How do competitive and noncompetitive bids differ?

6) What are the main characteristics of money market securities?

7) What are the major types of securities and who are the major participants in the money
markets?

8) Explain how and why repurchase agreements would be used.

9) The size of the asset-backed commercial paper market nearly doubled between 2004 and
2007 to about $1 trillion. Discuss how the subprime meltdown and collapse of the ABCP market
almost led to the collapse of the money market mutual fund market as well.
Chapter 12
12.1 Multiple Choice
1) Compared to money market securities, capital market securities have
A) more liquidity.
B) longer maturities.
C) lower yields.
D) less risk.
Answer: B

2) (I) Securities that have an original maturity greater than one year are traded in capital
markets.
(II) The best-known capital market securities are stocks and bonds.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
Answer: C

3) (I) Securities that have an original maturity greater than one year are traded in money
markets.
(II) The best known money market securities are stocks and bonds.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.

4) (I) Firms and individuals use the capital markets for long-term investments.
(II) Capital markets provide an alternative to investment in assets such as real estate and gold.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
Answer: C

5) The primary reason that individuals and firms choose to borrow long-term is to reduce the risk
that interest rates will ________ before they pay off their debt.
A) rise
B) fall
C) become more volatile
D) become more stable
Answer: A

6) The primary reason that individuals and firms choose to borrow long-term is to
A) reduce the risk that interest rates will fall before they pay off their debt.
B) reduce the risk that interest rates will rise before they pay off their debt.
C) reduce monthly interest payments, as interest rates tend to be higher on short-term than
long- term debt instruments.
D) reduce total interest payments over the life of the debt.
Answer: B

7) A firm will borrow long-term

A) if the extra interest cost of borrowing long-term is less than the expected cost of rising interest
rates before it retires its debt.
B) if the extra interest cost of borrowing short-term due to rising interest rates does not exceed
the expected premium that is paid for borrowing long-term.
C) if short-term interest rates are expected to decline during the term of the debt.
D) if long-term interest rates are expected to decline during the term of the debt.
Answer: A

8) Corporations may enter the capital markets because

A) they do not have sufficient capital to fund their investment opportunities.
B) they want to preserve their capital to protect against expected needs.
C) it is required by the Securities and Exchange Commission (SEC).
D) none of the above.
Answer: A

9) The primary issuers of capital market securities include

A) the federal and local governments.
B) the federal and local governments, and corporations.
C) the federal and local governments, corporations, and financial institutions.
D) local governments and corporations.
Answer: B

10) Governments never issue stock because

A) they cannot sell ownership claims.
B) the Constitution expressly forbids it.
C) both A and B of the above.
D) neither A nor B of the above.
Answer: A

11) (I) The primary issuers of capital market securities are federal and local governments, and
corporations. (II) Governments never issue stock because they cannot sell ownership claims.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
Answer: C

12) (I) The primary issuers of capital market securities are financial institutions.
(II) The largest purchasers of capital market securities are corporations.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
Answer: D

13) The distribution of a firm's capital between debt and equity is its
A) current ratio.
B) liability structure.
C) acid ratio.
D) capital structure.
Answer: D

14) The largest purchasers of capital market securities are

A) households.
B) corporations.
C) governments.
D) central banks.
Answer: A

15) Individuals and households frequently purchase capital market securities through financial
institutions such as
A) mutual funds.
B) pension funds.
C) money market mutual funds.
D) all of the above.
E) only A and B of the above.
Answer: E

16) (I) There are two types of exchanges in the secondary market for capital securities: organized
exchanges and over-the-counter exchanges. (II) When firms sell securities for the very first time,
the issue is an initial public offering.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
Answer: C

17) Capital market trading occurs in

A) the primary market.
B) the secondary market.
C) both A and B of the above.
D) none of the above.
Answer: C

18) Bonds
A) are securities that represent a debt owed by the issuer to the investor.
B) obligate the issuer to pay a specified amount at a given date, generally without periodic
interest payments.
C) both A and B of the above.
D) none of the above.
Answer: A

19) (I) Capital market securities fall into two categories: bonds and stocks. (II) Long-term bonds
include government bonds and long-term notes, municipal bonds, and corporate bonds.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
Answer: B
20) The ________ value of a bond is the amount that the issuer must pay at maturity.
A) market
B) present
C) discounted
D) face
Answer: D

21) The ________ rate is the rate of interest that the issuer must pay.
A) market
B) coupon
C) discount
D) funds
Answer: B

22) (I) The coupon rate is the rate of interest that the issuer of the bond must pay.
(II) The coupon rate is usually fixed for the duration of the bond and does not fluctuate with
market interest rates.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
Answer: C

23) (I) The coupon rate is the rate of interest that the issuer of the bond must pay.
(II) The coupon rate on old bonds fluctuates with market interest rates so they will remain
attractive to investors.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
Answer: A

24) Treasury bonds are subject to ________ risk but are essentially free of ________ risk.
A) default; interest-rate
B) default; underwriting
C) interest-rate; default
D) interest-rate; underwriting
Answer: C

25) The prices of Treasury notes, bonds, and bills are quoted
A) as a percentage of the coupon rate.
B) as a percentage of the previous day's closing value.
C) as a percentage of $100 face value.
D) as a multiple of the annual interest paid.
Answer: C

26) The security with the longest maturity is a Treasury

A) note.
B) bond.
C) acceptance.
D) bill.
Answer: B

27) Most of the time, the interest rate on Treasury notes and bonds is ________ that on money
market securities because of ________ risk.
A) above; interest-rate
B) above; default
C) below; interest-rate
D) below; default
Answer: A

28) (I) In most years, the rate of return on short-term Treasury bills is below that on the 20-year
Treasury bond. (II) Interest rates on Treasury bills are more volatile than rates on long-term
Treasury securities.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
Answer: C

29) (I) Because interest rates on Treasury bills are more volatile than rates on long-term
securities, the return on short-term Treasury securities is usually above that on longer-term
Treasury securities. (II) A Treasury STRIP separates the periodic interest payments from the final
principal
repayment.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
Answer: B

30) Which of the following statements about Treasury inflation-indexed bonds is not true?
A) The principal amount used to compute the interest payment varies with the consumer price
index.
B) The interest payment rises when inflation occurs.
C) The interest rate rises when inflation occurs.
D) At maturity, the securities pay the greater of face value or inflation-adjusted principal.
Answer: A

31) By the time the subprime financial crisis hit in force, Fannie and Freddie had ________
subprime and Alt-A assets on their books.
A) over $1 trillion of
B) very few
C) been prohibited from holding
D) none of the above
Answer: A

32) STRIPS (Separate Trading of Registered Interest and Principal Securities) are also called
A) interest-based securities.
B) zero-coupon securities.
C) leveraged securities.
D) covenant securities.
Answer: B

33) The risk on an agency bond is

A) high.
B) zero.
C) moderate.
D) low.
Answer: D

34) (I) Municipal bonds that are issued to pay for essential public projects are exempt from
federal taxation. (II) General obligation bonds do not have specific assets pledged as security or
a
specific source of revenue allocated for their repayment.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
Answer: C

35) Between 1984 and 2015, the annual volume of municipal bonds, in general, increased.
Volume peaked in 2010, with the total issuance of revenue and general obligation municipal
bonds around
A) $50 billion
B) $250 billion
C) $450 billion
D) $650 billion
Answer: C

36) (I) Most corporate bonds have a face value of $1,000, pay interest semiannually, and can be
redeemed anytime the issuer wishes. (II) Registered bonds have now been largely replaced by
bearer bonds, which do not have coupons.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
Answer: A

37) The bond contract that states the lender's rights and privileges and the borrower's
obligations
is called the
A) bond syndicate.
B) restrictive covenant.
C) bond covenant.
D) bond indenture.
Answer: D

38) The relationship between the AAA-yield and BBB-yield for corporate bonds can best be
described as which of the following?
A) The AAA-yield is always lower than the BBB-yield.
B) The AAA-yield is usually higher than the BBB-yield, but that relationship has changed at
times.
C) There is no obvious relationship between the AAA-yield and the BBB-yield.
D) The AAA-yield is always higher than the BBB-yield.
Answer: D

39) Policies that limit the discretion of managers as a way of protecting bondholders' interests
are
called
A) restrictive covenants.
B) debentures.
C) sinking funds.
D) bond indentures. Answer: A

40) Typically, the interest rate on corporate bonds will be ________ the more restrictions are
placed on management through restrictive covenants, because ________.
A) higher; corporate earnings will be limited by the restrictions
B) higher; the bonds will be considered safer by bondholders
C) lower; the bonds will be considered safer by buyers
D) lower; corporate earnings will be higher with more restrictions in place
Answer: C

41) Restrictive covenants can

A) limit the amount of dividends the firm can pay.
B) limit the ability of the firm to issue additional debt.
C) restrict the ability of the firm to enter into a merger agreement.
D) do all of the above.
E) do only A and B of the above.
Answer: D

42) (I) Restrictive covenants often limit the amount of dividends that firms can pay the
stockholders.
(II) Most corporate indentures include a call provision, which states that the issuer has the right
to force the holder to sell the bond back.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
Answer: C

43) Call provisions will be exercised when interest rates ________ and bond values ________.
A) rise; rise
B) fall; rise
C) rise; fall
D) fall; fall
Answer: B
44) A requirement in the bond indenture that the firm pay off a portion of the bond issue each
year is called
A) a sinking fund.
B) a call provision.
C) a restrictive covenant.
D) a shelf registration.
Answer: A
45) (I) Callable bonds usually have a higher yield than comparable noncallable bonds.
(II) Convertible bonds are attractive to bondholders and sell for a higher price than comparable
nonconvertible bonds.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
Answer: C

46) Long-term unsecured bonds that are backed only by the general creditworthiness of the
issuer are called
A) junk bonds.
B) callable bonds.
C) convertible bonds.
D) debentures.
Answer: D

47) Corporate bonds are less risky if they are ________ bonds and municipal bonds are less risky
if they are ________ bonds.
A) secured; revenue
B) secured; general obligation
C) unsecured; revenue
D) unsecured; general obligation
Answer: B

48) A secured bond is backed by

A) the general creditworthiness of the borrower.
B) an insurance company's financial guarantee.
C) the expected future earnings of the borrower.
D) specific collateral.
Answer: D

49) A corporate bond rated ________ has defaulted on an interest or principal payment.
A) NR
B) CCC
C) CC
D) D
Answer: D

50) Financial guarantees

A) are insurance policies to back bond issues.
B) are purchased by financially weaker security issuers.
C) lower the risk of the bonds covered by the guarantee.
D) do all of the above.
E) do only A and B of the above.
Answer: D

51) In its simplest form, a credit default swap provides

A) insurance against default in the principle and interest payments of a credit instrument.
B) an alternative method for bond issuers to pay principle and interest payments via a swap.
C) bond investors with a method to swap interest payments for principle payments during a
"credit event."
D) the government with a guarantee that certain bond issues will not run into credit problems.
Answer: A

52) Which of the following are true concerning the mission of the TRACE system?
A) TRACE established rules that say which bond transactions must be publicly reported.
B) TRACE established a trading platform that makes transaction data readily available to the
public.
C) TRACE established liquidity guidelines for bond traders.
D) All of the above are true.
E) Only A and B of the above are true.
Answer: E

53) Which of the following are true for the current yield?
A) The current yield is defined as the yearly coupon payment divided by the price of the security.
B) The formula for the current yield is identical to the formula describing the yield to maturity
for a discount bond.
C) The current yield is always a poor approximation for the yield to maturity.
D) All of the above are true.
E) Only A and B of the above are true.
Answer: A

54) The nearer a bond's price is to its par value and the longer the maturity of the bond, the
more
closely the ________ approximates the ________.
A) current yield; yield to maturity
B) current yield; coupon rate
C) yield to maturity; current yield
D) yield to maturity; coupon rate
Answer: A

55) Which of the following are true for the current yield?
A) The current yield is defined as the yearly coupon payment divided by the price of the security.
B) The current yield and the yield to maturity always move together.
C) The formula for the current yield is identical to the formula describing the yield to maturity
for a discount bond.
D) All of the above are true.
E) Only A and B of the above are true.
Answer: E

56) The current yield is a less accurate approximation of the yield to maturity the ________ the
time to maturity of the bond and the ________ the price is from/to the par value.
A) shorter; closer
B) shorter; farther
C) longer; closer
D) longer; farther
Answer: B

57) The current yield on a $6,000, 10 percent coupon bond selling for $5,000 is
A) 5%.
B) 10%.
C) 12%.
D) 15%.
Answer: C

58) The current yield on a $5,000, 8 percent coupon bond selling for $4,000 is
A) 5%.
B) 8%.
C) 10%.
D) 20%.
E) none of the above.
Answer: C

59) When an old bond's market value is above its par value, the bond is selling at a ________.
This occurs because the old bond's coupon rate is ________ the coupon rates of new bonds with
similar risk.
A) premium; below
B) premium; above
C) discount; below
D) discount; above
Answer: B

60) (I) To sell an old bond when interest rates have risen, the holder will have to discount the
bond until the yield to the buyer is the same as the market rate. (II) The risk that the value of a
bond will fall when market interest rates rise is called interest-rate risk.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
Answer: C
61) The first step in finding the value of a bond is to
A) discount back the cash flows using an interest rate that represents the yield available on other
bonds of like risk and maturity.
B) identify the cash flows the holder of the bond will receive.
C) contact the holder of the bond.
D) none of the above.
Answer: B

62) A change in the current yield ________ signals a change in the same direction of the yield to
maturity.
A) never
B) rarely
C) always
D) often
Answer: C

63) To sell an old bond when interest rates have ________, the holder will have to ________ the
price of the bond until the yield to the buyer is the same as the market rate.
A) risen; lower
B) risen; raise
C) fallen; lower
D) risen; inflate
Answer: A

64) From 1983 to 2015, total bond issuances peaked in 2006, at nearly
A) $2.6 trillion.
B) $3.5 trillion.
C) $4.1 trillion.
D) $5.0 trillion.
Answer: A

65) Although high-grade bonds seldom default, bond investors do face fluctuations in the price
of the bond, primarily due to
A) market interest-rate movements in the economy.
B) changes in the credit quality of the firm.
C) the general volatility of the bond market.
D) changes in Fed policy regarding inflation targets.
Answer: A

12.2 True/False
1) Firms and individuals use the money markets primarily to warehouse funds for short
periods of time until a more important need or a more productive use for the funds arises.
Answer: TRUE

2) The primary issuers of capital market securities are local governments and corporations.
Answer: FALSE

3) Governments never issue stock because they cannot sell ownership claims.
Answer: TRUE

4) The secondary market is where new issues of stocks and bonds are introduced.
Answer: FALSE

5) The coupon rate is the rate of interest that the investors require, which can be different from
the periodic interest payment made by the bond issuer, often called the coupon payment.
Answer: FALSE

6) Most of the time, the interest rate on Treasury notes is below that on money market securities
because of their low default risk.
Answer: FALSE

7) Municipal bonds that are issued to pay for essential public projects are exempt from federal
taxation.
Answer: TRUE

8) Most municipal bonds are revenue bonds rather than general obligation bonds.
Answer: TRUE

9) General obligation bonds have specific assets pledged as security or specific sources of
revenue allocated for their repayment.
Answer: FALSE

10) Most corporate bonds have a face value of $1,000, are sold at a discount, and can only be
redeemed at the maturity date.
Answer: FALSE

11) Registered bonds have now been largely replaced by bearer bonds, which do not have
coupons.
Answer: FALSE

12) A sinking fund is a requirement in the bond indenture that the firm pay off a portion of the
bond issue each year.
Answer: TRUE

13) In a leveraged buy-out, a firm greatly increases its debt level by issuing junk bonds to
finance the purchase of another firm's stock.
Answer: TRUE

14) Debentures are long-term unsecured bonds that are backed only by the general
creditworthiness of the issuer.
Answer: TRUE

15) A financial guarantee ensures that the lender (bond purchaser) will be paid both principal
and
interest in the event the issuer defaults.
Answer: TRUE

16) The Commodity Futures Modernization Act (2000) removed derivative securities, such as
credit default swaps, from regulatory oversight.
Answer: TRUE

17) Bonds typically sell in public markets where bid and ask prices are readily available and
transparent. By contrast, stocks typically trade over the counter, where transaction details can
be
hidden from the public.
Answer: FALSE

18) The current yield on a bond is a good approximation of the bond's yield to maturity when the
bond matures in five years or less and its price differs from its par value by a large amount.
Answer: FALSE

19) To sell an old bond when rates have risen, the holder will have to discount the bond until the
yield to the buyer is the same as the market rate.
Answer: TRUE

20) Capital market securities are less liquid and have longer maturities than money market
securities.
Answer: TRUE

12.3 Essay
1) What is the purpose of the capital market? How do capital market securities differ from
money market securities in their general characteristics?

2) Why don't federal, state, and local governments issue equity claims?

3) What is the difference between the primary market and secondary market? Where does most
of the trading occur for bonds?

4) What are the various features of bonds (par value, coupon rate, etc.)?

5) What are Treasury STRIPS?

6) What is the difference between a general obligation bond and a revenue bond?

7) Distinguish between general obligation and revenue municipal bonds.

8) What is a bond indenture?

9) What role do restrictive covenants play in bond markets?

10) What is a convertible bond? How does the convertibility feature affect the bond's price and
interest rate?

11) Explain the different types of corporate bonds.

12) What is a callable bond? How does the callability feature affect the bond's price and interest
rate?

13) The Commodity Futures Modernization Act (2000) removed derivative securities, such as
CDs, from regulatory oversight. This change opened the door for speculators to bet on the
health of a company or pool of assets, and was certainly a culprit in the 2007-2009 financial
crisis. Why did Congress pass such legislation?

14) What is the purpose of the TRACE system?

15) What is a bond's current yield? How does the current yield differ from the yield to maturity
and what determines how close the two values are?

16) What types of risks should bondholders be aware of and how do these affect bond prices and
yields?

17) Discuss the differences in volume between bond and stock issuances? Why do stock
issuances typically get more press?
CHAPTER 13

13.1 Multiple Choice

1) (I) A share of common stock in a firm represents an ownership interest in that firm.
(II) A share of preferred stock is as much like a bond as it is like common stock.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
Answer: C

2) Preferred stockholders hold a claim on assets that has priority over the claims of
A) both common stockholders and bondholders.
B) neither common stockholders nor bondholders.
C) common stockholders, but after that of bondholders.
D) bondholders, but after that of common stockholders.
Answer: C

3) (I) Preferred stockholders hold a claim on assets that has priority over the claims of common
stockholders, but after that of bondholders. (II) Firms issue preferred stock in far greater amounts
than common stock.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
Answer: A

4) (I) Preferred stockholders hold a claim on assets that has priority over the claims of common
stockholders. (II) Bondholders hold a claim on assets that has priority over the claims of
preferred stockholders.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
Answer: C

5) (I) Firms issue common stock in far greater amounts than preferred stock.
(II) In a given year, the total volume of stock issued is much less than the volume of bonds
issued.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
Answer: C

6) The riskiest capital market security is

A) preferred stock.
B) common stock.
C) corporate bonds.
D) Treasury bonds.
Answer: B

7) (I) The largest of the organized stock exchanges in the United States is the New York Stock
Exchange.
(II) To be listed on the NYSE, a firm must have a minimum of $100 million in market value or
$10 million in revenues.
A) (I) is true, (II) false.
B) (I) is false, (II) true.
C) Both are true.
D) Both are false.
Answer: A

8) To list on the NYSE, a firm must

A) have earnings of at least $10 million per year.
B) have at least $500 million in outstanding debt.
C) have a total of $100 million in market value.
D) meet all of the above requirements.
E) meet A and C of the above requirements.
Answer: E

9) A share of common stock in a firm represents an ownership interest in that firm and allows
stockholders to
A) vote.
B) receive dividends.
C) receive interest payments.
D) only A and B of the above.
Answer: D

10) Securities not listed on one of the exchanges trade in the over-the-counter market. In this
exchange, dealers "make a market" by
A) buying stocks for inventory when investors want to sell.
B) selling stocks from inventory when investors want to buy.
C) doing both of the above.
D) doing neither of the above.
Answer: C

11) The most active stock exchange in the world is the

A) Nikkei Stock Exchange.
B) London Stock Exchange.
C) Shanghai Stock Exchange.
D) New York Stock Exchange.
Answer: A

12) Which of the following statements about trading operations in an organized exchange is
correct?
A) Floor traders all deal in a wide variety of stocks.
B) In most trades, specialists match buy and sell orders.
C) In most trades, specialists buy for or sell from their own inventories.
D) The SuperDOT system is used to expedite large trades of over 100,000 shares.
Answer: B

13) Which of the following is not an advantage of Electronic Communications Networks

(ECNs)?
A) All unfilled orders are available for review by ECN traders.
B) Transactions costs are lower for ECN trades.
C) Trades are made and confirmed faster.
D) ECNs work well for thinly traded stocks.
Answer: D

14) Which of the following statements is false regarding Electronic Communications Networks
(ECNs)?
A) Archipelago and Instinet are two examples of ECNs.
B) Competition from ECNs has forced NASDAQ to cut its fees.
C) Traders benefit from lower trading costs and faster service.
D) ECNs allow institutional investors, but not individuals, to trade after hours.
Answer: D

15) What is the primary disadvantage of an ETF?

A) ETFs tend to have lower management fees than comparable index mutual bonds.
B) ETFs usually have no minimum investment amount.
C) Investors have to pay a broker commission each time they buy or sell shares.
D) None of the above are disadvantages of an ETF.
Answer: C

16) In 2013, the NYSE traded ________ shares on an average trading day.
A) 4 billion
B) 7 billion
C) 10 billion
D) 12 billion
Answer: A
17) Exchange traded funds (ETFs) have which of the following features?
A) They are listed and traded as individual stocks on a stock exchange.
B) They are indexed rather than actively managed.
C) Their value is based on the underlying net asset value of the stocks held in the index basket.
D) All of the above.
Answer: D

18) A basic principle of finance is that the value of any investment is

A) the present value of all future net cash flows generated by the investment.
B) the undiscounted sum of all future net cash flows generated by the investment.
C) unrelated to the future net cash flows generated by the investment.
D) unrelated to the degree of risk associated with the future net cash flows generated by the
investment.
Answer: A

19) A high price earnings ratio (PE) gives what interpretation?

A) The market expects earnings to fall in the future.
B) The market feels the firm's earnings are very high risk and are willing to pay a premium for
them.
C) The market expects the earnings to rise in the future.
D) The firm is not paying a dividend.
Answer: C

20) A ________ PE may indicate that the market feels the firm's earnings are very ________ risk
and is therefore willing to pay a ________ for them.
A) high; low; premium
B) high; high; discount
C) low; low; discount
D) high; high; premium
Answer: A

21) A stock currently sells for $25 per share and pays $0.24 per year in dividends. What is an
investor's valuation of this stock if she expects it to be selling for $30 in one year and requires a
15 percent return on equity investments?
A) $30.24
B) $26.30
C) $26.09
D) $27.74
Answer: B

22) A stock currently sells for $30 per share and pays $1.00 per year in dividends. What is an
investor's valuation of this stock if he expects it to be selling for $37 in one year and requires a
12 percent return on equity investments?
A) $38
B) $33.50
C) $34.50
D) $33.93
Answer: D
23) In the one-period valuation model, a stock's value will be higher
A) the higher its expected future price is.
B) the lower its dividend is.
C) the higher the required return on investments in equity is.
D) all of the above.
Answer: A

24) In the one-period valuation model, a stock's value falls if the ________ rises.
A) dividend
B) expected future price
C) required return on equity
D) current price
Answer: C

25) In the generalized dividend valuation model, a stock's value depends only on
A) its future dividend payments and its future price.
B) its future dividend payments and the required return on equity.
C) its future price and the required return on investments on equity.
D) its future dividend payments.
Answer: B

26) Which of the following is not an element of the Gordon growth model of stock valuation?
A) The stock's most recent dividend paid
B) The expected constant growth rate of dividends
C) The required return on investments in equity
D) The stock's expected future price
Answer: D

27) According to the Gordon growth model, what is an investor's valuation of a stock whose
current dividend is $1.00 per year if dividends are expected to grow at a constant rate of 10
percent over a long period of time and the investor's required return is 11 percent?
A) $110
B) $100
C) $11
D) $10
E) $5.24

28) According to the Gordon growth model, what is an investor's valuation of a stock whose
current dividend is $1.00 per year if dividends are expected to grow at a constant rate of 10
percent over a long period of time and the investor's required return is 15 percent?
A) $20
B) $11
C) $22
D) $7.33
E) $4.40
Answer: C

29) Holding other things constant, a stock's value will be highest if its dividend growth rate is
A) 15%.
B) 10%.
C) 5%.
D) 2%.
Answer: A

30) Holding other things constant, a stock's value will be highest if its most recent dividend is
A) $2.00.
B) $5.00.
C) $0.50.
D) $1.00.
Answer: B

31) Holding other things constant, a stock's value will be highest if the investor's required return
on investments in equity is
A) 20%.
B) 15%.
C) 10%.
D) 5%.
Answer: D

32) Suppose the average industry PE ratio for auto parts retailers is 20. What is the current price
of Auto Zone stock if the retailer's earnings per share is projected to be $1.85?
A) $21.85
B) $37
C) $10.81
D) $9.25
Answer: B

33) Which of the following is true regarding the Gordon growth model?
A) Dividends are assumed to grow at a constant rate forever.
B) The dividend growth rate is assumed to be greater than the required return on equity.
C) Both A and B of the above.
D) Neither A nor B of the above.
Answer: A

34) The PE ratio approach to valuing stock is especially useful for valuing
A) privately held firms.
B) firms that don't pay dividends.
C) both A and B of the above.
D) neither A nor B of the above.
Answer: C

35) The PE ratio approach to valuing stock is especially useful for valuing
A) publicly held corporations.
B) firms that regularly pay dividends.
C) both A and B of the above.
D) neither A nor B of the above.
Answer: D
36) A weakness of the PE approach to valuing stock is that it is
A) difficult to estimate the constant growth rate of a firm's dividends.
B) difficult to estimate the required return on equity.
C) difficult to predict how much a firm will pay in dividends.
D) based on industry averages rather than firm-specific factors.
Answer: D
37) (I) The market price of a security at a given time is the highest value any investor puts on the
security. (II) Superior information about a security increases its value by reducing its risk.
A) (I) is true, (II) is false.
B) (I) is false, (II) is true.
C) Both are true.
D) Both are false.
Answer: B

38) The main cause of fluctuations in stock prices is changes in

A) tax laws.
B) errors in technical stock analysis.
C) daily trading volume in stock markets.
D) information available to investors.
E) total household wealth in the economy.
Answer: D

39) Security prices are set by active market participants. Which of the following is NOT a
consequence of this fact?
A) The price is set by the buyer willing to pay the highest price.
B) The market price will be set by the buyer who can take best advantage of the asset.
C) Market participants have a strong incentive to reveal private information about a security.
D) Superior information about an asset can increase its value by reducing its risk.
Answer: C

40) Stock values computed by valuation models may differ from actual market prices because it
is difficult to
A) estimate future dividend growth rates.
B) estimate the risk of a stock.
C) forecast a stock's future dividends.
D) all of the above are true.
Answer: D

41) The 2001 terrorist attacks and the Enron financial scandal caused anticipated dividend
growth to ________, investors' required return on equity to ________, and stock prices to
________.
A) decrease; increase; decrease
B) decrease; increase; increase
C) increase; decrease; decrease
D) increase; decrease; increase
Answer: A

42) The subprime financial crisis led to one of the worst bear markets in the last 50 years. Stock
prices likely fell due to
A) an increase in required returns on equity investments.
B) a decline in growth prospects for U.S. companies.
C) Both A and B are likely reasons.
D) None of the above are correct.
Answer: A

43) Which of the following is not an objective of the Securities and Exchange Commission?
A) Maintain integrity of the securities markets
B) Advise investors about which particular stocks are good buys
C) Require firms to provide specific information to investors
D) Regulate major participants in securities markets
Answer: B

44) The most commonly quoted index is the Dow Jones Industrial Average (DJIA), an index
based on the performance of the stocks of ________ large companies.
A) 25
B) 30
C) 35
D) 40
Answer: B

45) From 2014 to 2015, the Dow Jones Industrial Average has fluctuated between
A) 7,500 and 10,000.
B) 12,500 and 15,000.
C) 16,000 and 19,000.
D) 20,000 and 22,000.
Answer: C

46) The problem with buying foreign stocks is that most foreign companies are not listed on any
of the U.S. stock exchanges, so the purchase of shares is difficult. Intermediaries have found a
way to solve this problem by selling
A) ADRs.
B) foreign stock indexes.
C) ETFs that include foreign stocks.
D) stock in U.S. companies with international sales.
Answer: A

47) The Securities Acts of 1933 and 1934 established the S.E.C. to enforce which of the follow
laws?
A) Require firms to tell the public the truth about their businesses.
B) Require brokers, dealers, and exchanges to treat investors fairly.
C) To ensure that no investment ever loses money.
D) All of the above are laws the S.E.C. enforces.
E) A and B above are laws the S.E.C. enforces.
Answer: E

48) Which of the following is not a division of the S.E.C.?

A) The Division of Fraud Investigation
B) The Division of Corporate Finance
C) The Division of Market Regulation
D) The Division of Investment Management
E) The Division of Enforcement
Answer: A

13.2 True/False
1) More stock trading in the U.S. occurs in over-the-counter markets rather than on organized
exchanges.
Answer: FALSE
2) In over-the-counter markets, dealers increase the liquidity of thinly traded securities.
Answer: TRUE

3) Electronic Communications Networks apply technology to make organized exchanges more

efficient and speedy.
Answer: FALSE

4) All stocks pay dividends, as that is the only way an investor can profit from holding stock.
Answer: FALSE

5) Common stock is the riskiest corporate security, followed by preferred stock and then bonds.
Answer: TRUE

6) About half of new equity issues are preferred stock.

Answer: FALSE

7) On the NYSE, in about 90% of trades, the specialist matches buyers with sellers. In the other
10%, the specialists may intervene by taking ownership of the stock themselves or by selling
stock from inventory.
Answer: TRUE

8) A stock's market value will be higher the higher its expected dividend stream is, all else being
equal.
Answer: TRUE

9) The Gordon growth model assumes that a stock's dividend grows at a constant rate forever.
Answer: TRUE

10) Even if a stock does not pay a dividend, the Gordon growth model is still useful for
computing the stock's price.
Answer: FALSE

11) A stock's market value will be higher the higher the investor's required rate of return is, all
else being equal.
Answer: FALSE

12) A lower than average PE may mean that the market expects earnings to rise in the future.
Answer: FALSE

13) Since market participants set security prices, the price of a stock is generally the highest
price the asset could fetch.
Answer: FALSE

14) The Enron financial scandal increased uncertainty about the quality of accounting
information and as a result, increased required return on investment in stocks.
Answer: TRUE

15) The Dow Jones Industrial Average is the broadest and best indicator of the stock market's
day-to-day performance.
Answer: FALSE
16) Unfortunately, due to current SEC regulations, U.S. investors cannot buy foreign stocks on
U.S. stock exchanges.
Answer: FALSE

17) The Securities and Exchange Commission requires firms to submit various documents to
increase the flow of information to investors but does not verify the accuracy of that information.
Answer: TRUE

18) The Securities and Exchange Commission Division of Fraud Investigation was credited with
uncovering the Enron and Madoff scandals.
Answer: FALSE

13.3 Essay
1) How do corporate stocks differ from bonds?

2) How do common stocks differ from preferred stocks?

3) How do over-the-counter markets differ from organized exchanges?

4) What is the role of specialists on a stock exchange?

5) What are the advantages and disadvantages of Electronic Communications Networks (ECNs)
for trading stocks?

6) What are the advantages and disadvantages of exchange traded funds (ETFs) fro trading
stocks?

7) What is the role of the required return on equity investments in stock valuation models?

8) Using the Gordon growth model, explain why the 2001 terrorist attacks and the Enron
financial scandal caused stock prices to decline.

9) Discuss several of the important factors that go into the determination of a security price by
the markets.

10) Why would a crisis in the subprime mortgage market lead to declining prices in the U.S.
equity markets?

11) Why do we have (and follow) the various stock market indexes?

12) What are American Depository Receipts (ADRs)?

13) What are the objectives of the Securities and Exchange Commission?
CHAPTER 15

15.1 Multiple Choice

1) American firms became less competitive compared to foreign firms during the 1980s because
A) the quality and productivity of American workers declined.
B) foreign firms were younger than American firms and as a result had more modern facilities
that made use of the latest technology.
C) the U.S. dollar became worth more in terms of foreign currencies.
D) the U.S. dollar became worth less in terms of foreign currencies.
Answer: C

2) A spot transaction in the foreign exchange market involves the

A) exchange of exports and imports at a specified future date.
B) exchange of bank deposits at a specified future date.
C) immediate (within two days) exchange of exports and imports.
D) immediate (within two days) exchange of bank deposits.
Answer: D

3) Forward exchange rates

A) involve the immediate exchange of bank deposits.
B) involve the exchange of bank deposits at some specified future date.
C) involve the immediate exchange of imports and exports.
D) none of the above.
Answer: B

4) When the value of the British pound changes from $1.50 to $1.25, the pound has ________
and the dollar has ________.
A) appreciated; appreciated
B) depreciated; appreciated
C) appreciated; depreciated
D) depreciated; depreciated
Answer: B

5) When the value of the dollar changes from £0.50 to £0.75, the pound has ________ and the
dollar has ________.
A) appreciated; appreciated
B) depreciated; appreciated
C) appreciated; depreciated
D) depreciated; depreciated
Answer: B

6) When the exchange rate changes from 1.0 euros to the dollar to 1.2 euros to the dollar, the
euro has ________ and the dollar has ________.
A) appreciated; appreciated
B) depreciated; appreciated
C) appreciated; depreciated
D) depreciated; depreciated
Answer: B

7) When the exchange rate changes from 1.0 euros to the dollar to 0.8 euros to the dollar, the
euro has ________ and the dollar has ________.
A) appreciated; appreciated
B) depreciated; appreciated
C) appreciated; depreciated
D) depreciated; depreciated
Answer: C

8) If the dollar ________ from 1.2 euros per dollar to 0.8 euros per dollar, the euro ________
from 0.83 dollars to 1.25 dollars per euro.
A) appreciates; appreciates
B) appreciates; depreciates
C) depreciates; depreciates
D) depreciates; appreciates
Answer: D
9) If the dollar appreciates from 0.8 euros per dollar to 1.2 euros per dollar, the euro depreciates
from ________ dollars to ________ dollars per euro.
A) 1.25; 0.83
B) 0.83; 1.25
C) 0.67; 1.50
D) 1.50; 0.67
Answer: A

10) If the dollar depreciates relative to the Swiss franc,

A) Swiss chocolate will become more expensive in the United States.
B) American computers will become less expensive in Switzerland.
C) Swiss chocolate will become cheaper in the United States.
D) both A and B of the above will happen.
Answer: D

11) If the dollar appreciates relative to the Swiss franc,

A) Swiss chocolate will become more expensive in the United States.
B) American computers will become less expensive in Switzerland.
C) Swiss chocolate will become cheaper in the United States.
D) both A and B of the above will happen.
Answer: C

12) When the exchange rate for the euro changes from $1.00 to $1.20, then, holding everything
else constant, the euro has
A) appreciated and German cars sold in the United States become more expensive.
B) appreciated and German cars sold in the United States become less expensive.
C) depreciated and American wheat sold in Germany becomes more expensive.
D) depreciated and American wheat sold in Germany becomes less expensive.
Answer: A

13) When the exchange rate for the euro changes from $1.20 to $1.00, then, holding everything
else constant, the euro has
A) appreciated and German cars sold in the United States become more expensive.
B) appreciated and German cars sold in the United States become less expensive.
C) depreciated and American wheat sold in Germany becomes more expensive.
D) depreciated and American wheat sold in Germany becomes less expensive.
Answer: C

14) The foreign exchange market

A) is organized as an over-the-counter market in which several hundred dealers stand ready to
buy and sell deposits denominated in foreign currencies.
B) is very competitive.
C) functions no differently from a centralized market.
D) all of the above.
Answer: D

15) Trades in the foreign exchange market consist of transactions in excess of

A) $500,000.
B) $1 million.
C) $5 million.
D) $10 million.
Answer: B

16) If a U.S. traveler needs foreign currency for a trip abroad, she would buy the currency in the
________ market from a dealer such as American Express.
A) dollar
B) foreign exchange
C) retail
D) bankers
Answer: C

17) Evidence from the United States during the period 1973-2016 indicates the correspondence
between nominal interest rates and exchange rate movements is
A) much closer than that between real interest rates and exchange rate movements.
B) not nearly as close as that between government spending and exchange rate movements.
C) not nearly as close as that between government deficits and exchange rate movements.
D) not nearly as close as that between real interest rates and exchange rate movements.
Answer: D

18) The purchasing power parity theory

A) has significant predictive power in the short run.
B) is the starting point for understanding how exchange rates are determined.
C) does not take into account that many goods and services are not traded across borders.
D) is none of the above.
Answer: C

19) In the long run, ________ affect the exchange rate.

A) relative price levels
B) tariffs and quotas
C) productivity
D) all of the above.
Answer: D

20) The starting point for understanding how exchange rates are determined is a simple idea
called ________, which states that if two countries produce an identical good, the price of the
good should be the same throughout the world no matter which country produces it.
A) Gresham's law
B) the law of one price
C) purchasing power parity
D) arbitrage
Answer: B

21) The theory of purchasing power parity is a theory of how exchange rates are determined in
A) the long run.
B) the short run.
C) both A and B of the above.
D) none of the above.
Answer: A

22) The ________ states that exchange rates between any two currencies will adjust to reflect
changes in the price levels of the two countries.
A) theory of purchasing power parity
B) law of one price
C) theory of money neutrality
D) quantity theory of money
Answer: A

23) The theory of purchasing power parity states that exchange rates between any two
currencies
will adjust to reflect changes in
A) the trade balances of the two countries.
B) the current account balances of the two countries.
C) fiscal policies of the two countries.
D) the price levels of the two countries.
Answer: D

24) In the long run, a rise in a country's price level (relative to the foreign price level) causes its
currency to ________, while a rise in the country's relative productivity causes its currency to
________.
A) appreciate; appreciate
B) appreciate; depreciate
C) depreciate; appreciate
D) depreciate; depreciate
Answer: C

25) If the 2015 inflation rate in Britain is 6 percent, and the inflation rate in the U.S. is 4 percent,
then the theory of purchasing power parity predicts that, during 2015, the value of the British
pound in terms of U.S. dollars will
A) rise by 10 percent.
B) rise by 2 percent.
C) fall by 10 percent.
D) fall by 2 percent.
E) do none of the above.
Answer: D

26) The theory of purchasing power parity cannot fully explain exchange rate movements
because
A) not all goods are identical in different countries.
B) monetary policy differs across countries.
C) some goods are not traded between countries.
D) both A and C of the above.
E) both B and C of the above.
Answer: D

27) From 1973 through 2016, the rise in the British price level relative to the U.S. price level is
________ with a rise in the value of the dollar. Over shorter periods, the PPP relationship
________ appear to hold.
A) associated; does not
B) not associated; also does not
C) associated; also does
D) not associated; does
Answer: A

28) The theory of purchasing power parity cannot fully explain exchange rate movements
because
A) all goods are identical even if produced in different countries.
B) monetary policy differs across countries.
C) some goods are not traded between countries.
D) fiscal policy differs across countries.
Answer: C

29) An increase in which factor will cause domestic currency depreciation?

A) trade barriers
B) export demand
C) import demand
D) relative productivity
Answer: C

30) In the short run, the quantity of dollars supplied (deposits, bonds, equities) is
A) fixed with respect to the exchange rate.
B) quite volatile and difficult to model in a supply-demand framework.
C) typically following the business cycle (procyclical).
D) is best represented with a horizontal supply curve.
Answer: A
31) Increased demand for a country's ________ causes its currency to appreciate in the long run,
while increased demand for ________ causes its currency to depreciate.
A) imports; imports
B) imports; exports
C) exports; imports
D) exports; exports
Answer: C

32) Foreign exchange transactions in the United States each year are well over ________ times
greater than the amount of U.S. exports and imports.
A) 5
B) 15
C) 25
D) 35
Answer: C

33) If the demand for ________ goods decreases relative to ________ goods, the domestic
currency will depreciate.
A) foreign; domestic
B) foreign; foreign
C) domestic; domestic
D) domestic; foreign
Answer: D

34) The theory of asset demand suggests that the most important factor affecting the demand
for
domestic and foreign deposits is
A) the level of trade and capital flows.
B) the expected return on these assets relative to one another.
C) the liquidity of these assets relative to one another.
D) the riskiness of these assets relative to one another.
Answer: B

35) Over short periods, the ________ has a much greater role in exchange rate determination
than does ________.
A) the price of foreign assets; the liquidity of foreign assets
B) decision to hold domestic or foreign assets; the demand for exports and imports
C) the liquidity of foreign assets; the price of foreign assets
D) the demand for exports and imports; decision to hold domestic or foreign assets
Answer: B

36) When Americans and foreigners expect the return on ________ deposits to be high relative to
the return on ________ deposits, there is a higher demand for dollar deposits and a
correspondingly lower demand for foreign deposits.
A) dollar; dollar
B) dollar; foreign
C) foreign; dollar
D) foreign; foreign
Answer: B

37) When Americans and foreigners expect the return on dollar deposits to be high relative to the
return on foreign deposits, there is a ________ demand for dollar deposits and a correspondingly
________ demand for foreign deposits.
A) higher; higher
B) higher; lower
C) lower; higher
D) lower; lower
Answer: B

38) As the relative expected return on dollar deposits increases, foreigners will want to hold more
________ deposits and less ________ deposits.
A) foreign; foreign
B) foreign; dollar
C) dollar; foreign
D) dollar; dollar
Answer: C

39) As the relative expected return on dollar deposits increases,

A) foreigners will want to hold fewer dollar deposits and more foreign deposits.
B) Americans will want to hold more dollar deposits and less foreign deposits.
C) Americans will want to hold fewer dollar deposits and more foreign deposits.
D) Americans and foreigners will be indifferent toward holding dollar deposits or foreign
deposits.
Answer: B

40) The more modern asset market approach to exchange rate determination
A) emphasizes the role of import and export demand.
B) emphasizes stocks of assets.
C) emphasizes both of the above.
D) emphasizes neither of the above.
Answer: B

41) Quotas
A) are restrictions placed on the quality of foreign goods that can be imported.
B) are fees placed on imported goods.
C) are restrictions placed on the quantity of foreign goods that can be exported.
D) are none of the above.
Answer: D

42) With the start of the subprime financial crisis in August 2007, the dollar ________ in value
against the euro as the Fed lowered interest rates. By December of 2008, with the financial crisis
spreading throughout Europe, foreign central banks cut their interest rates, leading to a ________
in the value of the dollar relative to the euro.
A) rose; further increase
B) rose; decline
C) declined; rise
D) declined; further decline
Answer: C

43) An increase in the foreign interest rate shifts the expected return schedule for ________
deposits to the ________ and causes the domestic currency to depreciate.
A) domestic; right
B) domestic; left
C) foreign; right
D) foreign; left
Answer: C

44) A decrease in the foreign interest rate shifts the expected return schedule for ________
deposits to the ________ and causes the domestic currency to appreciate.
A) domestic; right
B) domestic; left
C) foreign; right
D) foreign; left
Answer: D

45) A rise in the expected future exchange rate shifts the expected return schedule for ________
deposits to the ________ and causes the domestic currency to appreciate.
A) domestic; right
B) domestic; left
C) foreign; right
D) foreign; left
Answer: D

46) A fall in the expected future exchange rate shifts the expected return schedule for ________
deposits to the ________ and causes the domestic currency to depreciate.
A) domestic; right
B) domestic; left
C) foreign; right
D) foreign; left
Answer: C
47) An increase in the domestic interest rate shifts the expected return schedule for ________
deposits to the ________ and causes the domestic currency to appreciate.
A) domestic; right
B) domestic; left
C) foreign; right
D) foreign; left
Answer: A

48) A decrease in the domestic interest rate shifts the expected return schedule for ________
deposits to the ________ and causes the domestic currency to depreciate.
A) domestic; right
B) domestic; left
C) foreign; right
D) foreign; left
Answer: B

49) Which of the following causes a depreciation of the domestic currency?

A) A lower domestic interest rate due to a lower expected inflation rate.
B) A decline in the domestic real interest rate.
C) A decrease in the domestic money supply.
D) All of the above.
Answer: B

50) Which of the following causes an appreciation of the domestic currency?

A) A lower domestic interest rate due to a lower expected inflation rate.
B) A decline in the domestic real interest rate.
C) An increase in the domestic money supply.
D) All of the above.
Answer: A

51) When the domestic nominal interest rate rises because of an increase in expected inflation,
the expected appreciation of the dollar declines, ________ shifts out more than ________, and
the exchange rate declines.
A) RF; RD
B) RF; RF
C) RD; RD
D) RD; RF
Answer: A

52) The weakness of the dollar in the late 1970s and the strength of the dollar in the early 1980s
can be explained by movements in
A) real interest rates, but not nominal interest rates.
B) nominal interest rates, but not real interest rates.
C) relative price levels, but not real interest rates.
D) none of the above.
Answer: A

53) Higher tariffs and quotas cause a country's currency to ________ in the ________ run.
A) depreciate; short
B) appreciate; short
C) depreciate; long
D) appreciate; long
Answer: D

54) Lower tariffs and quotas cause a country's currency to ________ in the ________ run.
A) depreciate; short
B) appreciate; short
C) depreciate; long
D) appreciate; long
Answer: C

55) If the inflation rate in the United States is higher than that in Germany and productivity is
growing at a slower rate in the United States than it is in Germany, in the long run,
A) the euro should appreciate relative to the dollar.
B) the euro should depreciate relative to the dollar.
C) there should be no change in the euro price of dollars.
D) it is not clear what will happen to the euro price of dollars.
Answer: A
Topic: Chapter 15.4 Explaining Changes in Exchange Rates
.
56) If the French demand for American exports rises at the same time that U.S. productivity rises
relative to French productivity, then, in the long run,
A) the euro should appreciate relative to the dollar.
B) the dollar should depreciate relative to the euro.
C) the dollar should appreciate relative to the euro.
D) it is not clear whether the euro should appreciate or depreciate relative to the dollar.
Answer: C

57) When François the Foreigner considers the expected return on dollar deposits in terms of
foreign currency, the expected return must be adjusted for
A) any expected appreciation or depreciation of the dollar.
B) the interest rates on foreign deposits.
C) both A and B of the above.
D) neither A nor B of the above.
Answer: A

58) The expected return on dollar deposits in terms of foreign currency is the ________ the
interest rate on dollar deposits and the expected appreciation of the dollar.
A) product of
B) ratio of
C) sum of
D) difference in
Answer: C

59) If the interest rate on foreign deposits increases, holding everything else constant,
A) the expected return on these deposits must also increase.
B) the expected return on domestic deposits must decrease.
C) the expected return on domestic deposits must increase.
D) both A and B of the above.
E) both A and C of the above.
Answer: A

60) If the interest rate on dollar deposits is 10 percent, and the dollar is expected to appreciate
by
7 percent over the coming year, the expected return on dollar deposits in terms of the foreign
currency is
A) 3 percent.
B) 10 percent.
C) 13.5 percent.
D) 17 percent.
E) 24 percent. Answer: D
61) If the interest rate is 7 percent on euro deposits and 5 percent on dollar deposits, and if the
dollar is expected to appreciate at a 4 percent rate,
A) euro deposits have a higher expected return than dollar deposits.
B) the expected return on euro deposits in terms of dollars is 11 percent.
C) the expected return on dollar deposits in terms of euros is 1 percent.
D) the expected return on euro deposits in terms of dollars is 3 percent.
E) the expected return on dollar deposits equals the expected return on euro deposits.
Answer: D

62) If the interest rate is 13 percent on euro deposits and 15 percent on dollar deposits, and if
the
euro is expected to appreciate at a 4 percent rate relative to the dollar, then
A) euro deposits have a lower expected return than dollar deposits.
B) the expected return on euro deposits in terms of dollars is 9 percent.
C) the expected return on dollar deposits in terms of euros is 19 percent.
D) both A and B of the above will occur.
E) none of the above will occur.
Answer: E

63) The expected return on dollar deposits in terms of dollars, RD, is

A) always the interest rate on dollar deposits, iD, for any exchange rate.
B) the interest rate on dollar deposits, iD, only when Et > .
C) the interest rate on dollar deposits, iD, only when Et < .
D) the interest rate on dollar deposits, iD, only when Et = .
Answer: A

64) The condition which states that the domestic interest rate equals the foreign interest rate
minus the expected appreciation of the domestic currency is called
A) the purchasing power parity condition.
B) the interest parity condition.
C) money neutrality.
D) the theory of foreign capital mobility.
Answer: B

65) In a world with few impediments to capital mobility, the domestic interest rate equals the
sum of the foreign interest rate and the expected depreciation of the domestic currency, a
situation known as the
A) interest parity condition.
B) purchasing power parity condition.
C) exchange rate parity condition.
D) foreign asset parity condition.
Answer: A
66) According to the interest parity condition, the domestic interest rate is equal to the foreign
interest rate
A) plus the expected appreciation of the domestic currency.
B) less the expected appreciation of the domestic currency.
C) less the expected depreciation of the domestic currency.
D) less the expected depreciation of the domestic currency weighted by the domestic interest
rate.
Answer: B
67) According to the interest parity condition, if the domestic interest rate is ________ the
foreign interest rate, then ________.
A) above; there is expected appreciation of the foreign currency
B) above; there is expected depreciation of the foreign currency
C) below; there is expected appreciation of the foreign currency
D) below; the interest parity condition is violated
Answer: A

68) According to the interest parity condition, if the domestic interest rate is 12 percent and the
foreign interest rate is 10 percent, then the expected ________ of the foreign currency must be
________ percent.
A) appreciation; 4
B) appreciation; 2
C) depreciation; 2
D) depreciation; 4
Answer: B

69) According to the interest parity condition, if the domestic interest rate is 10 percent and the
foreign interest rate is 12 percent, then the expected ________ of the foreign currency must be
________ percent.
A) appreciation; 4
B) appreciation; 2
C) depreciation; 2
D) depreciation; 4
Answer: C

70) We currently live in a world in which there is capital mobility, meaning that
A) foreigners can easily purchase American assets, and Americans can easily purchase foreign
assets.
B) both Americans and foreigners prefer dollar assets, regardless of expected returns.
C) both Americans and foreigners prefer euro assets, regardless of expected returns.
D) Americans can easily purchase foreign assets, while foreigners have a difficult time
purchasing American assets.
Answer: A

71) The interest parity condition states that

A) the domestic interest rate equals the foreign interest rate minus the expected appreciation of
the domestic currency.
B) the domestic interest rate equals the foreign interest rate plus the expected appreciation of
the
foreign currency.
C) Neither A nor B is correct.
D) Both A and B are correct.
Answer: D

15.2 True/False
1) The foreign exchange market is organized as an over-the-counter market in which deposits
denominated in foreign currencies are bought and sold.
Answer: TRUE

2) When the value of the dollar changes from 0.50 pounds to 0.75 pounds, the pound has
appreciated and the dollar has depreciated.
Answer: FALSE

3) When the exchange rate for the euro changes from $0.90 to $0.85, then holding everything
else constant, the euro has depreciated and American wheat sold in Germany becomes more
expensive.
Answer: TRUE

4) If the dollar depreciates relative to the British pound, British sweaters will become more
expensive in the United States.
Answer: TRUE

5) If the dollar appreciates relative to the Swiss franc, Swiss chocolate will become cheaper in
the United States.

6) If the exchange rate between the dollar and the Swiss franc changes from 1.8 to 1.5 francs per
dollar, the franc depreciates and the dollar appreciates.
Answer: FALSE

7) Depreciation of a currency makes it easier for domestic manufacturers to sell their goods
abroad and makes foreign goods less competitive in domestic markets.
Answer: TRUE

8) There are two kinds of exchange rate transactions: spot transactions and forward transactions.
Answer: TRUE

9) The purchase of $50,000 worth of euros is an example of a foreign exchange transaction.

Answer: FALSE

10) The theory of purchasing power parity cannot fully explain exchange rate movements
because fiscal policy differs across countries.
Answer: FALSE

11) An increase in tariffs and quotas on imports causes a country's currency to appreciate.
Answer: TRUE

12) From 1973 through 2016, the rise in the British price level relative to the U.S. price level is
associated with a rise in the value of the dollar, as PPP predicts.
Answer: TRUE

13) Increased demand for a country's exports causes its currency to depreciate.
Answer: FALSE

14) In the short run, the quantity of dollars supplied is relatively fixed, and is best represented
with a vertical supply curve.
Answer: TRUE

15) A fall in the expected future exchange rate shifts the expected return schedule for domestic
deposits to the right and causes the domestic currency to depreciate.
Answer: FALSE

16) As the relative expected return on dollar deposits increases, Americans will want to hold
fewer dollar deposits and more foreign deposits.
Answer: FALSE

17) According to the interest parity condition, if the domestic interest rate is 12 percent and the
foreign interest rate is 10 percent, then the expected appreciation of the foreign currency must
be
2 percent.
Answer: TRUE

15.3 Essay
1) Explain why exchange rates are important, even to average citizens.

2) What is the difference between spot exchange rates and forward exchange rates?

3) Explain the logic underlying the law of one price and the theory of purchasing power parity.

4) Explain the theory of purchasing power parity.

5) What are some of the long-run determinants of the exchange rate?

6) Explain graphically how a change in the domestic price level will affect exchange rates,
holding everything else constant.

7) Explain graphically how a change in the foreign interest rate will affect exchange rates.

8) Discuss the relationship between changes in domestic real and nominal interest rates and
exchange rates.

9) With the start of the financial crisis in August 2007, the dollar began an accelerated decline in
value, falling by 9% against the euro. At that point, the financial crisis appeared to be a U.S.
problem. However, by mid-2008, the crisis spread to Europe. Discuss the reaction of the dollar to
actions taken by European central banks in late 2008 to deal with the widening financial crisis.
CHAPTER 24

24.1 Multiple Choice

1) Financial derivatives include ________.
A) stocks
B) bonds
C) futures
D) none of the above
Answer: C

2) Financial derivatives include ________.

A) stocks
B) bonds
C) forward contracts
D) both A and B
Answer: C

3) Which of the following is not a financial derivative?

A) stocks
B) futures
C) options
D) forward contracts
Answer: A
.
4) A contract that requires the investor to buy securities on a future date is called a ________.
A) short contract
B) long contract
C) hedge
D) cross
Answer: B
.
5) A contract that requires the investor to sell securities on a future date is called a ________.
A) short contract
B) long contract
C) hedge
D) micro hedge
Answer: A

6) A long contract requires that the investor

A) sell securities in the future.
B) buy securities in the future.
C) hedge in the future.
D) close out his position in the future.
Answer: B
7) A short contract requires that the investor
A) sell securities in the future.
B) buy securities in the future.
C) hedge in the future.
D) close out his position in the future.
Answer: A
.
8) Which is not a problem of forward contracts?
A) a lack of liquidity
B) a lack of flexibility
C) the difficulty of finding a counterparty
D) default risk
Answer: B
.
9) By selling short a futures contract of $100,000 at a price of 115, you are agreeing to deliver
________
face value securities for ________.
A) $100,000; $115,000
B) $115,000; $110,000
C) $100,000; $100,000
D) $115,000; $115,000
Answer: A
.
10) By selling short a futures contract of $100,000 at a price of 96, you are agreeing to deliver
________
face value securities for ________.
A) $100,000; $104,167
B) $96,000; $100,000
C) $100,000; $96,000
D) $100,000; $100,000
Answer: C
.
11) By buying a long $100,000 futures contract for 115, you agree to pay ________ for ________
face
value securities.
A) $100,000; $115,000
B) $115,000; $100,000
C) $86,956; $100,000
D) $86,956; $115,000
Answer: B
.
12) If you sell a short contract on financial futures, you hope interest rates will ________.
A) rise
B) fall
C) not change
D) fluctuate
Answer: A
13) If you buy a long contract on financial futures, you hope interest rates will ________.
A) rise
B) fall
C) not change
D) fluctuate
Answer: B
.
14) If you sell a short futures contract, you hope that bond prices will ________.
A) rise
B) fall
C) not change
D) fluctuate
Answer: B
.
15) The elimination of riskless profit opportunities in the futures market is referred to as ________.
A) speculation
B) hedging
C) arbitrage
D) open interest
E) mark to market
Answer: C
.
16) Futures contracts are regularly traded on the
A) Chicago Board of Trade.
B) New York Stock Exchange.
C) American Stock Exchange.
D) Chicago Board Options Exchange.
Answer: A
.
17) Financial futures are regularly traded on all of the following except the
A) Chicago Board of Trade.
B) Chicago Mercantile Exchange.
C) New York Futures Exchange.
D) Chicago Commodity Markets Board.
Answer: D

18) The agency responsible for regulation of the futures exchanges and trading in financial
futures is the
A) Commodity Futures Trading Commission.
B) Securities and Exchange Commission.
C) Federal Trade Commission.
D) Futures Exchange Commission.
Answer: A
.
19) The purpose of the Commodity Futures Trading Commission is to do all of the following
except
A) oversee futures trading.
B) see that prices are not manipulated.
C) approve proposed futures contracts.
D) establish minimum prices for futures contracts.
Answer: D
.
20) The number of contracts outstanding in a particular financial future is the ________.
A) demand coefficient
B) open interest
C) index level
D) outstanding balance
Answer: B
.
21) The futures markets have grown rapidly in recent years because
A) interest rate volatility has increased.
B) financial managers are more risk averse.
C) of both A and B.
D) of neither A nor B.
Answer: C
.
22) The advantage of forward contracts over futures contracts is that forward contracts
A) are standardized.
B) have lower default risk.
C) are more liquid.
D) are none of the above.
Answer: D
.
23) The advantage of forward contracts over futures contracts is that forward contracts
A) are standardized.
B) have lower default risk.
C) are more flexible.
D) both A and B are true.
Answer: C

24) Futures markets have grown rapidly because futures contracts

A) are standardized.
B) have lower default risk.
C) are liquid.
D) are all of the above.
Answer: D

25) Futures differ from forwards because they are

A) used to hedge portfolios.
B) used to hedge individual securities.
C) used in both financial and foreign exchange markets.
D) standardized contracts.
Answer: D

26) Futures differ from forwards because they are

A) used to hedge portfolios.
B) used to hedge individual securities.
C) used in both financial and foreign exchange markets.
D) marked to market daily.
Answer: D
27) Which of the following features of Treasury bond futures contracts were not designed to
increase
liquidity?
A) standardized contracts
B) traded up until maturity
C) not tied to one specific type of bond
D) marked to market daily
Answer: D
.
28) Which of the following features of Treasury bond futures contracts were not designed to
increase
liquidity?
A) standardized contracts
B) traded up until maturity
C) not tied to one specific type of bond
D) can be closed with offsetting trade
Answer: D
.
29) When a financial institution hedges the interest-rate risk for a specific asset, the hedge is
called a
________.
A) macro hedge
B) micro hedge
C) cross hedge
D) futures hedge
Answer: B
.
30) When a financial institution is hedging interest-rate risk on its overall portfolio, the hedge is a
________.
A) macro hedge
B) micro hedge
C) cross hedge
D) futures hedge
Answer: A
.
31) The risk that occurs because stock prices fluctuate is called ________.
A) stock market risk
B) reinvestment risk
C) interest-rate risk
D) default risk
Answer: A
.
32) The most widely traded stock index future is on the
A) Dow Jones 1000 index.
B) S&P 500 index.
C) NASDAQ index.
D) Dow Jones 30 index.
Answer: B

33) Who would be most likely to buy a long stock index future?
A) a mutual fund manager who believes the market will rise
B) a mutual fund manager who believes the market will fall
C) a mutual fund manager who believes the market will be stable
D) none of the above would be likely to purchase a futures contract
Answer: A
.
34) If you buy a futures contract on the S&P 500 Index at a price of 450 and the index rises to
500, you
will ________.
A) lose $12,500
B) gain $12,500
C) lose $50
D) gain $50
Answer: B

35) If you sell a futures contract on the S&P 500 Index at a price of 450 and the index rises to
500, you
will ________.
A) lose $12,500
B) gain $12,500
C) lose $50
D) gain $50
Answer: A
.
36) Which of the following is a likely reason for a portfolio manager to sell a stock index future
short?
A) He believes the market will rise.
B) He wants to lock in current prices.
C) He wants to reduce stock market risk.
D) Both B and C are correct.
Answer: D
.
37) If a portfolio manager believes stock prices will fall and knows that a block of funds will be
received
in the future, then he should
A) sell stock index futures short.
B) buy stock index futures long.
C) stay out of the futures market.
D) borrow and buy securities now.
Answer: A
.
38) If a firm is due to be paid in euros in two months, to hedge against exchange rate risk the
firm
should
A) sell foreign exchange futures short.
B) buy foreign exchange futures long.
C) stay out of the exchange futures market.
D) do none of the above.
Answer: A

39) If a firm must pay for goods it has ordered with foreign currency, it can hedge its foreign
exchange
rate risk by
A) selling foreign exchange futures short.
B) buying foreign exchange futures long.
C) staying out of the exchange futures market.
D) doing none of the above.
Answer: B
.
40) Options are contracts that give the purchasers the
A) opportunity to buy or sell an underlying asset.
B) the obligation to buy or sell an underlying asset.
C) the right to hold an underlying asset.
D) the right to switch payment streams.
Answer: A
.
41) The price specified in an option contract at which the holder can buy or sell the underlying
asset is
called the ________.
A) premium
B) call
C) strike price
D) put
Answer: C
.
42) The price specified in an option contract at which the holder can buy or sell the underlying
asset is
called the ________.
A) premium
B) strike price
C) exercise price
D) both B and C of the above.
Answer: D
.
43) The seller of an option has the
A) right to buy or sell the underlying asset.
B) the obligation to buy or sell the underlying asset.
C) ability to reduce transaction risk.
D) right to exchange one payment stream for another.
Answer: B
.
44) The seller of an option has the ________ to buy or sell the underlying asset, while the
purchaser of
an option has the ________ to buy or sell the asset.
A) obligation; right
B) right; obligation
C) obligation; obligation
D) right; right
Answer: A
.

45) An option that can be exercised at any time up to maturity is called a(n) ________.
A) swap
B) stock option
C) European option
D) American option
Answer: D
.
46) An option that can be exercised only at maturity is called a(n) ________.
A) swap
B) stock option
C) European option
D) American option
Answer: C
.
47) Options on individual stocks are referred to as ________.
A) stock options
B) futures options
C) American options
D) individual options
Answer: A
.
48) Options on futures contracts are referred to as ________.
A) stock options
B) futures options
C) American options
D) individual options
Answer: B
.
49) The agency which regulates stock options is the
A) Securities and Exchange Commission.
B) Commodities Futures Trading Commission.
C) Federal Trade Commission.
D) Both A and B are true.
Answer: A
.
50) The agency which regulates futures options is the
A) Securities and Exchange Commission.
B) Commodities Futures Trading Commission.
C) Federal Trade Commission.
D) Both A and B are true.
Answer: B
.
51) An option that gives the owner the right to buy a financial instrument at the exercise price
within a
specified period of time is a(n) ________.
A) call option
B) put option
C) American option
D) European option
Answer: A
52) An option that gives the owner the right to sell a financial instrument at the exercise price
within a
specified period of time is a(n) ________.
A) call option
B) put option
C) American option
D) European option
Answer: B
.
53) A call option gives the owner the ________ to ________ the underlying security.
A) right; sell
B) obligation; sell
C) right; buy
D) obligation; buy
Answer: C
.
54) A put option gives the owner the ________ to ________ the underlying security.
A) right; sell
B) obligation; sell
C) right; buy
D) obligation; buy
Answer: A
.
55) A call option gives the seller the ________ to ________ the underlying security.
A) right; sell
B) obligation; sell
C) right; buy
D) obligation; buy
Answer: B
.
56) A put option gives the seller the ________ to ________ the underlying security.
A) right; sell
B) obligation; sell
C) right; buy
D) obligation; buy
Answer: D
.
57) If you buy an option to buy Treasury futures at 115, and at expiration the market price is 110,
A) the call will be exercised.
B) the put will be exercised.
C) the call will not be exercised.
D) the put will not be exercised.
Answer: C
.
58) If you buy an option to sell Treasury futures at 115, and at expiration the market price is 110,
A) the call will be exercised.
B) the put will be exercised.
C) the call will not be exercised.
D) the put will not be exercised.
Answer: B
.
59) If you buy an option to buy Treasury futures at 110, and at expiration the market price is 115,
A) the call will be exercised.
B) the put will be exercised.
C) the call will not be exercised.
D) the put will not be exercised.
Answer: A
.
60) If you buy an option to sell Treasury futures at 110, and at expiration the market price is 115,
A) the call will be exercised.
B) the put will be exercised.
C) the call will not be exercised.
D) the put will not be exercised.
Answer: D
.
61) The main advantage of using options on futures contracts rather than the futures contracts
themselves is that interest-rate risk is
A) controlled while preserving the possibility of gains.
B) controlled while removing the possibility of losses.
C) not controlled but the possibility of gains is preserved.
D) not controlled but the possibility of gains is lost.
Answer: A
.
62) The main reason to buy an option on a futures contract rather than the futures contract itself
is
A) to reduce transaction cost.
B) to preserve the possibility for gains.
C) to limit losses.
D) to remove the possibility for gains.
Answer: B
.
63) The main disadvantage of futures contracts as compared to options on futures contracts is
that
futures
A) remove the possibility of gains.
B) increase the transactions cost.
C) are not as effective a hedge.
D) do not remove the possibility of losses.
Answer: A
.
64) All other things held constant, premiums on put options will increase when the
A) exercise price increases.
B) volatility of the underlying asset falls.
C) term to maturity increases.
D) A and C are both true.
Answer: D

65) All other things held constant, premiums on call options will increase when the
A) exercise price falls.
B) volatility of the underlying asset falls.
C) term to maturity decreases.
D) futures price increases.
Answer: A
.
66) All other things held constant, premiums on both put and call options will increase when the
A) exercise price increases.
B) volatility of the underlying asset increases.
C) term to maturity decreases.
D) futures price increases.
Answer: B
.
67) An increase in the volatility of the underlying asset, all other things held constant, will
________ the
option premium.
A) increase
B) decrease
C) not affect
D) Not enough information is given.
Answer: A
.
68) An increase in the exercise price, all other things held constant, will ________ the premium on
call
options.
A) increase
B) decrease
C) not affect
D) Not enough information is given.
Answer: B
.
69) If a bank manager wants to protect the bank against losses that would be incurred on its
portfolio of
Treasury securities should interest rates rise, he could ________ options on financial futures.
A) buy put
B) buy call
C) sell put
D) sell call
Answer: A
.
70) A financial contract that obligates one party to exchange a set of payments it owns for
another set of
payments owned by another party is called a ________.
A) cross hedge
B) cross call option
C) cross put option
D) swap
Answer: D

71) A swap that involves the exchange of a set of payments in one currency for a set of
payments in
another currency is a(n) ________.
A) interest-rate swap
B) currency swap
C) swaption
D) notional swap
Answer: B
.
72) A swap that involves the exchange of one set of interest payments for another set of interest
payments is called a(n) ________.
A) interest-rate swap
B) currency swap
C) swaption
D) notional swap
Answer: A
.
73) If Second National Bank has more rate-sensitive assets than rate-sensitive liabilities, it can
reduce
interest-rate risk with a swap which requires Second National to
A) pay a fixed rate while receiving a floating rate.
B) receive a fixed rate while paying a floating rate.
C) both receive and pay a fixed rate.
D) both receive and pay a floating rate.
Answer: B
.
74) If Second National Bank has more rate-sensitive liabilities than rate-sensitive assets, it can
reduce
interest-rate risk with a swap which requires Second National to
A) pay a fixed rate while receiving a floating rate.
B) receive a fixed rate while paying a floating rate.
C) both receive and pay a fixed rate.
D) both receive and pay a floating rate.
Answer: A
.
75) If a bank has a gap of -$10 million, it can reduce its interest-rate risk by
A) paying a fixed rate on $10 million and receiving a floating rate on $10 million.
B) paying a floating rate on $10 million and receiving a fixed rate on $10 million.
C) selling $20 million fixed-rate assets.
D) buying $20 million fixed-rate assets.
Answer: A
.
76) One advantage of using swaps to eliminate interest-rate risk is that swaps
A) are less costly than futures.
B) are less costly than rearranging balance sheets.
C) are more liquid than futures.
D) have better accounting treatment than options.
Answer: B
.

77) The disadvantage of swaps is that

A) they lack liquidity.
B) it is difficult to arrange for a counterparty.
C) they suffer from default risk.
D) they are all of the above.
Answer: D
.
78) As compared to a default on the notional principle, a default on a swap
A) is more costly.
B) is about as costly.
C) is less costly.
D) may cost more or less than default on the notional principle.
Answer: C
.
79) Intermediaries are active in the swap markets because
A) they increase liquidity.
B) they reduce default risk.
C) they reduce search cost.
D) all of the above are true.
Answer: D
.
80) A valid concern about financial derivatives is that
A) they allow financial institutions to increase their leverage.
B) they are too sophisticated because they are so complicated.
C) the notional amounts can greatly exceed a financial institution's capital.
D) all of the above are valid concerns.
E) none of the above are valid concerns.
Answer: A
.
81) The biggest danger of financial derivatives occurs
A) when notional amounts exceed a bank's capital.
B) when financial market prices and rates are highly volatile.
C) in the trading activities of financial institutions.
D) in the large amount of credit exposure.
Answer: C
.
82) The use of financial derivatives by financial institutions to hedge can decrease risk. However,
they
can also increase risk. Which of the following examples illustrates this?
A) Financial derivatives allow financial institutions to increase their leverage.
B) Some institutions such huge amounts of derivatives that the amounts exceed capital.
C) All of the above are valid examples.
D) None of the above are valid examples.
Answer: C

24.2 True/False
1) A forward contract is more flexible than a futures contract.
Answer: TRUE
.
2) Futures contracts are standardized.
Answer: TRUE
.
3) A long contract obligates the holder to sell securities in the future.
Answer: FALSE
.
4) A short contract obligates the holder to sell securities in the future.
Answer: TRUE
.
5) One problem with a futures contract is finding a counterparty.
Answer: FALSE
.
6) Futures contracts are subject to default risk.
Answer: FALSE
.
7) Futures trading is regulated by the Commodity Futures Trading Commission.
Answer: TRUE
.
8) Open interest allows investors to change the interest rate on futures contracts.
Answer: FALSE
.
9) To reduce the interest-rate risk of holding a portfolio of bonds, Treasury bond futures contracts
should
be bought.
Answer: FALSE
.
10) To reduce foreign exchange risk from selling goods to a foreign country, futures contracts
should be
sold.
Answer: TRUE
.
11) An option that gives the holder the right to buy an asset in the future is a put.
Answer: FALSE
.
12) Option premiums increase as the term to maturity increases.
Answer: TRUE
.
13) Option premiums fall as the volatility of the underlying asset falls.
Answer: TRUE
.
14) Using options to control interest-rate risk reduces the chance of a loss but increases the
chance of a
gain.
Answer: FALSE
.
15) One advantage of using options to hedge is that the accounting transaction will never require
the
firm to show large unrecognized losses.
Answer: TRUE
.
16) Interest-rate swaps involve the exchange of a set of payments in one currency for a set of
payments
in another.
Answer: FALSE
.
17) Currency swaps involve the exchange of a set of payments on one currency for a set of
payments in
another.
Answer: TRUE
.
18) If Friendly Finance Company has more rate-sensitive assets than rate-sensitive liabilities, it
may
reduce risk with a swap.
Answer: TRUE
.
19) Interest-rate swaps are more liquid than futures contracts.
Answer: FALSE
.
20) Intermediaries add value to the swap markets by reducing default risk.
Answer: TRUE
.
21) The 2007-2009 financial crisis illustrates that derivatives cannot be used to hedge -- financial
institutions should be barred from using them in any form.
Answer: TRUE

24.3 Essay
1) Distinguish between forward and futures contracts.
.
2) Why have the futures markets grown so rapidly in recent years?
.
3) Explain how a short hedge could be used to hedge a Treasury portfolio against interest-rate
risk.
.
4) Explain how a long hedge could be used to protect a bank from the risk that interest rates
could rise
before a loan is funded.
.
5) How would a firm use exchange rate futures to lock in current exchange rates?
.
6) Explain how a swap could be used to reduce interest-rate risk for a bank with more rate-
sensitive
assets than rate-sensitive liabilities.
.
7) Define and distinguish between call options and put options.
.
8) Explain how option contracts could be used to protect against losses in portfolio value that
may occur
as interest rates increase.
.
9) Explain the advantages of protecting against interest-rate risk using options rather than
futures
contracts.
.
10) Discuss the advantages of using swaps to protect against interest-rate risk rather than
restructuring
the balance sheet.
11) Discuss the challenges regulators face in controlling the use of derivatives by financial
institutions.