FINANCIAL MARKETS AND INSTITUTIONS
EXAM QUESTIONS AND 100% CORRECT
ANSWERS (BY JEFF MADURA’S)
1. Q: What is the primary function of financial markets? A: Financial
markets facilitate the transfer of funds from surplus units (savers) to deficit units
(borrowers), enabling efficient allocation of capital in the economy.
2. Q: Distinguish between direct and indirect finance. A: Direct finance
occurs when borrowers obtain funds directly from lenders through financial
markets. Indirect finance involves financial intermediaries that accept deposits
from savers and lend to borrowers.
3. Q: What are the main types of financial markets? A: Money markets
(short-term, less than 1 year), capital markets (long-term), primary markets
(new securities), secondary markets (existing securities), and derivative
markets.
4. Q: How do financial institutions reduce transaction costs? A: Through
economies of scale, expertise in evaluating creditworthiness, standardized
procedures, and technology that reduces per-transaction costs.
5. Q: What is asymmetric information in financial markets? A: A situation
where one party has more or better information than another, leading to adverse
selection and moral hazard problems.
Chapter 2: Determination of Interest Rates
6. Q: What factors determine the risk-free rate of interest? A: The real rate
of interest, expected inflation rate, and liquidity premium for the specific
maturity.
7. Q: Explain the Fisher effect. A: The Fisher effect states that nominal
interest rates adjust to reflect expected inflation: Nominal rate = Real rate +
Expected inflation rate.
8. Q: What is the term structure of interest rates? A: The relationship
between interest rates and time to maturity for securities with identical risk
characteristics.
,9. Q: Describe the expectations theory of the term structure. A: Long-term
interest rates are geometric averages of expected future short-term rates, with no
risk premium for maturity.
10. Q: What is the liquidity premium theory? A: Investors require higher
yields on longer-term securities to compensate for greater interest rate risk and
lower liquidity.
Chapter 3: Structure of Interest Rates
11. Q: What factors cause yield differences among securities with the same
maturity? A: Credit risk, liquidity, tax treatment, call provisions, and
convertibility features.
12. Q: How does credit risk affect bond yields? A: Higher credit risk results
in higher required yields to compensate investors for the increased probability
of default.
13. Q: What is the yield spread? A: The difference in yields between two
bonds, typically measured relative to Treasury securities of similar maturity.
14. Q: How do tax considerations affect municipal bond yields? A:
Municipal bonds typically offer lower yields than corporate bonds because their
interest income is exempt from federal taxes.
15. Q: What is duration and why is it important? A: Duration measures a
bond's price sensitivity to interest rate changes, helping investors assess interest
rate risk.
PART II: THE FED AND MONETARY POLICY
Chapter 4: Functions of the Fed
16. Q: What are the primary functions of the Federal Reserve? A:
Conducting monetary policy, supervising banks, maintaining financial system
stability, and providing payment system services.
17. Q: Describe the structure of the Federal Reserve System. A: 12 regional
Federal Reserve Banks, Board of Governors (7 members), and Federal Open
Market Committee (FOMC).
18. Q: What is the Federal Open Market Committee (FOMC)? A: The Fed's
monetary policymaking body consisting of the 7 Board members plus 5 regional
Fed presidents who vote on monetary policy.
, 19. Q: How does the Fed influence the money supply? A: Through open
market operations, reserve requirements, and the discount rate (federal funds
rate).
20. Q: What is the federal funds rate? A: The interest rate at which banks
lend excess reserves to other banks overnight, serving as the Fed's primary
policy tool.
Chapter 5: Monetary Policy
21. Q: What are the Fed's dual mandate objectives? A: Price stability (low
inflation) and maximum sustainable employment (full employment).
22. Q: Distinguish between expansionary and contractionary monetary
policy. A: Expansionary policy increases money supply to stimulate economic
growth; contractionary policy reduces money supply to control inflation.
23. Q: What is quantitative easing? A: Large-scale purchases of long-term
securities by the central bank to increase money supply when short-term rates
are near zero.
24. Q: How do changes in the federal funds rate affect the economy? A:
Rate changes influence borrowing costs, investment decisions, consumer
spending, and ultimately economic growth and inflation.
25. Q: What is the transmission mechanism of monetary policy? A: The
process by which monetary policy decisions affect economic variables through
interest rates, credit availability, and exchange rates.
PART III: DEBT SECURITY MARKETS
Chapter 6: Money Markets
26. Q: What characterizes money market securities? A: Short-term (less
than 1 year), high liquidity, low default risk, and large denominations.
27. Q: What are Treasury bills? A: Short-term government securities with
maturities of 4, 13, 26, or 52 weeks, sold at discount and maturing at face value.
28. Q: Describe commercial paper. A: Unsecured short-term promissory notes
issued by corporations with high credit ratings, typically maturing in 30-270
days.
29. Q: What is a certificate of deposit (CD)? A: A time deposit at a bank with
a specified maturity date and interest rate, available in negotiable and non-
negotiable forms.
EXAM QUESTIONS AND 100% CORRECT
ANSWERS (BY JEFF MADURA’S)
1. Q: What is the primary function of financial markets? A: Financial
markets facilitate the transfer of funds from surplus units (savers) to deficit units
(borrowers), enabling efficient allocation of capital in the economy.
2. Q: Distinguish between direct and indirect finance. A: Direct finance
occurs when borrowers obtain funds directly from lenders through financial
markets. Indirect finance involves financial intermediaries that accept deposits
from savers and lend to borrowers.
3. Q: What are the main types of financial markets? A: Money markets
(short-term, less than 1 year), capital markets (long-term), primary markets
(new securities), secondary markets (existing securities), and derivative
markets.
4. Q: How do financial institutions reduce transaction costs? A: Through
economies of scale, expertise in evaluating creditworthiness, standardized
procedures, and technology that reduces per-transaction costs.
5. Q: What is asymmetric information in financial markets? A: A situation
where one party has more or better information than another, leading to adverse
selection and moral hazard problems.
Chapter 2: Determination of Interest Rates
6. Q: What factors determine the risk-free rate of interest? A: The real rate
of interest, expected inflation rate, and liquidity premium for the specific
maturity.
7. Q: Explain the Fisher effect. A: The Fisher effect states that nominal
interest rates adjust to reflect expected inflation: Nominal rate = Real rate +
Expected inflation rate.
8. Q: What is the term structure of interest rates? A: The relationship
between interest rates and time to maturity for securities with identical risk
characteristics.
,9. Q: Describe the expectations theory of the term structure. A: Long-term
interest rates are geometric averages of expected future short-term rates, with no
risk premium for maturity.
10. Q: What is the liquidity premium theory? A: Investors require higher
yields on longer-term securities to compensate for greater interest rate risk and
lower liquidity.
Chapter 3: Structure of Interest Rates
11. Q: What factors cause yield differences among securities with the same
maturity? A: Credit risk, liquidity, tax treatment, call provisions, and
convertibility features.
12. Q: How does credit risk affect bond yields? A: Higher credit risk results
in higher required yields to compensate investors for the increased probability
of default.
13. Q: What is the yield spread? A: The difference in yields between two
bonds, typically measured relative to Treasury securities of similar maturity.
14. Q: How do tax considerations affect municipal bond yields? A:
Municipal bonds typically offer lower yields than corporate bonds because their
interest income is exempt from federal taxes.
15. Q: What is duration and why is it important? A: Duration measures a
bond's price sensitivity to interest rate changes, helping investors assess interest
rate risk.
PART II: THE FED AND MONETARY POLICY
Chapter 4: Functions of the Fed
16. Q: What are the primary functions of the Federal Reserve? A:
Conducting monetary policy, supervising banks, maintaining financial system
stability, and providing payment system services.
17. Q: Describe the structure of the Federal Reserve System. A: 12 regional
Federal Reserve Banks, Board of Governors (7 members), and Federal Open
Market Committee (FOMC).
18. Q: What is the Federal Open Market Committee (FOMC)? A: The Fed's
monetary policymaking body consisting of the 7 Board members plus 5 regional
Fed presidents who vote on monetary policy.
, 19. Q: How does the Fed influence the money supply? A: Through open
market operations, reserve requirements, and the discount rate (federal funds
rate).
20. Q: What is the federal funds rate? A: The interest rate at which banks
lend excess reserves to other banks overnight, serving as the Fed's primary
policy tool.
Chapter 5: Monetary Policy
21. Q: What are the Fed's dual mandate objectives? A: Price stability (low
inflation) and maximum sustainable employment (full employment).
22. Q: Distinguish between expansionary and contractionary monetary
policy. A: Expansionary policy increases money supply to stimulate economic
growth; contractionary policy reduces money supply to control inflation.
23. Q: What is quantitative easing? A: Large-scale purchases of long-term
securities by the central bank to increase money supply when short-term rates
are near zero.
24. Q: How do changes in the federal funds rate affect the economy? A:
Rate changes influence borrowing costs, investment decisions, consumer
spending, and ultimately economic growth and inflation.
25. Q: What is the transmission mechanism of monetary policy? A: The
process by which monetary policy decisions affect economic variables through
interest rates, credit availability, and exchange rates.
PART III: DEBT SECURITY MARKETS
Chapter 6: Money Markets
26. Q: What characterizes money market securities? A: Short-term (less
than 1 year), high liquidity, low default risk, and large denominations.
27. Q: What are Treasury bills? A: Short-term government securities with
maturities of 4, 13, 26, or 52 weeks, sold at discount and maturing at face value.
28. Q: Describe commercial paper. A: Unsecured short-term promissory notes
issued by corporations with high credit ratings, typically maturing in 30-270
days.
29. Q: What is a certificate of deposit (CD)? A: A time deposit at a bank with
a specified maturity date and interest rate, available in negotiable and non-
negotiable forms.
