FINANCIAL MARKETS AND INSTITUTIONS FINAL
PAPER 2026 STUDY GUIDE WITH COMPLETE
ANSWER KEY
◉ What explains why yield curves tend to slope upward when short-
term rates are low? Answer: The liquidity premium term in the
equation.
◉ What explains why yield curves can be inverted when short-term
rates are high? Answer: A low expected average in the liquidity
premium context.
◉ What is one limitation of the Expectations Theory? Answer: It
cannot explain why yield curves usually slope upward.
◉ What is a characteristic of long-term bonds compared to short-
term bonds? Answer: They are subject to greater interest-rate risk
and are often less liquid.
◉ What is the relationship between liquidity premium and yield
curves? Answer: A larger liquidity premium as the term to maturity
lengthens typically leads to upward-sloping yield curves.
,◉ What is a stockholder? Answer: A stockholder (or shareholder)
has a legal claim on the firm's profits and equity.
◉ Why are stocks referred to as equities? Answer: Because
ownership of stocks represents partial ownership of a firm.
◉ What is the liability of a sole proprietor? Answer: A sole
proprietor has unlimited liability for the firm's debts.
◉ What is limited liability? Answer: Limited liability is the legal
provision that protects owners of a corporation from losing more
than their investment.
◉ What are the two types of stockholders? Answer: Preferred
stockholders and common stockholders.
◉ What do preferred stockholders receive? Answer: A fixed dividend
that is set when the corporation issues the stock.
◉ How does the dividend for common stockholders vary? Answer: It
fluctuates as the profitability of the corporation varies over time.
◉ What is market capitalization? Answer: The total market value of
a firm's common and preferred stock.
,◉ What is a publicly traded company? Answer: A corporation that
sells stock in the U.S. stock market.
◉ What is a stock market index? Answer: An average of stock prices
used to measure the overall performance of the stock market.
◉ How do fluctuations in stock prices affect the economy? Answer:
They can affect household and firm spending, as well as overall
economic uncertainty.
◉ What is the required return on equities (kE)? Answer: The
expected return necessary to compensate for the risk of investing in
stocks.
◉ What does the Generalized Dividend Valuation Model state?
Answer: The value of stock today is the present value of all future
cash flows.
◉ How is the market price of a stock determined? Answer: By the
buyer willing to pay the highest price.
◉ What effect does superior information have on stock prices?
Answer: It can increase the asset's value by reducing its perceived
risk.
, ◉ How can monetary policy affect stock prices? Answer: By
lowering interest rates, which can decrease the required rate of
return on equities and stimulate economic growth.
◉ What triggered the stock market crash in February 2020? Answer:
The spread of the coronavirus, leading to expectations of lower
dividend growth and higher required returns.
◉ What are adaptive expectations? Answer: Expectations formed
from past experiences that change slowly over time.
◉ What are rational expectations? Answer: Expectations that are
identical to optimal forecasts using all available information.
◉ What is the efficient markets hypothesis? Answer: It applies
rational expectations to financial markets, implying that the
equilibrium price of a security equals its fundamental value.
◉ What happens when new information is released about a firm?
Answer: Expectations and prices change, leading to frequent
changes in stock prices.
◉ What is financial arbitrage? Answer: The process of buying and
selling securities to profit from price changes over a brief period.
PAPER 2026 STUDY GUIDE WITH COMPLETE
ANSWER KEY
◉ What explains why yield curves tend to slope upward when short-
term rates are low? Answer: The liquidity premium term in the
equation.
◉ What explains why yield curves can be inverted when short-term
rates are high? Answer: A low expected average in the liquidity
premium context.
◉ What is one limitation of the Expectations Theory? Answer: It
cannot explain why yield curves usually slope upward.
◉ What is a characteristic of long-term bonds compared to short-
term bonds? Answer: They are subject to greater interest-rate risk
and are often less liquid.
◉ What is the relationship between liquidity premium and yield
curves? Answer: A larger liquidity premium as the term to maturity
lengthens typically leads to upward-sloping yield curves.
,◉ What is a stockholder? Answer: A stockholder (or shareholder)
has a legal claim on the firm's profits and equity.
◉ Why are stocks referred to as equities? Answer: Because
ownership of stocks represents partial ownership of a firm.
◉ What is the liability of a sole proprietor? Answer: A sole
proprietor has unlimited liability for the firm's debts.
◉ What is limited liability? Answer: Limited liability is the legal
provision that protects owners of a corporation from losing more
than their investment.
◉ What are the two types of stockholders? Answer: Preferred
stockholders and common stockholders.
◉ What do preferred stockholders receive? Answer: A fixed dividend
that is set when the corporation issues the stock.
◉ How does the dividend for common stockholders vary? Answer: It
fluctuates as the profitability of the corporation varies over time.
◉ What is market capitalization? Answer: The total market value of
a firm's common and preferred stock.
,◉ What is a publicly traded company? Answer: A corporation that
sells stock in the U.S. stock market.
◉ What is a stock market index? Answer: An average of stock prices
used to measure the overall performance of the stock market.
◉ How do fluctuations in stock prices affect the economy? Answer:
They can affect household and firm spending, as well as overall
economic uncertainty.
◉ What is the required return on equities (kE)? Answer: The
expected return necessary to compensate for the risk of investing in
stocks.
◉ What does the Generalized Dividend Valuation Model state?
Answer: The value of stock today is the present value of all future
cash flows.
◉ How is the market price of a stock determined? Answer: By the
buyer willing to pay the highest price.
◉ What effect does superior information have on stock prices?
Answer: It can increase the asset's value by reducing its perceived
risk.
, ◉ How can monetary policy affect stock prices? Answer: By
lowering interest rates, which can decrease the required rate of
return on equities and stimulate economic growth.
◉ What triggered the stock market crash in February 2020? Answer:
The spread of the coronavirus, leading to expectations of lower
dividend growth and higher required returns.
◉ What are adaptive expectations? Answer: Expectations formed
from past experiences that change slowly over time.
◉ What are rational expectations? Answer: Expectations that are
identical to optimal forecasts using all available information.
◉ What is the efficient markets hypothesis? Answer: It applies
rational expectations to financial markets, implying that the
equilibrium price of a security equals its fundamental value.
◉ What happens when new information is released about a firm?
Answer: Expectations and prices change, leading to frequent
changes in stock prices.
◉ What is financial arbitrage? Answer: The process of buying and
selling securities to profit from price changes over a brief period.
