Test Bank For Financial Markets And Institutions 8th Edition By Saunders

Test Bank For Financial Markets And Institutions 8th Edition By Saunders Chapter 01 - Introduction 36. What have been the major factors contributing to growth in the foreign financial markets? 1. Increase in the amount of savings available for investment in foreign countries. 2. International investors have looked to the United States for better investment opportunities. 3. The Internet has helped provide additional information on foreign markets and overseas investment opportunities. 4. Specialized intermediaries such as country specific mutual funds and ADRs have been developed to facilitate overseas investments. 5. Deregulation of foreign markets has allowed many new investors to participate in international investing. AACSB: Reflective Thinking Blooms: Understand Difficulty: 2 Medium Learning Goal: 01-09 Recognize that financial markets are becoming increasingly global. Topic: Globalization of Financial Markets and Institutions 37. You are a corporate treasurer seeking to raise funds for your firm. What are some advantages of raising funds via a financial intermediary (FI) rather than by selling securities to the public? Advantages include: * Speed: funds can normally be raised more quickly through FIs. * Registration process/cost: The registration process can be quite costly and time-consuming in terms of workers' hours, audit fees, and fees to investment bankers. Raising funds via a FI can be less expensive, particularly for smaller capital needs or when funds are needed for only a short time period. (Maturities of 270 days or less do not require registration, nor do private placements). * Nonstandard terms can be negotiated with FIs but are difficult to sell to the public. For example, if a borrower can only begin paying interest after 2 years, they would have a difficult time selling bonds to the public. * There is a greater ability to renegotiate terms if necessary. Terms of public issue generally cannot be changed outside of court. * Less information is made public. AACSB: Reflective Thinking Blooms: Understand Difficulty: 3 Difficult Learning Goal: 01-01 Differentiate between primary and secondary markets. Learning Goal: 01-06 Know the services financial institutions perform. Topic: Overview of Financial Institutions Topic: Overview of Financial Markets 1-29 Chapter 01 - Introduction 38. How can a depository intermediary afford to purchase long-term risky direct claims from fund's demanders and finance these purchases with safe, liquid, short-term, low denomination deposits? What can go wrong in this process? DIs can afford to do so because the rate they must pay to attract funds is lower than the rate they can charge on their riskier assets. A lot can go wrong however. * If the money lent is not repaid, the DI may not be able to repay its depositors on demand (credit and liquidity risk). Diversification of the credit risk is a key way DIs limit credit risk. * The difference between the rate earned on assets and the rate paid on liabilities is called the Net Interest Margin (NIM). The NIM can turn negative if interest rates rise or if the rates on long-term securities fall below the interest rates risk on short-term securities (after adjusting for risk). * Because the assets and liabilities are different claims, it is possible for the value of the assets to drop resulting in an insolvent institution (insolvency risk). Because the assets are primarily financial, their value can be quite volatile. As a result, risk management is crucial at today's financial institution. *DIs attract many savers with a small amount of funds. DIs then invest the bulk of these savings in investments that cannot be immediately liquidated. If the savers lose confidence in the DI they will seek to withdraw their money, which can precipitate a liquidity crisis and cause insolvency. AACSB: Reflective Thinking Blooms: Create Blooms: Understand Difficulty: 3 Difficult Learning Goal: 01-06 Know the services financial institutions perform. Topic: Overview of Financial Institutions 1-30 Chapter 01 - Introduction 39. Discuss the benefits to funds' suppliers of using a financial intermediary asset transformer in place of directly purchasing claims such as stocks or bonds. What is the major disadvantage? Potential benefits to funds' suppliers (SSUs): * Professional risk managers to assess risk of borrowers' (DSU's) claim and help decide the correct price to pay. * Risk reduction via: - insurance - additional diversification - more frequent monitoring - additional cushion of FI equity - improved liquidity of SSU claim on FI * Denomination intermediation. * Maturity intermediation. What is the downside of putting your money in an intermediary? * Forego potentially higher returns if you do not purchase the more risky direct claims. AACSB: Reflective Thinking Blooms: Understand Difficulty: 2 Medium Learning Goal: 01-01 Differentiate between primary and secondary markets. Learning Goal: 01-06 Know the services financial institutions perform. Topic: Overview of Financial Institutions Topic: Overview of Financial Markets 1-31 Chapter 01 - Introduction 40. Discuss the major macro benefits of financial intermediaries. What role does the government have in the credit allocation process? * Money supply transmission: Depository institutions affect the level of money supply growth in the economy. The money supply is increased when the Fed increases money available to banks, but the extent of money supply growth is affected by banks' decisions to lend the increased supply of funds. If the banks do not lend the increased money, the given increase in funds by the Fed will result in only a small change in the total money supply in the economy. * Credit Allocation: FIs price risk and allocate capital to users who they believe can generate a high enough rate of return to compensate the lender for the risk the lender bears in loaning the money. FIs also monitor the borrower's condition after the loan is made. A wellfunctioning economy must have sound mechanisms for allocating capital. In capitalist countries, FIs and markets allocate capital to its highest valued uses, thereby maximizing economic growth. The role of government is to ensure disclosure of risks and fair practices of all involved. In communist and some socialist countries, governments allocate capital according to a current political agenda and strong, lasting economic growth is rarely, if ever, seen in these countries. As the text indicates, the government can also channel credit to socially deserving areas such as housing, farms, and small business development. *Intergenerational wealth transfers and risk shifting: Pension funds and insurance firms allow investors to transfer wealth through time, while avoiding taxation, and/or allow investors the ability to choose which risks in their life they will bear and which they will insure. * Payment services: The ability to store and quickly move large sums of money (or many small sums) at low cost with little risk encourages greater investment by market participants and, thus, lowers the overall cost of funds in our economy. AACSB: Reflective Thinking Blooms: Understand Difficulty: 3 Difficult Learning Goal: 01-07 Know the risks financial institutions face. Learning Goal: 01-08 Appreciate why financial institutions are regulated. Learning Goal: 01-09 Recognize that financial markets are becoming increasingly global. Topic: Globalization of Financial Markets and Institutions Topic: Overview of Financial Institutions 1-32 Chapter 01 - Introduction 41. What determines the price of financial instruments? Which are riskier, capital market instruments or money market instruments? Why? The price of any financial instrument is the present value of future cash flows discounted at an appropriate rate. A small change in interest rates causes a large change in present value of distant cash flows. Hence, the prices of long-term capital market instruments are more sensitive to changes in interest rates than prices of short-term instruments. In addition, distant cash flows for stocks are not known with certainty. Changing economic prospects can cause very large changes in current stock values. Money market instruments have predictable cash flows and mature in one year or less, so they are much less risky. AACSB: Reflective Thinking Blooms: Understand Difficulty: 2 Medium Learning Goal: 01-05 Distinguish between the different types of financial institutions. Learning Goal: 01-06 Know the services financial institutions perform. Topic: Overview of Financial Institutions 42. Explain how the credit crunch originating in the mortgage markets hurt financial intermediaries' attempts to use diversification and monitoring to limit the riskiness of their loans and investments while offering more liquid claims to savers. Financial intermediaries' (FIs) attempts to diversify away from specific risk failed when large portions of the debt markets "seized up" and stopped functioning. At this point many security prices declined all at once, regardless of historical correlations among security prices. This is a failure of diversification to reduce risk. FIs exploit diversification principles and economies of scale to allow the FI to invest large amounts of money. They also must closely monitor the riskiness of their loans and securities, and many FIs are also regulated by the government to ensure they manage the riskiness of their assets. Some would argue that FIs failed to monitor the riskiness of many of their mortgage investments as well leading to large numbers of poor investments. AACSB: Reflective Thinking Blooms: Understand Difficulty: 3 Difficult Learning Goal: 01-02 Differentiate between money and capital markets. Topic: Overview of Financial Markets 1-33 Chapter 2: Determinants of Interest Rates True/False 1. The real interest rate is the increment to purchasing power that the lender earns in order to induce him or her to forego current consumption. Answer: True Level: Medium 2. If you earn 0.5% a month in your bank account, this would be the same as earning a 6% annual interest rate with annual compounding. Answer: False Level: Medium 3. Simple interest calculations assume the interest earned is never reinvested. Answer: True Level: Easy 4. An investor earned a 5% nominal rate of return over the year. However, over the year prices increased by 2%. The investor’s real rate of return was less than their nominal rate of return. Answer: True Level: Easy 5. Earning a 5% interest rate with annual compounding is better than earning a 4.95% interest rate with semiannual compounding. Answer: False Level: Difficult 6. For any positive interest rate the present value of a given annuity will be less than the sum of the cash flows and the future value of the same annuity will be greater than the sum of the cash flows. Answer: True Ch 2 - 1 Level: Medium 7. With a zero interest rate both the present value and the future value of an N payment annuity would equal N x payment. Answer: True Level: Medium 8. Households generally supply more funds to the markets as their income and wealth increase, ceteris paribus. Answer: True Level: Easy 9. An increase in the perceived riskiness of investments would cause a movement up along the supply curve. Answer: False Level: Medium 10. Ceteris paribus, an increase in the marginal tax rates for all U.S. taxpayers would probably result in reduced supply of funds by households. Answer: True Level: Easy 11. When the quantity of a financial security supplied or demanded changes at every given interest rate in response to a change in a factor, this causes a shift in the supply or demand curve. Answer: True Level: Medium 12. An improvement in economic conditions would likely shift the supply curve down and to the right and shift the demand curve for funds up and to the right. Answer: True Level: Medium 13. The risk that a security cannot be sold at a predictable price with low transaction costs at Ch 2 - 2 short notice is called liquidity risk. Answer: True Level: Easy 14. Convertible bonds will normally have lower promised yields than straight bonds of similar terms and quality. Answer: True Level: Medium 15. We expect liquidity premiums to move inversely with interest rate volatility. Answer: False Level: Difficult 16. Everything else equal, the interest rate required on a callable bond will be less than the interest rate on a convertible bond. Answer: False Level: Easy 17. The term structure of interest rates is the relationship between interest rates on bonds similar in terms except for maturity. Answer: True Level: Easy 18. The unbiased expectations hypothesis of the term structure posits that long term interest rates are unrelated to expected future short term rates. Answer: False Level: Medium 19. The traditional liquidity premium theory states that long term interest rates are greater than the average of expected future interest rates. Answer: True Level: Medium Ch 2 - 3 20. According to the market segmentation theory short term investors will not normally switch to intermediate or long term investments. Answer: True Level: Easy Multiple Choice 21. An investment pays $400 in one year, X amount of dollars in two years and $500 in 3 years. The total present value of all the cash flows (including X) is equal to $1500. If i is 6%, what is X? A) $702.83 B) $822.41 C) $789.70 D) $749.67 E) $600.00 Answer: C Response: X = [1500 – (400/1.06) – (500/1.06 Level: Difficult 3 )]*1.06 2 22. An annuity and an annuity due that have the same number of payments also have the same present value if r = 10%. Which one has the higher payment? A) The annuity has the higher payment B) The annuity due has the higher payment C) They both must have the same payment since the present values are the same D) There is no way to tell which has the higher payment E) An annuity and an annuity due cannot have the same present value Answer: A Level: Medium 23. An insurance company is trying to sell you a retirement annuity. The annuity will give you 20 payments with the first payment in 12 years when you retire. The insurance firm is asking you to pay $50,000 today. If this is a fair deal, what must the payment amount be (to the dollar) if the interest rate is 8%? A) $ 5,093 B) $12,824 C) $ 9,472 D) $11,874 E) $10,422 Ch 2 - 4 Answer: D Response: $50,000× 1.08 = Pmt × PVIFA(8%,20 yrs) Level: Difficult 11 24. You borrow $95 today for six and a half weeks. You must repay $100 at loan maturity. What is the effective annual rate on this loan? A) 50.73% B) 40.00% C) 32.33% D) 27.95% E) 37.93% Answer: A Response: (100 / 95) Level: Difficult (52 / 6.5) 25. If M > 1 and you solve the following equation to find i: PV * (1 + (i/M)) M*N = FV, the i you get will be A) The bond equivalent yield B) The EAR C) The TOE D) The EYE E) The rate per compounding period Answer: A Level: Difficult 26. An annuity and an annuity due with the same number of payments have the same future value if r = 10%. Which one has the higher payment? A) They both must have the same payment since the future values are the same B) There is no way to tell which has the higher payment C) An annuity and an annuity due cannot have the same future value D) The annuity has the higher payment E) The annuity due has the higher payment Answer: D Level: Difficult Ch 2 - 5 27. You go to the Wall Street Journal and notice that yields on almost all corporate and Treasury bonds have decreased. The yield decreases may perhaps be explained by which one of the following: A) A decrease in U.S. inflationary expectations B) Newly expected decline in the value of the dollar C) An increase in current and expected future returns of real corporate investments D) Decreased Japanese purchases of U.S. Treasury Bills/Bonds E) Increases in the U.S. Government budget deficit Answer: A Level: Medium Refer to the information below for questions 28 & 29: Figure 2-1 YIELD CURVE FOR ZERO COUPON BONDS RATED AA Maturity YTM Maturity YTM Maturity YTM 1 year 8.00% 7 year 9.15% 13 year 10.45% 2 year 8.11% 8 year 9.25% 14 year 10.65% 3 year 8.20% 9 year 9.35% 15 year 10.75% 4 year 8.50% 10 year 9.47% 16 year 10.95% 5 year 8.75% 11 year 9.52% 17 year 11.00% 6 year 8.85% 12 year 9.77% 18 year 11.25% Assume that there are no liquidity premiums. 28. To the nearest basis point what is the expected interest rate on a four year maturity AA zero coupon bond purchased six years from today? A) 10.41% B) 10.05% C) 9.16% D) 10.56% E) 9.96% Answer: A Refer To: 2-1 Response: ((1.0947 10 / 1.0885 -1 Level: Difficult 6 )) (1/4) 29. You just bought a fifteen year maturity Xerox corporate bond rated AA with a 0% coupon. You expect to sell the bond in eight years. Find the expected interest rate at the time of sale (watch out for rounding error). A) 11.00% B) 8.85% C) 12.49% Ch 2 - 6