M and B 2, 2nd Edition by Dean Croushore – Test Bank

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INSTANT DOWNLOAD COMPLETE TEST BANK WITH ANSWERS

 

M and B 2, 2nd Edition by Dean Croushore – Test Bank

 

Sample  Questions

 

Chapter 3—Money and Payments

 

MULTIPLE CHOICE

 

  1. Inflation affects money because
a. it increases money’s efficiency as a medium of exchange.
b. it reduces money’s role as a store of value.
c. it reduces the supply of money.
d. it reduces transactions and search costs.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic              TOP:   How We Use Money

TYP:   Factual

 

  1. The following are all functions of money, except
a. medium of exchange.
b. store of value.
c. source of anxiety.
d. standard of deferred payment.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic              TOP:   How We Use Money

TYP:   Factual

 

  1. Hyperinflation occurs when
a. the inflation rate is extremely high.
b. people get excited about inflationary expectations.
c. a dollar today has the same real value as one million dollars last year.
d. the inflation rate is positive.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic              TOP:   How We Use Money

TYP:   Factual

 

  1. The law states that a lender must accept money in the repayment of debts, which means that money is
a. the unit of account.
b. the medium of exchange.
c. outside money.
d. legal tender.

 

 

ANS:  D                    PTS:   1                    DIF:    Basic              TOP:   How We Use Money

TYP:   Factual

 

  1. In its role as a medium of exchange, money makes exchanges easier by reducing
a. inflation.
b. transactions costs.
c. costs of pricing goods.
d. legal costs in negotiating loan contracts.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic              TOP:   How We Use Money

TYP:   Factual

 

 

  1. When people use money by trading it for goods and services, money is serving the role of
a. medium of exchange.
b. unit of account.
c. store of value.
d. standard of deferred payment.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic              TOP:   How We Use Money

TYP:   Factual

 

  1. The costs of trading are known as ________ costs.
a. trading
b. menu
c. shoe-leather
d. transactions

 

 

ANS:  D                    PTS:   1                    DIF:    Basic              TOP:   How We Use Money

TYP:   Factual

 

  1. An inflation rate exceeding 50 percent per month is said to be
a. hyperinflation.
b. deflation.
c. disinflation.
d. superinflation.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic              TOP:   How We Use Money

TYP:   Factual

 

  1. When money serves as the item in which prices are denoted, money is serving the role of
a. medium of exchange.
b. unit of account.
c. store of value.
d. standard of deferred payment.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic              TOP:   How We Use Money

TYP:   Factual

 

  1. When people keep money for some period instead of spending it or investing it, money is serving the role of
a. medium of exchange.
b. unit of account.
c. store of value.
d. standard of deferred payment.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic              TOP:   How We Use Money

TYP:   Factual

 

 

  1. When you buy something one day and pay for it later, and the repayment you make is denoted in terms of money, money is serving the role of
a. medium of exchange.
b. unit of account.
c. store of value.
d. standard of deferred payment.

 

 

ANS:  D                    PTS:   1                    DIF:    Basic              TOP:   How We Use Money

TYP:   Factual

 

  1. Legal tender is the condition that a ________ must accept ________ in the repayment of debts, by law.
a. lender; bonds
b. borrower; money
c. borrower; bonds
d. lender; money

 

 

ANS:  D                    PTS:   1                    DIF:    Basic              TOP:   How We Use Money

TYP:   Factual

 

  1. Gresham’s Law states that
a. the more you make, the more you spend.
b. bad money drives out good money.
c. money supply creates its own demand.
d. money is memory.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic

TOP:   Gresham’s Law and Money in P.O.W. Camps                 TYP:   Factual

 

  1. The idea that bad money drives good money out of circulation is known as
a. Roy’s Identity.
b. Say’s Law.
c. Gresham’s Law.
d. Seignorage Science.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic

TOP:   Gresham’s Law and Money in P.O.W. Camps                 TYP:   Factual

 

  1. The payments system is the set of mechanisms used for
a. sending out credit card applications.
b. issuing paychecks.
c. electronically filing federal taxes.
d. making transactions.

 

 

ANS:  D                    PTS:   1                    DIF:    Basic              TOP:   The Payments System

TYP:   Factual

 

 

  1. The set of mechanisms used for making transactions is called the
a. outside money mechanism.
b. payments system.
c. inside money system.
d. standard of deferred payments.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic              TOP:   The Payments System

TYP:   Factual

 

  1. Outside money is
a. money created by the government or by nature.
b. money created by the private sector, such as checking accounts at banks.
c. money that has value only because the government decrees that it has value.
d. checks that are in the process of clearing but have not cleared yet.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic              TOP:   The Payments System

TYP:   Factual

 

  1. U.S. currency is currently
a. commodity money.
b. full-bodied money.
c. inside money.
d. fiat money.

 

 

ANS:  D                    PTS:   1                    DIF:    Basic              TOP:   The Payments System

TYP:   Factual

 

  1. In addition to checks, another example of inside money is
a. Fedwire.
b. silver.
c. traveler’s checks.
d. $100 bills.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic              TOP:   The Payments System

TYP:   Factual

 

  1. Money created in the private sector, such as checking accounts at banks, is
a. fiat money.
b. commodity money.
c. outside money.
d. inside money.

 

 

ANS:  D                    PTS:   1                    DIF:    Basic              TOP:   The Payments System

TYP:   Factual

 

 

  1. A mechanism by which a short-term loan is made, allowing a shopper to purchase goods or services today and pay at a later date, is known as a ____ card.
a. debit
b. commodity
c. credit
d. fiat

 

 

ANS:  C                    PTS:   1                    DIF:    Basic              TOP:   The Payments System

TYP:   Factual

 

  1. Money created by the government or by nature is called
a. inside money.
b. outside money.
c. natural money.
d. artificial money.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic              TOP:   The Payments System

TYP:   Factual

 

  1. Inside money is
a. money created by the government or by nature.
b. money created by the private sector, such as checking accounts at banks.
c. money that has value only because the government decrees that it has value.
d. checks that are in the process of clearing but have not cleared yet.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic              TOP:   The Payments System

TYP:   Factual

 

  1. If money is gold or silver, it is called ____ money
a. fiat
b. inside
c. commodity
d. glitter

 

 

ANS:  C                    PTS:   1                    DIF:    Basic              TOP:   The Payments System

TYP:   Factual

 

  1. Commodity money is usually
a. paper money.
b. also known as fiat money.
c. inside money.
d. gold or silver.

 

 

ANS:  D                    PTS:   1                    DIF:    Basic              TOP:   The Payments System

TYP:   Factual

 

 

  1. Another name for commodity money is
a. fiat money.
b. outside money.
c. full-bodied money.
d. inside money.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic              TOP:   The Payments System

TYP:   Factual

 

  1. Full-bodied money is
a. commodity money.
b. paper money.
c. fiat money.
d. inside money.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic              TOP:   The Payments System

TYP:   Factual

 

  1. Money that has value in large part by the government’s proclamation is known as
a. fiat money.
b. commodity money.
c. full-bodied money.
d. inside money.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic              TOP:   The Payments System

TYP:   Factual

 

  1. Fiat money is
a. also known as full-bodied money.
b. money that has value in large part by the government’s proclamation.
c. money in checking accounts.
d. inside money.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic              TOP:   The Payments System

TYP:   Factual

 

  1. Because transactions clear immediately, Fedwire is called a(n) ____ payment system.
a. real-time
b. real-good
c. inside
d. fiat

 

 

ANS:  A                    PTS:   1                    DIF:    Basic              TOP:   The Payments System

TYP:   Factual

 

 

  1. A type of inside money that allows a shopper to prepay some amount and then spend it at will is a ____ card.
a. debit
b. credit
c. commodity
d. stored-value

 

 

ANS:  D                    PTS:   1                    DIF:    Basic              TOP:   The Payments System

TYP:   Factual

 

  1. Suppose your bank lowers its minimum balance requirement to get free checking by $500. So you take $500 out of your checking account and put it into a money market deposit account. What is the overall effect on M1 and M2?
a. M1 falls by $500, M2 rises by $500.
b. M1 is unchanged, M2 is unchanged.
c. M1 falls by $500, M2 is unchanged.
d. M1 is unchanged, M2 rises by $500.

 

 

ANS:  C                    PTS:   1                    DIF:    Moderate        TOP:   Counting Money

TYP:   Conceptual

 

  1. M2 includes
a. large-denomination time deposits.
b. term repurchase agreements.
c. institution only money-market-mutual-funds.
d. M1.

 

 

ANS:  D                    PTS:   1                    DIF:    Basic              TOP:   Counting Money

TYP:   Factual

 

  1. The demand for U.S. currency increased in the early 1990s mainly because
a. banks began charging higher ATM fees.
b. demand increased from Eastern Europe.
c. people began hoarding coins.
d. interest rates declined, reducing the opportunity cost of holding cash.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic              TOP:   Counting Money

TYP:   Factual

 

  1. A weighted average of the components of M1 and M2, with the weights dependent on the interest rates of each component, is known as
a. a Divisia monetary aggregate.
b. a simple-sum monetary aggregate.
c. MZM.
d. fiat money.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic              TOP:   Counting Money

TYP:   Factual

 

 

  1. Aaron takes $100 out of his checking account and puts it in his savings account while Biff withdraws $200 from his money market mutual fund in the form of cash. The total effect is that M1 ____ and M2 ____.
a. is unchanged; falls by $100
b. is unchanged; is unchanged
c. rises by $100; falls by $100
d. rises by $100; is unchanged

 

 

ANS:  D                    PTS:   1                    DIF:    Moderate        TOP:   Counting Money

TYP:   Conceptual

 

  1. Most U.S. currency is held by
a. U.S. citizens.
b. banks.
c. the Federal Reserve.
d. foreigners.

 

 

ANS:  D                    PTS:   1                    DIF:    Basic              TOP:   Counting Money

TYP:   Factual

 

  1. The Fed measures the money supply following a system based mainly on
a. the liquidity and size of the different types of money.
b. the interest rate on different assets.
c. the correlation of different assets with GDP growth.
d. legal requirements.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic              TOP:   Counting Money

TYP:   Factual

 

  1. The liquidity of a monetary asset is
a. the difference between the interest rate on the asset and the interest rate on short-term government securities.
b. how quickly and easily it can be used to purchase goods and services.
c. its time to maturity.
d. also called its principal value.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic              TOP:   Counting Money

TYP:   Factual

 

  1. The speed and ease with which a monetary asset can be used to purchase goods and services is its
a. quality.
b. duration.
c. time to maturity.
d. liquidity.

 

 

ANS:  D                    PTS:   1                    DIF:    Basic              TOP:   Counting Money

TYP:   Factual

 

 

  1. A measure of the total supply of money in the economy is called a(n)
a. monetary aggregate.
b. liquidity total.
c. aggregate money supply.
d. amount of currency in circulation.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic              TOP:   Counting Money

TYP:   Factual

 

  1. M1 consists of
a. coins, paper currency, and travelers checks.
b. coins, paper currency, travelers checks, and amounts in checking accounts.
c. coins, paper currency, travelers checks, and amounts in checking accounts and savings accounts.
d. coins, paper currency, travelers checks, and amounts in checking accounts and retail money-market mutual funds.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic              TOP:   Counting Money

TYP:   Factual

 

  1. M2 consists of
a. Amounts in savings accounts, money-market mutual funds (held by individuals), and small time deposits (under $100,000).
b. Amounts in savings accounts, and money-market mutual funds (held by individuals).
c. M1 plus amounts in savings accounts, money-market mutual funds (held by individuals), small time deposits (under $100,000), and repurchase agreements issued by banks.
d. M1 plus amounts in savings accounts, money-market mutual funds (held by individuals), and small time deposits (under $100,000).

 

 

ANS:  D                    PTS:   1                    DIF:    Basic              TOP:   Counting Money

TYP:   Factual

 

  1. Credit cards are
a. not counted as money because they represent borrowing, not making payments.
b. counted as part of M1.
c. counted as part of MZM.
d. counted as part of M2, but not M1.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic              TOP:   Counting Money

TYP:   Factual

 

  1. Carter’s $150,000 CD matures and he deposits the funds into his checking account so he can buy a house. The total effect is that M1 ____ and M2 ____.
a. is unchanged; falls by $150,000
b. rises by $150,000; is unchanged
c. rises by $150,000; falls by $150,000
d. rises by $150,000; rises by $150,000

 

 

ANS:  D                    PTS:   1                    DIF:    Moderate        TOP:   Counting Money

TYP:   Conceptual

 

  1. Dividing the amount of U.S. currency in circulation by the number of people in the United States shows that, on average, each person holds almost $3,000 in cash. The most important explanation for this remarkably large sum is
a. the underground economy is huge, with many dollar transactions.
b. huge amounts of cash have been lost over time.
c. most is circulating in foreign countries.
d. banks keep huge amounts of cash in their ATMs and bank vaults.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic              TOP:   Counting Money

TYP:   Factual

 

  1. A Divisia monetary aggregate is
a. a method of accounting for differences in the size of different monetary assets, giving greater weight to larger assets.
b. a simple-sum monetary aggregate.
c. a weighted average of the components of M1 and M2, with the weights depending on the interest rates of each component.
d. equal to the Fed’s measures of money, but excludes money with zero maturity.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic              TOP:   Counting Money

TYP:   Factual

 

  1. MZM is defined as
a. M1 + small time deposits.
b. M2 – small time deposits + institutional MMMFs.
c. M2 – small time deposits + institutional MMMFs + government bonds.
d. M1 – small time deposits.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic              TOP:   Counting Money

TYP:   Factual

 

  1. Another name for M2 – small time deposits + institutional MMMFs is
a. Divisia M2.
b. MX.
c. MZ.
d. MZM.

 

 

ANS:  D                    PTS:   1                    DIF:    Basic              TOP:   Counting Money

TYP:   Factual

 

  1. In the United States, coins are produced by ____ and distributed around the country by ____.
a. the U.S. Mint; the Federal Reserve.
b. the Bureau of Engraving and Printing; the Treasury Department.
c. the U.S. Mint; the Treasury Department.
d. the Bureau of Engraving and Printing; the Federal Reserve.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic

TOP:   What Do You Do With Your Change?                            TYP:   Factual

 

 

  1. The main source of the U.S. coin shortage in 1999 was
a. increased demand for coins from foreign countries.
b. a new law allowing coins to be melted for their metal content.
c. the introduction of the state quarter program.
d. the introduction of the Sacagawea golden dollar.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic

TOP:   What Do You Do With Your Change?                            TYP:   Factual

 

  1. The new coin introduced in 2000, which added to the coin shortage that had begun in 1999, was the
a. Sacagawea golden dollar.
b. Virginia state quarter.
c. Buffalo nickel.
d. Dale Earnhardt dollar.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic

TOP:   What Do You Do With Your Change?                            TYP:   Factual

 

PROBLEM

 

  1. Describe each of the four functions of money and provide an example of how money serves each of those roles.

 

ANS:

Money’s role as a medium of exchange occurs when money is used to purchase goods and services; for example, someone writes a check to buy groceries. Money’s role as a unit of account occurs when prices of goods are quoted in terms of money; for example, stores in the United States almost invariably list prices in terms of dollars. Money’s role as a store of value occurs because money can be used to buy goods and services in the future; for example, people keep money in their wallets over time in case they need it to buy something, though such cash earns no interest. Money’s role as a standard of deferred payment occurs when loans are repaid in terms of money; for example, someone taking out a mortgage loan for $100,000 must repay interest plus the $100,000 in principal in dollars in the future.

 

PTS:   1                    TOP:   How We Use Money

 

  1. A bill is introduced into Congress proposing that the U.S. go back to the gold standard, in which only gold coins could circulate as money. What are the major drawbacks of such a proposal?

 

ANS:

The major drawbacks are that the government would need to spend resources digging up gold from the ground to create money (whereas fiat money can be produced at a much lower cost) and the value of money would fluctuate with the worldwide price of gold, which would likely lead to substantial periods of inflation and deflation.

 

PTS:   1                    TOP:   The Payments System

 

 

  1. Describe the difference between inside money and outside money, and explain whether each of the following items represent inside money or outside money:
a. Checking account
b. Coin
c. Travelers check
d. Money-market mutual fund
e. $100 bill

 

 

ANS:

Inside money is created by the private sector, whereas outside money is created by the government or nature.

a. inside
b. outside
c. inside
d. inside
e. outside

 

 

PTS:   1                    TOP:   The Payments System

 

  1. Gary Goldwater has $5,000 in cash. He deposits $1,000 in his checking account, buys $500 of traveler’s checks, puts $1,500 in his money-market mutual fund, and buys a $2,000 CD. How does this transaction affect M1 and M2?

 

ANS:

The $5,000 in cash was in M1, therefore also in M2. Of the $5,000, he keeps $1,500 in accounts that are part of M1 (checking account + travelers checks), so M1 declines by $5,000 – $1,500 = $3,500. Both the MMMF and CD are part of M2, so M2 does not change.

 

PTS:   1                    TOP:   Counting Money

 

  1. Donovan’s $200,000 CD matures. He deposits $20,000 into his checking account, buys a CD for $150,000, and puts $30,000 into his money-market mutual fund. How does this affect M1, M2, and MZM?

 

ANS:

He cashed in a large time deposit, which was not part of M1 or M2. He put $20,000 into an M1 asset (checking account) and $30,000 into an M2 asset (MMMF). M1 rises by $20,000. Because M1 is part of M2, M2 rises by $20,000 + $30,000 = $50,000. Because MZM is money with zero maturity, it equals M2 – small time deposits + institutional MMMFs. In this case, Donovan’s CDs are large time deposits, so they are not part of M2, and Donovan’s MMMF is an individual one (Donovan is a person, not a company), so MZM is affected the same as M2; thus MZM rises by $50,000.

 

PTS:   1                    TOP:   Counting Money

 

 

  1. Donovan’s $200,000 CD matures. He deposits $20,000 into his checking account, buys a CD for $80,000, and puts $100,000 into his money-market mutual fund. How does this affect M1, M2, and MZM?

 

ANS:

He cashed in a large time deposit, which was not part of M1 or M2. He put $20,000 into an M1 asset (checking account), and $180,000 in M2 assets (MMMF and small time deposit). M1 rises by $20,000. Since M1 is part of M2, M2 rises by $20,000 + $180,000 = $200,000. Since MZM is money with zero maturity, it equals M2 – small time deposits + institutional MMMFs. In this case, Donovan’s original CD was a large time deposit, so it was not part of M2 or MZM, and Donovan’s MMMF is an individual one. (Donovan is a person, not a company.) But Donovan’s new CD is a small time deposit, so it is subtracted from M2, so MZM increases by $200,000 – $80,000 = $120,000.

 

PTS:   1                    TOP:   Counting Money

 

  1. Why did M1 grow so rapidly in the early 1990s, whereas M2 did not?

 

ANS:

M1 grew rapidly because of demand for U.S. currency by people in Eastern Europe. M2 grew slowly because the economy was growing slowly. The difference in growth rates is possible because currency is a much larger fraction of M1 than it is of M2.

 

PTS:   1                    TOP:   Counting Money

 

  1. What is seignorage revenue and how does it apply to U.S. coins?

 

ANS:

Under our fiat money system, the government makes a profit, known as seignorage revenue, on every coin that is issued. Coins cost less to manufacture than their face values. Letting coins pile up at home if like making an interest-free loan to the federal government.

 

PTS:   1                    TOP:   What Do You Do with Your Change?

 

  1. Describe the coin shortage of 1999 and 2000 and describe why it occurred. What ended the shortage?

 

ANS:

The coin shortage began when people demanded an unexpectedly high number of state quarters in 1999. The U.S. Mint was unable to keep up with the demand. As a result, it shifted production to state quarters from other coins, people began hoarding the state quarters, and spending occurred with other denominations, which also became short in supply. In 2000, production of the Sacagawea golden dollar added to the problem as it diverted production away from the popular state quarters. As the state quarter program declined in popularity in 2001 and the Mint increased its production capacity, the shortage ended.

 

PTS:   1                    TOP:   What Do You Do With Your Change?

 

Chapter 7—Stocks and Other Assets

 

MULTIPLE CHOICE

 

  1. Shareholders are also called
a. bondholders.
b. equity-holders.
c. stockholders.
d. debt-holders.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic              TOP:   The Stock Market

TYP:   Factual

 

  1. A place where people buy or sell stocks is known as a stock
a. exchange.
b. index.
c. fund.
d. holding.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic              TOP:   The Stock Market

TYP:   Factual

 

  1. The lock-in effect occurs when
a. a specialist is the only person who is allowed to sell options in a stock.
b. a stock price declines, so that short selling is not allowed.
c. stock prices decline more than 5 percent in one day.
d. an investor doesn’t sell a stock so she can avoid paying capital-gains taxes.

 

 

ANS:  D                    PTS:   1                    DIF:    Basic              TOP:   The Stock Market

TYP:   Factual

 

  1. The S&P 500 stock index is an index of
a. the thirty largest industrial companies whose shares trade in U.S. markets.
b. all the companies whose shares trade on the New York Stock Exchange.
c. 500 major companies whose shares trade in U.S. markets.
d. the largest 500 companies in the world.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic              TOP:   The Stock Market

TYP:   Factual

 

  1. A mutual fund is
a. a hedge fund that only wealthy people may invest in.
b. an investment company that pools the funds of many investors and buys a large number of different stocks or other securities.
c. a fund that buys a share of each stock in the entire stock market.
d. an investment company that buys stocks in companies that are not growing strongly.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic              TOP:   The Stock Market

TYP:   Factual

 

 

  1. Implicit capital gains are
a. increases in the value of a firm that occur because a firm has retained earnings that are exempt from corporate profits taxes.
b. capital gains that are owned by foreigners.
c. capital gains that have been realized.
d. capital gains that have been accrued but not yet realized.

 

 

ANS:  D                    PTS:   1                    DIF:    Basic              TOP:   The Stock Market

TYP:   Factual

 

  1. An investor buys stock for $10,000 and earns dividends of $250 during the course of the year. At the end of the year, the stock is worth $9,300. The dividend yield for the year is
a. 2.5 percent.
b. -2.5 percent.
c. -4.5 percent.
d. -7.0 percent.

 

 

ANS:  A                    PTS:   1                    DIF:    Moderate        TOP:   The Stock Market

TYP:   Conceptual

 

  1. A stock index tells you
a. the average price of a collection of stocks.
b. the real value of your stock portfolio.
c. where to buy or sell stocks.
d. what stocks to buy or sell.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic              TOP:   The Stock Market

TYP:   Factual

 

  1. An index fund is
a. a mutual fund that mimics a stock index, such as the S&P 500.
b. an investment company that pools the funds of many investors and buys government bonds.
c. a mutual fund that buys mortgage-backed securities (MBSs).
d. a company that rates companies in terms of their financial strength, such as AAA, AA, A, BAA, etc.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic              TOP:   The Stock Market

TYP:   Factual

 

  1. A shareholder is someone who
a. shares in the profits of a mutual fund.
b. owns stock in a corporation.
c. shares the interest on a Treasury bond with another investor who shares the return of principal.
d. owns depositary receipts in a foreign company.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic              TOP:   The Stock Market

TYP:   Factual

 

 

  1. An index of thirty major U.S. industrial companies is the
a. NASDAQ index.
b. NYSE index.
c. Dow Jones Industrial Average.
d. S&P 500.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic              TOP:   The Stock Market

TYP:   Factual

 

  1. An index of small firms is the
a. Russell 2000 index.
b. NYSE index.
c. Dow Jones Industrial Average.
d. S&P 500.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic              TOP:   The Stock Market

TYP:   Factual

 

  1. The Wilshire 5000 stock index is
a. an index of the 2000 largest industrial companies whose shares trade in U.S. markets.
b. an index of all the companies with U.S. headquarters whose shares trade in the U.S.
c. an index of 500 major companies whose shares trade in U.S. markets.
d. an index of many small firms.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic              TOP:   The Stock Market

TYP:   Factual

 

  1. An investment company that pools the funds of many small investors and buys a large number of different stocks or other securities is called
a. a hedge fund.
b. a mutual fund.
c. an index pool.
d. a savings and loan institution.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic              TOP:   The Stock Market

TYP:   Factual

 

  1. The Russell 2000 stock index is
a. an index of the 2000 largest industrial companies whose shares trade in U.S. markets.
b. an index of all the companies whose shares trade on the New York Stock Exchange.
c. an index of 500 major companies whose shares trade in U.S. markets.
d. an index of many small firms.

 

 

ANS:  D                    PTS:   1                    DIF:    Basic              TOP:   The Stock Market

TYP:   Factual

 

 

  1. A mutual fund that mimics a stock index, such as the S&P 500, is called
a. a hedge fund.
b. an index fund.
c. a participation pool.
d. a mutual mutual.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic              TOP:   The Stock Market

TYP:   Factual

 

  1. An investor buys stock for $10,000 and earns dividends of $250 during the course of the year. At the end of the year, the stock is worth $9,300. The capital-gains yield for the year is
a. 2.5 percent.
b. -2.5 percent.
c. -4.5 percent.
d. -7.0 percent.

 

 

ANS:  D                    PTS:   1                    DIF:    Moderate        TOP:   The Stock Market

TYP:   Conceptual

 

  1. An investor buys stock for $10,000 and earns dividends of $250 during the course of the year. At the end of the year, the stock is worth $9,300. The total return for the year is
a. 2.5 percent.
b. -2.5 percent.
c. -4.5 percent.
d. -7.0 percent.

 

 

ANS:  C                    PTS:   1                    DIF:    Moderate        TOP:   The Stock Market

TYP:   Conceptual

 

  1. An investor earns dividends of $450 during the course of the year. At the end of the year, the stock is worth $10,700. The capital-gains yield on the stock was 8 percent. At the beginning of the year, the stock was worth
a. $9,007.
b. $9,457.
c. $9,907.
d. $10,357.

 

 

ANS:  C                    PTS:   1                    DIF:    Moderate        TOP:   The Stock Market

TYP:   Conceptual

 

  1. An investor earns dividends of $360.27 during the course of the year. At the end of the year, the stock is worth $10,700. The dividend yield on the stock was 4 percent. At the beginning of the year, the stock was worth
a. $9,007.
b. $9,457.
c. $9,907.
d. $10,357.

 

 

ANS:  A                    PTS:   1                    DIF:    Moderate        TOP:   The Stock Market

TYP:   Conceptual

 

  1. An investor earns dividends of $450 during the course of the year. At the end of the year, the stock is worth $10,142. The total return on the stock was 12 percent. At the beginning of the year, the stock was worth
a. $9,007.
b. $9,457.
c. $9,907.
d. $10,357.

 

 

ANS:  B                    PTS:   1                    DIF:    Challenging    TOP:   The Stock Market

TYP:   Conceptual

 

  1. The biggest disadvantage to a stockholder of receiving dividends is
a. receiving cash flow.
b. depositing dividend checks.
c. hiring accountants.
d. paying taxes.

 

 

ANS:  D                    PTS:   1                    DIF:    Basic              TOP:   The Stock Market

TYP:   Factual

 

  1. Realized capital gains are
a. increases in the value of a firm that occur because a firm has retained earnings that are exempt from corporate profits taxes.
b. capital gains that are owned by foreigners.
c. capital gains that an investor receives from selling stock.
d. capital gains that have been accrued but not yet received because the stock has not been sold.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic              TOP:   The Stock Market

TYP:   Factual

 

  1. Capital gains that have been accrued but not yet received because the stock has not been sold are called
a. implicit capital gains.
b. realized capital gains.
c. float.
d. securitized capital gains.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic              TOP:   The Stock Market

TYP:   Factual

 

  1. When an investor doesn’t sell a stock so he can avoid paying capital-gains taxes,
a. the lock-in effect occurs.
b. realized capital gains are less than accrued capital gains.
c. the investor has violated the law.
d. the corporation must pay taxes on behalf of the investor.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic              TOP:   The Stock Market

TYP:   Factual

 

  1. An investor buys stock for $10,000 at the beginning of the year. She earns dividends of $300 during the course of the year. At the end of the year, the stock is worth $10,800, but the investor does not sell it. The tax rate on dividends and capital gains is 15 percent. The inflation rate is 3 percent. The investor’s after-tax real return is
a. 6.35 percent.
b. 6.95 percent.
c. 7.55 percent.
d. 8.15 percent.

 

 

ANS:  C                    PTS:   1                    DIF:    Moderate        TOP:   The Stock Market

TYP:   Conceptual

 

  1. An investor buys stock for $10,000 at the beginning of the year. She earns dividends of $300 during the course of the year. At the end of the year, the stock is worth $10,800, and the investor sells it. The tax rate on dividends and capital gains is 15 percent. The inflation rate is 3 percent. The investor’s after-tax real return is
a. 6.35 percent.
b. 6.95 percent.
c. 7.55 percent.
d. 8.15 percent.

 

 

ANS:  A                    PTS:   1                    DIF:    Moderate        TOP:   The Stock Market

TYP:   Conceptual

 

  1. An investor who bought the average stock in 1929 and sold it in 1959 would have a real capital gain of about
a. -50 percent.
b. 0 percent.
c. 100 percent.
d. 200 percent.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic              TOP:   The Stock Market

TYP:   Factual

 

  1. An investor who bought the average stock in 1966 and sold it in 1990 would have a real capital gain of about
a. -50 percent.
b. 0 percent.
c. 100 percent.
d. 200 percent.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic              TOP:   The Stock Market

TYP:   Factual

 

  1. In recessions, the average real return to the stock market is about ____ percent each year
a. 10 percent.
b. 5 percent.
c. 0 percent.
d. -5 percent.

 

 

ANS:  D                    PTS:   1                    DIF:    Basic              TOP:   The Stock Market

TYP:   Factual

 

  1. In the second half of the 1990s, the average annual real return to the stock market was about
a. 25 percent.
b. 10 percent.
c. 5 percent.
d. 2 percent.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic              TOP:   The Stock Market

TYP:   Factual

 

  1. The idea that stock prices fully reflect all available information is called
a. asymmetric information.
b. an anomaly.
c. adverse selection.
d. the efficient markets hypothesis.

 

 

ANS:  D                    PTS:   1                    DIF:    Basic

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Factual

 

  1. Under the efficient markets hypothesis,
a. stock prices fully reflect all available information.
b. buying and selling stocks can be done at no transactions cost.
c. anomalies exist.
d. the expected real return to investing in the stock market is greater, and an investor’s portfolio is less risky.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Factual

 

  1. If the stock market is efficient and investors are risk neutral, then
a. anomalies exist.
b. stock prices are predictable.
c. the CAPM model works perfectly.
d. stock prices follow a random walk.

 

 

ANS:  D                    PTS:   1                    DIF:    Basic

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Factual

 

  1. When stock prices are unpredictable, they are said to
a. maintain an anomaly.
b. follow a random walk.
c. lack a martingale.
d. be ex-dividend.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Factual

 

  1. An anomaly is
a. a stock that has greater than average risk.
b. an observation that does not fit a model.
c. an odd lot of stock.
d. a stock whose dividend has not yet been paid.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Factual

 

  1. An observation that does not fit a model is called
a. a martingale.
b. an anomaly.
c. a random walk.
d. a beta coefficient.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Factual

 

  1. The discovery that stocks in small firms have higher risk-adjusted returns than stock in large firms is an example of
a. a martingale.
b. the efficient markets hypothesis.
c. an anomaly.
d. a random walk.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Factual

 

  1. The capital asset pricing model (CAPM) models the return to a stock as
a. a random walk.
b. dependent on oil prices, interest rates, and economic growth.
c. dependent on how risky the stock is compared with the market average.
d. dependent on the stock’s risk and the risk to bonds.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Factual

 

  1. A model in which the return to a stock depends only on how risky the stock is compared with the market average is the
a. APT.
b. CAPM.
c. IBM.
d. SPDR.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Factual

 

  1. In the CAPM, the risk to a stock’s return that is attributable to the fluctuations in the overall stock market
a. is called idiosyncratic risk.
b. can be diversified away.
c. is known as systematic risk.
d. is unsystematic risk.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Factual

 

 

  1. In the CAPM, the risk to a stock’s return that is not attributable to the fluctuations in the overall stock market
a. is called idiosyncratic risk.
b. cannot be diversified away.
c. is known as systematic risk.
d. is market risk.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Factual

 

  1. In the CAPM, systematic risk
a. is also known as idiosyncratic risk.
b. can be diversified away.
c. is the risk to a stock’s return that is attributable to the fluctuations in the overall stock market.
d. is the risk to a stock’s return that is not attributable to the fluctuations in the overall stock market.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Factual

 

  1. In the CAPM, unsystematic risk
a. is also known as market risk.
b. cannot be diversified away.
c. is the risk to a stock’s return that is attributable to the fluctuations in the overall stock market.
d. is the risk to a stock’s return that is not attributable to the fluctuations in the overall stock market.

 

 

ANS:  D                    PTS:   1                    DIF:    Basic

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Factual

 

  1. In the CAPM, systematic risk
a. is also known as idiosyncratic risk.
b. can be diversified away.
c. is also known as market risk.
d. is the risk to a stock’s return that is not attributable to the fluctuations in the overall stock market.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Factual

 

  1. In the CAPM, unsystematic risk
a. is also known as market risk.
b. can be diversified away.
c. is the risk to a stock’s return that is attributable to the fluctuations in the overall stock market.
d. is part of the APT.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Factual

 

  1. In the CAPM, if a stock has a large beta coefficient, then
a. the stock’s return is less volatile than the market’s average return.
b. the stock’s return is about as volatile as the market’s average return.
c. the stock’s return is more volatile than the market’s average return.
d. the stock’s risk is greater than its expected return.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Factual

 

  1. In the CAPM, unsystematic risk
a. is also known as market risk.
b. cannot be diversified away.
c. is the risk to a stock’s return that is attributable to the fluctuations in the overall stock market.
d. is the risk to a stock’s return that is not attributable to the fluctuations in the overall stock market.

 

 

ANS:  D                    PTS:   1                    DIF:    Basic

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Factual

 

  1. In the CAPM, if a stock has a beta coefficient near one, then
a. the stock’s return is less volatile than the market’s average return.
b. the stock’s return is about as volatile as the market’s average return.
c. the stock’s return is more volatile than the market’s average return.
d. the stock’s risk is greater than its expected return.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Factual

 

  1. In the CAPM, if a stock has a beta coefficient near zero, then
a. the stock’s return is less volatile than the market’s average return.
b. the stock’s return is about as volatile as the market’s average return.
c. the stock’s return is more volatile than the market’s average return.
d. the stock’s risk is greater than its expected return.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Factual

 

  1. Fundamental value is the ________ value of expected earnings of a company or of all companies in the stock market as a whole.
a. past
b. future
c. expected
d. present

 

 

ANS:  D                    PTS:   1                    DIF:    Basic

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Factual

 

 

  1. If stock prices exceed their fundamental values,
a. the stock market is overvalued.
b. the stock market is undervalued.
c. investors have rational expectations.
d. mutual funds will be worth more than their price.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Factual

 

  1. If stock prices are below their fundamental values,
a. the stock market is overvalued.
b. the stock market is undervalued.
c. investors have rational expectations.
d. mutual funds will be worth more than their price.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Factual

 

  1. Use the capital-asset pricing model to predict the return next year of a stock with a beta of 0.5, if you expect the return to holding stocks to be 8 percent on average, and the interest rate on three-month T-bills will be 3 percent. What is the expected return to this stock?
a. 2.5 percent
b. 3.5 percent
c. 5.5 percent
d. 7.0 percent

 

 

ANS:  C                    PTS:   1                    DIF:    Moderate

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Conceptual

 

  1. Use the capital-asset pricing model to predict the return next year of a stock with a beta of 1.0, if you expect the return to holding stocks to be 8 percent on average, and the interest rate on three-month T-bills will be 3 percent. What is the expected return to this stock?
a. 2.5 percent
b. 5.0 percent
c. 5.5 percent
d. 8.0 percent

 

 

ANS:  D                    PTS:   1                    DIF:    Moderate

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Conceptual

 

  1. A model of stock prices that allows for more sources of risk than just the stock market’s excess return is the ________ theory.
a. excess-return
b. random-walk
c. arbitrage-pricing
d. idiosyncratic-risk

 

 

ANS:  C                    PTS:   1                    DIF:    Basic

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Factual

 

  1. Use the APT model to predict the return next year of a stock with two factors: (1) the change over the last year in the inflation rate, in percentage points; and (2) the spread between ten-year Treasury bonds and three-month Treasury bills, in percentage points. Suppose the average risk-free interest rate is 1 percent. The stock has a beta on the change in the inflation rate of -2 and a beta on the spread of 5, if you expect the inflation rate to rise 1 percentage point and you think the spread will be 3 percentage points. What is the expected return to this stock?
a. 11 percent
b. 12 percent
c. 14 percent
d. 18 percent

 

 

ANS:  C                    PTS:   1                    DIF:    Moderate

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Conceptual

 

  1. Use the APT model to predict the return next year of a stock with two factors: (1) the change over the last year in the inflation rate, in percentage points; and (2) the spread between ten-year Treasury bonds and three-month Treasury bills, in percentage points. Suppose the average risk-free interest rate is 1 percent. The stock has a beta on the change in the inflation rate of -2 and a beta on the spread of 5, if you expect the inflation rate to be unchanged and you think the spread will be 2 percentage points. What is the expected return to this stock?
a. 11 percent
b. 12 percent
c. 14 percent
d. 18 percent

 

 

ANS:  A                    PTS:   1                    DIF:    Moderate

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Conceptual

 

  1. A theory that investors use all the information available to them about companies future prospects in determining their buying and selling decisions is called ________ expectations.
a. rational
b. irrational
c. adaptive
d. realized

 

 

ANS:  A                    PTS:   1                    DIF:    Basic

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Factual

 

  1. If people have rational expectations,
a. the stock market may overvalued.
b. the stock market may be undervalued.
c. stock prices always equal their fundamental value.
d. it is easy for investors to obtain a risk-adjusted return that is better than the market average return.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Factual

 

 

  1. Stock prices always equal their fundamental value
a. in the CAPM model.
b. in the APT model.
c. when people have rational expectations.
d. when people have irrational expectations.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Factual

 

  1. A theory that investors do not have rational expectations is called ________ expectations.
a. rational
b. adaptive
c. irrational
d. realized

 

 

ANS:  C                    PTS:   1                    DIF:    Basic

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Factual

 

  1. If earnings are expected to grow at a constant rate over time of 0.03 and investors’ rate of discount is constant at 0.04, and if earnings last year were $152, then the fundamental value of the stock market would be
a. $152.
b. $190.
c. $1,520.
d. $15,656.

 

 

ANS:  D                    PTS:   1                    DIF:    Moderate

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Conceptual

 

  1. If earnings are expected to grow at a constant rate over time of 0.02 and investors’ rate of discount is constant at 0.05, and if earnings last year were $37, then the fundamental value of the stock market would be
a. $74.
b. $111.
c. $1,258.
d. $11,100.

 

 

ANS:  C                    PTS:   1                    DIF:    Moderate

TOP:   How Can an Investor Profit in the Stock Market?           TYP:   Conceptual

 

  1. The equity-premium puzzle refers to the surprising result that
a. the transactions costs for buying stocks may be as high as 5 percent of the total value of those stocks, greatly reducing the net returns to stocks.
b. the average return on stocks is higher than the average return on bonds by far more than seems justified by the risk.
c. equity prices are much too high when compared with the fundamental value of the stock market, as determined by using the present-value formula.
d. stock prices are inversely related to interest rates.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic

TOP:   Application to Everyday Life: Comparing Stocks with Bonds and Other Investments

TYP:   Factual

 

  1. The odd fact that the average return on stocks is higher than the average return on bonds by far more than seems justified by the risk is known as the
a. equity-premium puzzle.
b. stock-market index result.
c. over-valuation conundrum.
d. on-the-run question.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic

TOP:   Application to Everyday Life: Comparing Stocks with Bonds and Other Investments

TYP:   Factual

 

  1. The difference between the average return on stocks and on other financial investments is known as the
a. beta coefficient.
b. gamma coefficient.
c. return spread.
d. equity premium.

 

 

ANS:  D                    PTS:   1                    DIF:    Basic

TOP:   Application to Everyday Life: Comparing Stocks with Bonds and Other Investments

TYP:   Factual

 

  1. The average annual real return on stocks over the last 51 years is about
a. 1 percent.
b. 2 percent.
c. 7 percent.
d. 10 percent.

 

 

ANS:  C                    PTS:   1                    DIF:    Basic

TOP:   Application to Everyday Life: Comparing Stocks with Bonds and Other Investments

TYP:   Factual

 

  1. The average annual equity premium over the last 51 years is about
a. 1 percent.
b. 6 percent.
c. 8 percent.
d. 10 percent.

 

 

ANS:  B                    PTS:   1                    DIF:    Basic

TOP:   Application to Everyday Life: Comparing Stocks with Bonds and Other Investments

TYP:   Factual

 

  1. The average annual real return on short-term Treasury securities over the last 51 years is about
a. 2 percent.
b. 4 percent.
c. 7 percent.
d. 10 percent.

 

 

ANS:  A                    PTS:   1                    DIF:    Basic

TOP:   Application to Everyday Life: Comparing Stocks with Bonds and Other Investments

TYP:   Factual

 

PROBLEM

 

  1. Suppose an investor purchased 100 shares of JDSU stock at a price of $50 per share on December 31, 2011. On December 31, 2012, JDSU paid dividends of $1.50 per share, and the investor received the dividends, then sold the stock at a price of $65 per share.

 

a. If there were no taxes or inflation, what was the total return?
b. If there were no taxes, but inflation was 3.5 percent, what was the real return?
c. If the tax rate was 15 percent on dividends and capital gains, what was the after-tax real return?

 

 

ANS:

a. Income = dividends + capital gains = $1.50 + ($65 – $50) = $16.50
b. Loss of principal value to inflation = inflation rate ´ principal value
= 0.035 ´ $50 = $1.75
c. Taxes = (0.15 ´ dividends) + (0.15 ´ capital gains)
= (0.15 ´ $1.50) + (0.15 ´ $15)
= $0.225 + $2.25
= $2.475
After-tax real income = $16.50 – $1.75 – $2.475 = $12.275

 

 

PTS:   1                    TOP:   The Stock Market

 

  1. An investor buys stock for $5,000 at the beginning of the year. She earns dividends of $200 during the course of the year. At the end of the year, the stock is worth $5,150. The tax rate on dividends and capital gains is 15 percent. The inflation rate is 2 percent.

 

a. Calculate the investor’s after-tax real return if she does not sell the stock at the end of the year.
b. Calculate the investor’s after-tax real return if she sells the stock at the end of the year.

 

 

 

ANS:

a. Income = dividends + capital gains = $200 + ($5,150 – $5,000) = $350
Loss of principal value to inflation = inflation rate ´ principal value
= 0.02 ´ $5000 = $100
Taxes = (0.15 ´ dividends) + (0.15 ´ capital gains) = 0.15 ´ dividends
= 0.15 ´ $200 = $30
After-tax real income = $350 – $30 – $100 = $220
After-tax real return = $220/$5,000 = 0.044 = 4.4%
b. Taxes = (0.15 ´ dividends) + (0.15 ´ capital gains) = 0.15 ´ income
= 0.15 ´ $350 = $52.50
After-tax real income = $350 – $52.50 – $100 = $197.50
After-tax real return = $197.50/$5,000 = 0.0395 = 3.95%.

 

 

PTS:   1                    TOP:   The Stock Market

 

  1. Answer the questions below.

 

a. Write the equation for the capital-asset pricing model.
b. Describe, in words, what the CAPM is trying to explain, and describe each element of the equation in part a.
Use the capital-asset pricing model to predict the returns next year of the following stocks, if you expect the return to holding stocks to be 12 percent on average, and the interest rate on three-month T-bills will be 2 percent. Show your calculations.
c. A stock with a beta of -0.3
d. A stock with a beta of 0.7
e. A stock with a beta of 1.6

 

 

ANS:

a. Rit = rt + bi (Rtrt) + eit
b. The capital asset pricing model (CAPM) relates a stock’s return (relative to the risk-free rate) to the market return (relative to the risk-free rate):
: The realized return to holding stock i at date t
rt: The interest rate on a risk-free bond
Rtrt: The market’s excess return
Rt: The average return to all stocks in the market
: The part of the return that is unexplained by the market’s return
Returns on different stocks react differently to changes in the market’s excess return, so the coefficient bi differs across stocks.
c. E(Rit + 1) = E(rt + 1) + bi (Rt + 1rt + 1) = 2% + (-0.3 ´ 10%) = -1%
d. E(Rit + 1) = E(rt + 1) + bi (Rt + 1rt + 1) = 2% + (0.7 ´ 10%) = 9%
e. E(Rit + 1) = E(rt + 1) + bi (Rt + 1rt + 1) = 2% + (1.6 ´ 10%) = 18%

 

 

PTS:   1                    TOP:   How Can an Investor Profit in the Stock Market?

 

  1. Suppose the following version of the APT is a good model of risk in the stock market. There are three factors: (1) the stock market’s excess return, in percentage points; (2) the change over the last year in the inflation rate, in percentage points; and (3) the spread between ten-year Treasury bonds and three-month Treasury bills, in percentage points. Suppose the stock market’s average excess return is 7 percentage points and the average risk-free interest rate is 1 percent, the average change in the inflation rate is 0 percentage points, and the average spread between ten-year Treasury bonds and three-month Treasury bills is 2 percentage points. Each of the following stocks has the beta coefficients shown in the table below:

 

b1i b2i b3i
Microsoft 2 -1   1
Goldcrafters 3   2 -1
State Farm 0 -2   0

 

a. What is the expected return to each of the three stocks? Show your calculations.
b. If the market’s excess return were to rise 10 percentage points in a particular year (that is, instead of the average of 7 percent, the market’s excess return will be 17 percent), what would you expect the effect to be on the return to each of the three stocks? Show your calculations.
c. If the inflation rate was expected to rise 2 percentage points in a particular year (that is, instead of the average of 0 percent, the inflation rate will rise by 2 percentage points), what would you expect the effect to be on the return to each of the three stocks?
d. If the interest-rate spread rose 2 percentage points in a particular year (that is, instead of the average of 2 percentage points, the interest-rate spread will be 4 percentage points), what would you expect the effect to be on the return to each of the three stocks?

 

 

ANS:

a. From the APT equation Rit = rt + b1i f 1t + b2i f 2t + … + bki f  kt + eit, we use the expected return
E(Rit) = rt + b1i f 1t + b2i f 2t + … + bki f kt.
Microsoft: 1% + (2 ´ 7%) + (-1 ´ 0) + (1 ´ 2%) = 17%
Goldcrafters: 1% + (3 ´ 7%) + (2 ´ 0) + (-1 ´ 2%) = 20%
State Farm: 1% + (0 ´ 7%) + (-2 ´ 0) + (0 ´ 2%) = 1%

 

 

b. The first factor is 17 percent instead of 7 percent.
Microsoft: 1% + (2 ´ 17%) + (-1 ´ 0) + (1 ´ 2%) = 37%
Goldcrafters: 1% + (3 ´ 17%) + (2 ´ 0) + (-1 ´ 2%) = 50%
State Farm: 1% + (0 ´ 17%) + (-2 ´ 0) + (0 ´ 2%) = 1%
c. The second factor is 2 percent instead of 0 percent.
Microsoft: 1% + (2 ´ 7%) + (-1 ´ 2%) + (1 ´ 2%) = 15%
Goldcrafters: 1% + (3 ´ 7%) + (2 ´ 2%) + (-1 ´ 2%) = 24%
State Farm: 1% + (0 ´ 7%) + (-2 ´ 2%) + (0 ´ 2%) = -3%
d. The third factor is 4 percent instead of 2 percent.
Microsoft: 1% + (2 ´ 7%) + (-1 ´ 0) + (1 ´ 4%) = 19%
Goldcrafters: 1% + (3 ´ 7%) + (2 ´ 0) + (-1 ´ 4%) = 18%
State Farm: 1% + (0 ´ 7%) + (-2 ´ 0) + (0 ´ 4%) = 1%

 

 

PTS:   1                    TOP:   How Can an Investor Profit in the Stock Market?

 

  1. Suppose the following version of the APT is a good model of risk in the stock market. There are three factors: (1) the stock market’s excess return, in percentage points; (2) the unemployment rate minus its natural rate (the level the unemployment rate would be if the economy were at full employment), in percentage points; and (3) the real federal funds rate minus its long-run equilibrium value. Suppose the natural rate of unemployment is 4.5 percent and the long-run equilibrium value of the real federal funds rate is 3.0 percent. Each of the following stocks has the beta coefficients shown in the table below:

 

b1i b2i b3i
Royal Dutch Shell 3 -3   4
Merck 2   6   0
Wachovia 1 -3 -8

 

a. If your forecast for next year is that the risk-free interest rate next year will be 1.0 percent, the overall stock market will return 10.0 percent, the unemployment rate will be 5.0 percent, and the real federal funds rate will be 2.0 percent, what is the expected return (in percent, with two decimals) to each of the three stocks? Show your calculations.
b. If your forecast for next year is that the risk-free interest rate next year will be 2.0 percent, the overall stock market will return 20.0 percent, the unemployment rate will be 4.0 percent, and the real federal funds rate will be 4.0 percent, what is the expected return (in percent, with two decimals) to each of the three stocks? Show your calculations.

 

 

 

ANS:

a. From the APT equation Rit = rt + b1i f 1t + b2i f 2t + … + bk i f kt + eit, we use the expected return
E(R it) = rt + b1i f 1t + b2i f 2t + … + bk i f kt.
Royal Dutch

Shell:

1.0% + [3 ´ (10.0% – 1.0%)] + [-3 ´ (5.0% – 4.5%)] + [4 ´ (2.0% – 3.0%)] = 1.0% + 27.0% – 1.5% – 4% = 22.5%
Merck: 1.0% + [2 ´ (10.0% – 1.0%)] + [6 ´ (5.0% – 4.5%)] + [0 ´ (2.0% – 3.0%)] = 1.0% + 18.0% + 3.0% + 0% = 22.0%
Wachovia: 1.0% + [1 ´ (10.0% – 1.0%)] + [-3 ´ (5.0% – 4.5%)] + [-8 ´ (2.0% – 3.0%)] = 1.0% + 9.0% – 1.5% + 8.0% = 16.5%
b. From the APT equation Rit = rt + b1i f 1t + b2i f 2t + … + bk i  f kt + eit, we use the expected return
E(Rit) = rt + b1i f 1t + b2i f 2t + … + bk i f kt.
Royal Dutch

Shell:

2.0% + [3 ´ (20.0% – 2.0%)] + [-3 ´ (4.0% – 4.5%)] + [4 ´ (4.0% – 3.0%)] = 2.0% + 54.0% + 1.5% + 4.0% = 61.5%
Merck: 2.0% + [2 ´ (20.0% – 2.0%)] + [6 ´ (4.0% – 4.5%)] + [0 ´ (4.0% – 3.0%)] = 2.0% + 36.0% – 3.0% + 0.0% = 35.0%
Wachovia: 2.0% + [1 ´ (20.0% – 2.0%)] + [-3 ´ (4.0% – 4.5%)] + [-8 ´ (4.0% – 3.0%)] = 2.0% + 18.0% + 1.5% – 8.0% = 13.5%

 

 

PTS:   1                    TOP:   How Can an Investor Profit in the Stock Market?

 

  1. Write a formula for the equity premium.

 

ANS:

Let ep = the equity premium, s = the average percentage return on stocks, and d = the average percentage return on debt securities. Then,

 

ep = s – d

 

PTS:   1

TOP:   Application to Everyday Life: Comparing Stocks with Bonds and Other Investments

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