The Economics Of Money Banking And Financial Markets 6th Canadian Edition By Mishkin – Test Bank

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The Economics Of Money Banking And Financial Markets 6th Canadian Edition By Mishkin – Test Bank

Economics of Money, Banking, and Financial Markets 6e (Mishkin)

Chapter 6   The Risk and Term Structure of Interest Rates

 

6.1   Risk Structure of Interest Rates

 

1) The risk structure of interest rates is ________.

  1. A) the structure of how interest rates move over time
  2. B) the relationship among interest rates of different bonds with the same maturity
  3. C) the relationship among the term to maturity of different bonds
  4. D) the relationship among interest rates on bonds with different maturities

Answer:  B

Diff: 1      Type: MC

Skill:  Recall

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

2) The risk that interest payments will not be made, or that the face value of a bond is not repaid when a bond matures is ________.

  1. A) interest rate risk
  2. B) inflation risk
  3. C) moral hazard
  4. D) default risk

Answer:  D

Diff: 1      Type: MC

Skill:  Recall

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

3) Canadian government bonds have no default risk because ________.

  1. A) they are backed by the full faith and credit of the federal government
  2. B) the federal government can increase taxes to pay its obligations
  3. C) they are backed with gold reserves
  4. D) they can be exchanged for silver at any time

Answer:  B

Diff: 1      Type: MC

Skill:  Recall

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

4) Default risk is the risk that ________.

  1. A) a bond issuer is unable to make interest payments
  2. B) a bond issuer is unable to make a profit
  3. C) a bond issuer is unable to pay the face value at maturity
  4. D) A and C only

Answer:  D

Diff: 1      Type: MC

Skill:  Recall

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

5) Bonds with no default risk are called ________.

  1. A) flower bonds
  2. B) no-risk bonds
  3. C) default-free bonds
  4. D) zero-risk bonds

Answer:  C

Diff: 1      Type: MC

Skill:  Recall

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

6) The spread between the interest rates on bonds with default risk and default-free bonds is called the ________.

  1. A) risk premium
  2. B) junk margin
  3. C) bond margin
  4. D) default premium

Answer:  A

Diff: 1      Type: MC

Skill:  Recall

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

7) If the probability of a bond default increases because corporations begin to suffer large losses, then the default risk on corporate bonds will ________ and the expected return on these bonds will ________, everything else held constant.

  1. A) decrease; increase
  2. B) decrease; decrease
  3. C) increase; increase
  4. D) increase; decrease

Answer:  D

Diff: 3      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

8) Which of the following bonds are considered to be default-risk free?

  1. A) Municipal bonds
  2. B) Investment-grade bonds
  3. C) Canadian government bonds
  4. D) Junk bonds

Answer:  C

Diff: 1      Type: MC

Skill:  Recall

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

 

9) A bond with default risk will always have a ________ risk premium and an increase in its default risk will ________ the risk premium.

  1. A) positive; raise
  2. B) positive; lower
  3. C) negative; raise
  4. D) negative; lower

Answer:  A

Diff: 2      Type: MC

Skill:  Recall

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

10) If a corporation begins to suffer large losses, then the default risk on the corporate bond will ________, everything else held constant.

  1. A) increase and the bond’s return will become more uncertain, meaning the expected return on the corporate bond will fall
  2. B) increase and the bond’s return will become less uncertain, meaning the expected return on the corporate bond will fall
  3. C) decrease and the bond’s return will become less uncertain, meaning the expected return on the corporate bond will fall
  4. D) decrease and the bond’s return will become less uncertain, meaning the expected return on the corporate bond will rise

Answer:  A

Diff: 3      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

11) If the possibility of a default increases because corporations begin to suffer losses, then the default risk on corporate bonds will ________, and the bonds’ returns will become ________ uncertain, meaning that the expected return on these bonds will decrease, everything else held constant.

  1. A) increase; less
  2. B) increase; more
  3. C) decrease; less
  4. D) decrease; more

Answer:  B

Diff: 3      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

 

12) Other things being equal, an increase in the default risk of corporate bonds shifts the demand curve for corporate bonds to the ________ and the demand curve for Canada bonds to the ________.

  1. A) right; right
  2. B) right; left
  3. C) left; right
  4. D) left; left

Answer:  C

Diff: 1      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

13) An increase in the riskiness of corporate bonds will ________ the price of corporate bonds and ________ the price of Canada bonds, everything else held constant.

  1. A) increase; increase
  2. B) reduce; reduce
  3. C) reduce; increase
  4. D) increase; reduce

Answer:  C

Diff: 1      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

14) An increase in the riskiness of corporate bonds will ________ the yield on corporate bonds and ________ the yield on government securities, everything else held constant.

  1. A) increase; increase
  2. B) reduce; reduce
  3. C) increase; reduce
  4. D) reduce; increase

Answer:  C

Diff: 1      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

15) An increase in default risk on corporate bonds ________ the demand for these bonds, but ________ the demand for default-free bonds, everything else held constant.

  1. A) increases; lowers
  2. B) lowers; increases
  3. C) does not change; greatly increases
  4. D) moderately lowers; does not change

Answer:  B

Diff: 1      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

 

16) As default risk increases and bond prices adjust, the expected return on corporate bonds ________, and the return becomes ________ uncertain, everything else held constant.

  1. A) increases; less
  2. B) increases; more
  3. C) decreases; less
  4. D) decreases; more

Answer:  B

Diff: 1      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

17) Which of the following statements is true?

  1. A) A decrease in default risk on corporate bonds lowers the demand for these bonds, but increases the demand for default-free bonds.
  2. B) The interest rate on corporate bonds decreases as default risk increases.
  3. C) A corporate bond’s return becomes less uncertain as default risk increases.
  4. D) As their relative riskiness increases, the interest rate on corporate bonds increases relative to the interest rate on default-free bonds.

Answer:  D

Diff: 2      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

18) The spread between interest rates on low quality corporate bonds and Canada bonds ________.

  1. A) widens significantly during recessions
  2. B) narrows significantly during recessions
  3. C) narrows moderately during recessions
  4. D) does not change during recessions

Answer:  A

Diff: 3      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

19) As their relative riskiness ________, the equilibrium price of corporate bonds ________ relative to the expected return on default-free bonds, everything else held constant.

  1. A) increases; increases
  2. B) increases; decreases
  3. C) decreases; decreases
  4. D) decreases; does not change

Answer:  B

Diff: 1      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

 

20) Everything else held constant, if the federal government were to guarantee today that it will pay creditors if a corporation goes bankrupt in the future, the interest rate on corporate bonds will ________ and the interest rate on government securities will ________.

  1. A) increase; increase
  2. B) increase; decrease
  3. C) decrease; increase
  4. D) decrease; decrease

Answer:  C

Diff: 2      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

21) Bonds with relatively high risk of default are called ________.

  1. A) Brady bonds
  2. B) junk bonds
  3. C) zero coupon bonds
  4. D) investment grade bonds

Answer:  B

Diff: 1      Type: MC

Skill:  Recall

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

22) Bonds with relatively low risk of default are called ________ securities and have a rating of Baa (or BBB) and above; bonds with ratings below Baa (or BBB) have a higher default risk and are called ________.

  1. A) investment grade; lower grade
  2. B) investment grade; junk bonds
  3. C) high quality; lower grade
  4. D) high quality; junk bonds

Answer:  B

Diff: 2      Type: MC

Skill:  Recall

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

23) Which of the following bonds would have the highest default risk?

  1. A) Provincial bonds
  2. B) Investment-grade bonds
  3. C) Canada bonds
  4. D) Junk bonds

Answer:  D

Diff: 1      Type: MC

Skill:  Recall

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

 

24) Which of the following long-term bonds has the highest interest rate?

  1. A) Corporate Baa bonds
  2. B) Canada bonds
  3. C) Corporate Aaa bonds
  4. D) Provincial bonds

Answer:  A

Diff: 1      Type: MC

Skill:  Recall

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

25) Which of the following securities has the lowest interest rate?

  1. A) Junk bonds
  2. B) Canada bonds
  3. C) Investment-grade bonds
  4. D) Corporate Baa bonds

Answer:  B

Diff: 1      Type: MC

Skill:  Recall

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

26) During the Great Depression years 1930-1933 there was a very high rate of business failures and defaults, we would expect the risk premium for ________ bonds to be very high.

  1. A) federal government
  2. B) corporate Aaa
  3. C) provincial
  4. D) corporate Baa

Answer:  D

Diff: 2      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

27) Risk premiums on corporate bonds tend to ________ during business cycle expansions and ________ during recessions, everything else held constant.

  1. A) increase; increase
  2. B) increase; decrease
  3. C) decrease; increase
  4. D) decrease; decrease

Answer:  C

Diff: 2      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

 

28) If you have a very low tolerance for risk, which of the following bonds would you be least likely to hold in your portfolio?

  1. A) A federal government bond
  2. B) A provincial bond
  3. C) A corporate bond with a rating of Aaa
  4. D) A corporate bond with a rating of Baa

Answer:  D

Diff: 1      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

29) The collapse of the subprime mortgage market ________.

  1. A) did not affect the corporate bond market
  2. B) increased the perceived riskiness of Treasury securities
  3. C) reduced the Baa-Aaa spread
  4. D) increased the Baa-Aaa spread

Answer:  D

Diff: 3      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

30) The collapse of the subprime mortgage market increased the spread between Baa and default-free Canada bonds. This is due to ________.

  1. A) a reduction in risk
  2. B) a reduction in maturity
  3. C) a flight to quality
  4. D) a flight to liquidity

Answer:  C

Diff: 2      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

31) During a “flight to quality” ________.

  1. A) the spread between Canada bonds and Baa bonds increases
  2. B) the spread between Canada bonds and Baa bonds decreases
  3. C) the spread between Canada bonds and Baa bonds is not affected
  4. D) the change in the spread between Canada bonds and Baa bonds cannot be predicted

Answer:  A

Diff: 2      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

32) Which of the following statements is true?

  1. A) A liquid asset is one that can be quickly and cheaply converted into cash.
  2. B) The demand for a bond declines when it becomes less liquid, decreasing the interest rate spread between it and relatively more liquid bonds.
  3. C) The differences in bond interest rates reflect differences in default risk only.
  4. D) The corporate bond market is the most liquid bond market.

Answer:  A

Diff: 2      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

33) Corporate bonds are not as liquid as Canada bonds because ________.

  1. A) fewer corporate bonds for any one corporation are traded, making them more costly to sell
  2. B) the corporate bond rating must be calculated each time they are traded
  3. C) corporate bonds are not callable
  4. D) corporate bonds cannot be resold

Answer:  A

Diff: 2      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

34) When Canada bonds become more liquid, other things equal, the demand curve for corporate bonds shifts to the ________ and the demand curve for Canada bonds shifts to the ________.

  1. A) right; right
  2. B) right; left
  3. C) left; right
  4. D) left; left

Answer:  C

Diff: 1      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

35) A decrease in the liquidity of corporate bonds, other things being equal, shifts the demand curve for corporate bonds to the ________ and the demand curve for Canada bonds shifts to the ________.

  1. A) right; right
  2. B) right; left
  3. C) left; left
  4. D) left; right

Answer:  D

Diff: 1      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

36) An increase in the liquidity of corporate bonds will ________ the price of corporate bonds and ________ the interest rate on those corporate bonds, everything else held constant.

  1. A) increase; increase
  2. B) reduce; reduce
  3. C) increase; reduce
  4. D) reduce; increase

Answer:  C

Diff: 1      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

37) The risk premium on corporate bonds reflects the fact that corporate bonds have a higher default risk and are ________ Canada bonds.

  1. A) less liquid than
  2. B) less speculative than
  3. C) tax-exempt unlike
  4. D) lower-yielding than

Answer:  A

Diff: 1      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

38) Bonds with relatively low risk of default are called ________.

  1. A) zero coupon bonds
  2. B) junk bonds
  3. C) investment grade bonds
  4. D) fallen angels

Answer:  C

Diff: 1      Type: MC

Skill:  Recall

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

39) Which of the following statements is true?

  1. A) Because coupon payments on tax-exempt bonds are exempt from federal income tax, the expected after-tax return on them will be higher for individuals in higher income tax brackets.
  2. B) An increase in tax rates will decrease the demand for tax-exempt bonds, lowering their interest rates.
  3. C) Interest rates on tax-exempt bonds will be higher than comparable bonds without the tax exemption.
  4. D) Because coupon payments on tax-exempt are exempt from federal income tax, the expected after-tax return on them will be lower for individuals in higher income tax brackets.

Answer:  A

Diff: 3      Type: MC

Skill:  Recall

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

40) Which of the following statements is true?

  1. A) Because coupon payments on tax-exempt bonds are exempt from federal income tax, the expected after-tax return on them will be higher for individuals in higher income tax brackets.
  2. B) An decrease in tax rates will increase the demand for U.S Treasury bonds, lowering their interest rates.
  3. C) Interest rates on tax-exempt bonds will be higher than comparable bonds without the tax exemption.
  4. D) An decrease in tax rates will increase the supply of U.S Treasury bonds, lowering their interest rates.

Answer:  A

Diff: 3      Type: MC

Skill:  Recall

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

41) The interest rate on tax-exempt bonds falls relative to the interest rate on U.S. Treasury securities when ________.

  1. A) there is a major default in the tax-exempt bond market
  2. B) income tax rates are raised
  3. C) tax-exempt bonds become less widely traded
  4. D) corporate bonds become riskier

Answer:  B

Diff: 3      Type: MC

Skill:  Recall

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

42) The interest rate on tax-exempt bonds rises relative to the interest rate on U.S. Treasury securities when ________.

  1. A) income tax rates are raised
  2. B) tax-exempt bonds become more widely traded
  3. C) corporate bonds become riskier
  4. D) income tax rates are lowered

Answer:  D

Diff: 3      Type: MC

Skill:  Recall

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

43) Tax-exempt bond interest rates increase relative to corporate bond interest rates when ________.

  1. A) income taxes are increased
  2. B) corporate bonds become riskier
  3. C) U.S. Treasury securities become more widely traded
  4. D) there is a major default in the tax-exempt bond market

Answer:  D

Diff: 3      Type: MC

Skill:  Recall

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

44) If income tax rates were lowered, then ________.

  1. A) the interest rate on tax-exempt bonds would fall
  2. B) the interest rate on U.S. Treasury bonds would rise
  3. C) the interest rate on tax-exempt bonds would rise
  4. D) the price of Canada bonds would fall

Answer:  C

Diff: 2      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

45) If income tax rates were lowered, then ________.

  1. A) the prices of tax-exempt bonds would fall
  2. B) the interest rate on tax-exempt bonds would fall
  3. C) the interest rate on U.S. Treasury bonds would rise
  4. D) the prices of tax-exempt bonds would rise

Answer:  A

Diff: 2      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

46) If income tax rates were lowered, then ________.

  1. A) the interest rate on tax-exempt bonds would rise
  2. B) the interest rate on U.S. Treasury bonds would rise
  3. C) the interest rate on tax-exempt bonds would fall
  4. D) the interest rate on tax-exempt bonds would stay the same

Answer:  A

Diff: 2      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

47) Three factors explain the risk structure of interest rates: ________.

  1. A) liquidity, default risk, and the income tax treatment of a security
  2. B) maturity, default risk, and the income tax treatment of a security
  3. C) maturity, liquidity, and the income tax treatment of a security
  4. D) maturity, default risk, and the liquidity of a security

Answer:  A

Diff: 1      Type: MC

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

 

48) The spread between the interest rates on Baa corporate bonds and Canada bonds was very large during the Great Depression years 1930-1933. Explain this difference using the bond supply and demand analysis.

Answer:  During the Great Depression many businesses failed. The default risk for the corporate bond increased compared to the default-free Treasury bond. The demand for corporate bonds decreased while the demand for Treasury bonds increased resulting in a larger risk premium.

Diff: 3      Type: ES

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

49) If the U.S. government where to raise the income tax rates, would this have any impact on a state’s cost of borrowing funds? Explain.

Answer:  Yes, if the U.S. government raises income tax rates, demand for municipal bonds which are federal income tax exempt would increase. This would lower the interest rate on the municipal bonds thus lowering the cost to the state of borrowing funds.

Diff: 3      Type: ES

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

50) Explain the factors that determine the risk structure of interest rates. Explain how a change of each factor changes interest rates.

Answer:  Default risk is the risk that interest or principal payments will not be made.

Liquidity is the ability to convert an asset to cash quickly and cheaply.

Tax-exempt bonds are more attractive to investors in high tax brackets.

An increase in default risk, a reduction in liquidity, and a tax cut increase interest rates on the affected assets. A reduction of default risk, an increase in liquidity, and a tax increase reduce interest rates on the affected assets.

Diff: 3      Type: ES

Skill:  Recall

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

51) Demonstrate graphically and explain how a reduction in default risk affects the demand or supply of corporate and Canada bonds.

Answer:  A reduction of default risk increases the demand for corporate bonds and reduces the demand for Canada bonds. Corporate bond prices rise and interest rates fall. Canada bond prices fall and interest rates rise.

Diff: 2      Type: ES

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

 

52) Explain using a diagram how the “flight to quality” after the Subprime collapse lead to a rising spread between lower-quality (BBB-rated) and highest-quality (AAA-rated) bonds.

Answer:  Students must use supply and demand analysis on a graph to show that the subprime collapse led to doubts about the financial health of lower-quality (BBB-rated) companies, reducing demand for their bonds shifting their demand curve to the left and thus decreasing their price and increasing their interest. The shift of the demand from BBB-rated to AAA-rated bonds known as “flight to quality” increased the demand of AAA-bonds shifting the demand curve to the right and thus increasing their price and decreasing their interest rates, resulting in a wider interest rate spread between BBB and AAA-rated bonds.

Diff: 3      Type: ES

Skill:  Applied

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

53) Based on default risk, which bonds are called: a. “investment grade”, b. “junk bonds” or “speculative-grade”, and c. “fallen angels”?

Answer:

  1. Investment grade are the bonds that have a relatively low risk of default and are rated BBB or above.
  2. Junk bonds or speculative-grade are the bonds that have relatively higher risk of default and are rated BB or lower.
  3. Fallen angels are the bonds that their rating from investment grade has fallen to junk.

Diff: 1      Type: ES

Skill:  Recall

Objective:  6.1 Identify and explain the three factors affecting the risk structure of interest rates

 

 

6.2   Term Structure of Interest Rates

 

1) The term structure of interest rates is ________.

  1. A) the relationship among interest rates of different bonds with the same maturity
  2. B) the structure of how interest rates move over time
  3. C) the relationship among the term to maturity of different bonds
  4. D) the relationship among interest rates on bonds with different maturities

Answer:  D

Diff: 1      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

2) A plot of the interest rates on default-free Canada bonds with different terms to maturity is called ________.

  1. A) a risk-structure curve
  2. B) a default-free curve
  3. C) a yield curve
  4. D) an interest-rate curve

Answer:  C

Diff: 1      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

3) Differences in ________ explain why interest rates on Treasury securities are not all the same.

  1. A) risk
  2. B) liquidity
  3. C) time to maturity
  4. D) tax characteristics

Answer:  C

Diff: 1      Type: MC

Skill:  Applied

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

4) Typically, yield curves are ________.

  1. A) gently upward sloping
  2. B) mound shaped
  3. C) flat
  4. D) bowl shaped

Answer:  A

Diff: 1      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

5) When yield curves are steeply upward sloping, ________.

  1. A) long-term interest rates are above short-term interest rates
  2. B) short-term interest rates are above long-term interest rates
  3. C) short-term interest rates are about the same as long-term interest rates
  4. D) medium-term interest rates are above both short-term and long-term interest rates

Answer:  A

Diff: 2      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

6) When yield curves are flat, ________.

  1. A) long-term interest rates are above short-term interest rates
  2. B) short-term interest rates are above long-term interest rates
  3. C) short-term interest rates are about the same as long-term interest rates
  4. D) medium-term interest rates are above both short-term and long-term interest rates

Answer:  C

Diff: 2      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

7) When yield curves are downward sloping, ________.

  1. A) long-term interest rates are above short-term interest rates
  2. B) short-term interest rates are above long-term interest rates
  3. C) short-term interest rates are about the same as long-term interest rates
  4. D) medium-term interest rates are above both short-term and long-term interest rates

Answer:  B

Diff: 2      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

8) An inverted yield curve ________.

  1. A) slopes up
  2. B) is flat
  3. C) slopes down
  4. D) has a U shape

Answer:  C

Diff: 1      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

9) Economists’ attempts to explain the term structure of interest rates ________.

  1. A) illustrate how economists modify theories to improve them when they are inconsistent with the empirical evidence
  2. B) illustrate how economists continue to accept theories that fail to explain observed behavior of interest rate movements
  3. C) prove that the real world is a special case that tends to get short shrift in theoretical models
  4. D) have proved entirely unsatisfactory to date

Answer:  A

Diff: 3      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

10) According to the expectations theory of the term structure, the interest rate on a long-term bond will equal the ________ of the short-term interest rates that people expect to occur over the life of the long-term bond.

  1. A) average
  2. B) sum
  3. C) difference
  4. D) multiple

Answer:  A

Diff: 1      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

11) The ________ of the term structure of interest rates states that the interest rate on a long-term bond will equal the average of short-term interest rates that individuals expect to occur over the life of the long-term bond, and investors have no preference for short-term bonds relative to long-term bonds.

  1. A) segmented markets theory
  2. B) expectations theory
  3. C) liquidity premium theory
  4. D) separable markets theory

Answer:  B

Diff: 2      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

 

12) If bonds with different maturities are perfect substitutes, then the ________ on these bonds must be equal.

  1. A) expected return
  2. B) surprise return
  3. C) surplus return
  4. D) excess return

Answer:  A

Diff: 1      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

13) If the expected path of one-year interest rates over the next five years is 4 percent, 5 percent, 7 percent, 8 percent, and 6 percent, then the expectations theory predicts that today’s interest rate on the five-year bond is ________.

  1. A) 4 percent
  2. B) 5 percent
  3. C) 6 percent
  4. D) 7 percent

Answer:  C

Diff: 2      Type: MC

Skill:  Applied

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

14) If the expected path of 1-year interest rates over the next four years is 5 percent, 4 percent, 2 percent, and 1 percent, then the expectations theory predicts that today’s interest rate on the four-year bond is ________.

  1. A) 1 percent
  2. B) 2 percent
  3. C) 3 percent
  4. D) 4 percent

Answer:  C

Diff: 2      Type: MC

Skill:  Applied

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

 

15) If the expected path of 1-year interest rates over the next five years is 1 percent, 2 percent, 3 percent, 4 percent, and 5 percent, the expectations theory predicts that the bond with the highest interest rate today is the one with a maturity of ________.

  1. A) two years
  2. B) three years
  3. C) four years
  4. D) five years

Answer:  D

Diff: 2      Type: MC

Skill:  Applied

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

16) If the expected path of 1-year interest rates over the next five years is 2 percent, 4 percent, 1 percent, 4 percent, and 3 percent, the expectations theory predicts that the bond with the lowest interest rate today is the one with a maturity of ________.

  1. A) one year
  2. B) two years
  3. C) three years
  4. D) four years

Answer:  A

Diff: 2      Type: MC

Skill:  Applied

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

17) Over the next three years, the expected path of 1-year interest rates is 4, 1, and 1 percent. The expectations theory of the term structure predicts that the current interest rate on 3-year bond is ________.

  1. A) 1 percent
  2. B) 2 percent
  3. C) 3 percent
  4. D) 4 percent

Answer:  B

Diff: 2      Type: MC

Skill:  Applied

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

 

18) According to the expectations theory of the term structure ________.

  1. A) the interest rate on long-term bonds will exceed the average of short-term interest rates that people expect to occur over the life of the long-term bonds, because of their preference for short-term securities
  2. B) interest rates on bonds of different maturities move together over time
  3. C) buyers of bonds prefer short-term to long-term bonds
  4. D) buyers require an additional incentive to hold long-term bonds

Answer:  B

Diff: 3      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

19) According to the expectations theory of the term structure ________.

  1. A) when the yield curve is steeply upward sloping, short-term interest rates are expected to remain relatively stable in the future
  2. B) when the yield curve is downward sloping, short-term interest rates are expected to remain relatively stable in the future
  3. C) investors have strong preferences for short-term relative to long-term bonds, explaining why yield curves typically slope upward
  4. D) yield curves should be equally likely to slope downward as slope upward

Answer:  D

Diff: 3      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

20) According to the segmented markets theory of the term structure ________.

  1. A) bonds of one maturity are close substitutes for bonds of other maturities, therefore, interest rates on bonds of different maturities move together over time
  2. B) the interest rate for each maturity bond is determined by supply and demand for that maturity bond
  3. C) investors’ strong preferences for short-term relative to long-term bonds explains why yield curves typically slope downward
  4. D) because of the positive term premium, the yield curve will not be observed to be downward-sloping

Answer:  B

Diff: 2      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

21) According to the segmented markets theory of the term structure ________.

  1. A) the interest rate on long-term bonds will equal an average of short-term interest rates that people expect to occur over the life of the long-term bonds
  2. B) buyers of bonds do not prefer bonds of one maturity over another
  3. C) interest rates on bonds of different maturities do not move together over time
  4. D) buyers require an additional incentive to hold long-term bonds

Answer:  C

Diff: 3      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

22) According to this theory of the term structure, bonds of different maturities are not substitutes for one another.

  1. A) Segmented markets theory
  2. B) Expectations theory
  3. C) Liquidity premium theory
  4. D) Separable markets theory

Answer:  A

Diff: 1      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

23) In actual practice, short-term interest rates and long-term interest rates usually move together; this is the major shortcoming of the ________.

  1. A) segmented markets theory
  2. B) expectations theory
  3. C) liquidity premium theory
  4. D) separable markets theory

Answer:  A

Diff: 2      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

24) A key assumption in the segmented markets theory is that bonds of different maturities ________.

  1. A) are not substitutes at all
  2. B) are perfect substitutes
  3. C) are substitutes only if the investor is given a premium incentive
  4. D) are substitutes but not perfect substitutes

Answer:  A

Diff: 2      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

25) The segmented markets theory can explain ________.

  1. A) why yield curves usually tend to slope upward
  2. B) why interest rates on bonds of different maturities tend to move together
  3. C) why yield curves tend to slope upward when short-term interest rates are low and to be inverted when short-term interest rates are high
  4. D) why yield curves have been used to forecast business cycles

Answer:  A

Diff: 2      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

26) The expectations theory and the segmented markets theory do not explain the facts very well, but they provide the groundwork for the most widely accepted theory of the term structure of interest rates, ________.

  1. A) the Keynesian theory
  2. B) separable markets theory
  3. C) liquidity premium theory
  4. D) the asset market approach

Answer:  C

Diff: 2      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

27) According to the liquidity premium theory of the term structure ________.

  1. A) because buyers of bonds may prefer bonds of one maturity over another, interest rates on bonds of different maturities do not move together over time
  2. B) the interest rate on long-term bonds will equal an average of short-term interest rates that people expect to occur over the life of the long-term bonds plus a term premium
  3. C) because of the positive term premium, the yield curve will not be observed to be downward sloping
  4. D) the interest rate for each maturity bond is determined by supply and demand for that maturity bond

Answer:  B

Diff: 3      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

 

28) The ________ of the term structure states the following: the interest rate on a long-term bond will equal an average of short-term interest rates expected to occur over the life of the long-term bond plus a term premium that responds to supply and demand conditions for that bond.

  1. A) segmented markets theory
  2. B) expectations theory
  3. C) liquidity premium theory
  4. D) separable markets theory

Answer:  C

Diff: 2      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

29) The additional incentive that the purchaser of a Treasury security requires to buy a long-term security rather than a short-term security is called the ________.

  1. A) risk premium
  2. B) term premium
  3. C) tax premium
  4. D) market premium

Answer:  B

Diff: 1      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

30) The preferred habitat theory of the term structure is closely related to the ________.

  1. A) expectations theory of the term structure
  2. B) segmented markets theory of the term structure
  3. C) liquidity premium theory of the term structure
  4. D) the inverted yield curve theory of the term structure

Answer:  C

Diff: 2      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

 

31) If 1-year interest rates for the next three years are expected to be 4, 2, and 3 percent, and the 3-year term premium is 1 percent, than the 3-year bond rate will be ________.

  1. A) 1 percent
  2. B) 2 percent
  3. C) 3 percent
  4. D) 4 percent

Answer:  D

Diff: 2      Type: MC

Skill:  Applied

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

32) If 1-year interest rates for the next five years are expected to be 4, 2, 5, 4, and 5 percent, and the 5-year term premium is 1 percent, than the 5-year bond rate will be ________.

  1. A) 2 percent
  2. B) 3 percent
  3. C) 4 percent
  4. D) 5 percent

Answer:  D

Diff: 2      Type: MC

Skill:  Applied

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

33) According to the liquidity premium theory of the term structure ________.

  1. A) bonds of different maturities are not substitutes
  2. B) if yield curves are downward sloping, then short-term interest rates are expected to fall by so much that, even when the positive term premium is added, long-term rates fall below short-term rates
  3. C) yield curves should never slope downward
  4. D) interest rates on bonds of different maturities do not move together over time

Answer:  B

Diff: 3      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

 

34) According to the liquidity premium theory of the term structure, a steeply upward sloping yield curve indicates that short-term interest rates are expected to ________.

  1. A) rise in the future
  2. B) remain unchanged in the future
  3. C) decline moderately in the future
  4. D) decline sharply in the future

Answer:  A

Diff: 2      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

35) According to the liquidity premium theory of the term structure, a slightly upward sloping yield curve indicates that short-term interest rates are expected to ________.

  1. A) rise in the future
  2. B) remain unchanged in the future
  3. C) decline moderately in the future
  4. D) decline sharply in the future

Answer:  B

Diff: 2      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

36) According to the liquidity premium theory of the term structure, a flat yield curve indicates that short-term interest rates are expected to ________.

  1. A) rise in the future
  2. B) remain unchanged in the future
  3. C) decline moderately in the future
  4. D) decline sharply in the future

Answer:  C

Diff: 2      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

37) According to the liquidity premium theory of the term structure, a downward sloping yield curve indicates that short-term interest rates are expected to ________.

  1. A) rise in the future
  2. B) remain unchanged in the future
  3. C) decline moderately in the future
  4. D) decline sharply in the future

Answer:  D

Diff: 2      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

38) According to the liquidity premium theory, a yield curve that is flat means that ________.

  1. A) bond purchasers expect interest rates to rise in the future
  2. B) bond purchasers expect interest rates to stay the same
  3. C) bond purchasers expect interest rates to fall in the future
  4. D) the yield curve has nothing to do with expectations of bond purchasers

Answer:  C

Diff: 2      Type: MC

Skill:  Applied

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

39) If the yield curve is flat for short maturities and then slopes downward for longer maturities, the liquidity premium theory (assuming a mild preference for shorter-term bonds) indicates that the market is predicting ________.

  1. A) a rise in short-term interest rates in the near future and a decline further out in the future
  2. B) constant short-term interest rates in the near future and a decline further out in the future
  3. C) a decline in short-term interest rates in the near future and a rise further out in the future
  4. D) a decline in short-term interest rates in the near future and an even steeper decline further out in the future

Answer:  D

Diff: 3      Type: MC

Skill:  Applied

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

40) If the yield curve slope is flat for short maturities and then slopes steeply upward for longer maturities, the liquidity premium theory (assuming a mild preference for shorter-term bonds) indicates that the market is predicting ________.

  1. A) a rise in short-term interest rates in the near future and a decline further out in the future
  2. B) constant short-term interest rates in the near future and further out in the future
  3. C) a decline in short-term interest rates in the near future and a rise further out in the future
  4. D) constant short-term interest rates in the near future and a decline further out in the future

Answer:  C

Diff: 3      Type: MC

Skill:  Applied

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

41) If the yield curve has a mild upward slope, the liquidity premium theory (assuming a mild preference for shorter-term bonds) indicates that the market is predicting ________.

  1. A) a rise in short-term interest rates in the near future and a decline further out in the future
  2. B) constant short-term interest rates in the near future and further out in the future
  3. C) a decline in short-term interest rates in the near future and a rise further out in the future
  4. D) a decline in short-term interest rates in the near future and an even steeper decline further out in the future

Answer:  B

Diff: 3      Type: MC

Skill:  Applied

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

42) A particularly attractive feature of the ________ is that it tells you what the market is predicting about future short-term interest rates by just looking at the slope of the yield curve.

  1. A) segmented markets theory
  2. B) expectations theory
  3. C) liquidity premium theory
  4. D) separable markets theory

Answer:  C

Diff: 2      Type: MC

Skill:  Recall

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

 

43) The steeply upward sloping yield curve in the figure above indicates that ________.

  1. A) short-term interest rates are expected to rise in the future
  2. B) short-term interest rates are expected to fall moderately in the future
  3. C) short-term interest rates are expected to fall sharply in the future
  4. D) short-term interest rates are expected to remain unchanged in the future

Answer:  A

Diff: 2      Type: MC

Skill:  Applied

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

44) The steeply upward sloping yield curve in the figure above indicates that ________ interest rates are expected to ________ in the future.

  1. A) short-term; rise
  2. B) short-term; fall moderately
  3. C) short-term; remain unchanged
  4. D) long-term; fall moderately

Answer:  A

Diff: 2      Type: MC

Skill:  Applied

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

45) The U-shaped yield curve in the figure above indicates that short-term interest rates are expected to ________.

  1. A) rise in the near-term and fall later on
  2. B) fall sharply in the near-term and rise later on
  3. C) fall moderately in the near-term and rise later on
  4. D) remain unchanged in the near-term and rise later on

Answer:  B

Diff: 3      Type: MC

Skill:  Applied

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

46) The U-shaped yield curve in the figure above indicates that the inflation rate is expected to ________.

  1. A) remain constant in the near-term and fall later on
  2. B) fall sharply in the near-term and rise later on
  3. C) rise moderately in the near-term and fall later on
  4. D) remain constant in the near-term and rise later on

Answer:  B

Diff: 3      Type: MC

Skill:  Applied

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

47) The mound-shaped yield curve in the figure above indicates that short-term interest rates are expected to ________.

  1. A) rise in the near-term and fall later on
  2. B) fall moderately in the near-term and rise later on
  3. C) fall sharply in the near-term and rise later on
  4. D) remain unchanged in the near-term and fall later on

Answer:  A

Diff: 3      Type: MC

Skill:  Applied

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

48) The mound-shaped yield curve in the figure above indicates that the inflation rate is expected to ________.

  1. A) remain constant in the near-term and fall later on
  2. B) fall moderately in the near-term and rise later on
  3. C) rise moderately in the near-term and fall later on
  4. D) remain unchanged in the near-term and rise later on

Answer:  C

Diff: 3      Type: MC

Skill:  Applied

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

 

49) An inverted yield curve predicts that short-term interest rates ________.

  1. A) are expected to rise in the future
  2. B) will rise and then fall in the future
  3. C) will remain unchanged in the future
  4. D) will fall in the future

Answer:  D

Diff: 1      Type: MC

Skill:  Applied

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

50) When short-term interest rates are expected to fall sharply in the future, the yield curve will ________.

  1. A) slope up
  2. B) be flat
  3. C) be inverted
  4. D) be an inverted U shape

Answer:  C

Diff: 1      Type: MC

Skill:  Applied

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

51) If investors expect interest rates to fall significantly in the future, the yield curve will be inverted. This means that the yield curve has a ________ slope.

  1. A) steep upward
  2. B) slight upward
  3. C) flat
  4. D) downward

Answer:  D

Diff: 1      Type: MC

Skill:  Applied

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

52) When the yield curve is flat or downward-sloping, it suggests that the economy is more likely to enter ________.

  1. A) a recession
  2. B) an expansion
  3. C) a boom time
  4. D) a period of increasing output

Answer:  A

Diff: 1      Type: MC

Skill:  Applied

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

53) A ________ yield curve predicts a future increase in inflation.

  1. A) steeply upward sloping
  2. B) slight upward sloping
  3. C) flat
  4. D) downward sloping

Answer:  A

Diff: 1      Type: MC

Skill:  Applied

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

54) If a higher inflation is expected, what would you expect to happen to the shape of the yield curve? Why?

Answer:  The yield curve should have a steep upward slope. Nominal interest rates will increase if the inflation rate increases, therefore, bond purchasers will require a higher term premium to hold the riskier long-term bond.

Diff: 1      Type: ES

Skill:  Applied

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

55) What is the shape of the yield curve when short rates are expected to fall in the medium term, and then increase? Demonstrate this graphically.

Answer:  The curve will have a U shape reflecting the expected fall and then increase.

 

Diff: 3      Type: ES

Skill:  Applied

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

56) What is the shape of the yield curve when short-term rates are expected to rise sharply in the mid-term and moderately in the long-term?

Answer:

 

The students must draw a yield curve like the one above and explain that the sharp increase in short-term rates in the mid-term is shown as the part of the yield curve with a steep slope and the moderate increase in the long-term is the later part of the yield curve.

Diff: 2      Type: ES

Skill:  Applied

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

57) When interest rates on 1-2-3-4-5 year bonds are 2.0, 2.1, 2.3, 2.4, and 2.5 percent respectively, what information do we derive on future economic growth and real output?

Answer:  According to these interest rates, the yield curve is gently upward sloping, indicating that short-term interest rates are not expected to change significantly in the next 5 years. We do know that periods of economic growth and output booms are associated with rising interest rates, and recessions are associated with low interest rates. As the yield curve is found to be an accurate predictor of the business cycle, we would expect no significant changes in real output over the next 5 years.

Diff: 3      Type: ES

Skill:  Applied

Objective:  6.2 List and explain the three theories of why interest rates vary across different maturities

 

Economics of Money, Banking, and Financial Markets 6e (Mishkin)

Chapter 7   The Stock Market, the Theory of Rational Expectations, and the Efficient Market Hypothesis

 

7.1   Computing the Price of Common Stock

 

1) A stockholder’s ownership of a company’s stock gives her the right to ________.

  1. A) vote and be the primary claimant of all cash flows
  2. B) vote and be the residual claimant of all cash flows
  3. C) manage and assume responsibility for all liabilities
  4. D) vote and assume responsibility for all liabilities

Answer:  B

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.1 Calculate the price of common stock

 

2) Stockholders’ rights include ________.

  1. A) the right to vote
  2. B) the right to manage
  3. C) primary claims on all cash flows
  4. D) ownership of bonds

Answer:  A

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.1 Calculate the price of common stock

 

3) Stockholders’ rights include ________.

  1. A) the right to manage
  2. B) the right to change personnel policy
  3. C) the right to veto management’s decisions
  4. D) residual claim on all of a company’s assets

Answer:  D

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.1 Calculate the price of common stock

 

4) Stockholders are residual claimants, meaning that they ________.

  1. A) have the first priority claim on all of a company’s assets
  2. B) are liable for all of a company’s debts
  3. C) will never share in a company’s profits
  4. D) receive the remaining cash flow after all other claims are paid

Answer:  D

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.1 Calculate the price of common stock

 

5) Common stock is the principal way that corporations raise ________.

  1. A) short-term debt
  2. B) foreign exchange
  3. C) long-term debt
  4. D) equity capital

Answer:  D

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.1 Calculate the price of common stock

 

6) Dividends are paid from ________.

  1. A) liabilities
  2. B) debts
  3. C) net earnings
  4. D) interest

Answer:  C

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.1 Calculate the price of common stock

 

7) Periodic payments of net earnings to shareholders are known as ________.

  1. A) capital gains
  2. B) dividends
  3. C) profits
  4. D) interest

Answer:  B

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.1 Calculate the price of common stock

 

8) The value of any investment is found by computing the ________.

  1. A) present value of all future sales
  2. B) present value of all future liabilities
  3. C) future value of all future expenses
  4. D) present value of all future cash flows

Answer:  D

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.1 Calculate the price of common stock

 

 

9) The value of any investment is found by computing the ________.

  1. A) present value of all coupon payments
  2. B) present value of all future liabilities
  3. C) future value of all dividends
  4. D) value in today’s dollars of all future cash flows

Answer:  D

Diff: 2      Type: MC

Skill:  Recall

Objective:  7.1 Calculate the price of common stock

10) In the one-period valuation model, the value of a share of stock today depends upon ________.

  1. A) the present value of both dividends and the expected sales price
  2. B) only the present value of the future dividends
  3. C) the actual value of the dividends and expected sales price received in one year
  4. D) the future value of dividends and the actual sales price

Answer:  A

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.1 Calculate the price of common stock

 

11) In the one-period valuation model, the current stock price increases if ________.

  1. A) the expected sales price increases
  2. B) the expected sales price falls
  3. C) the required return increases
  4. D) dividends are cut

Answer:  A

Diff: 2      Type: MC

Skill:  Recall

Objective:  7.1 Calculate the price of common stock

 

12) In the one-period valuation model, an increase in the required return on investments in equity ________.

  1. A) increases the expected sales price of a stock
  2. B) increases the current price of a stock
  3. C) reduces the expected sales price of a stock
  4. D) reduces the current price of a stock

Answer:  D

Diff: 2      Type: MC

Skill:  Recall

Objective:  7.1 Calculate the price of common stock

 

 

13) In the one-period valuation model with no dividend payments the current price of the stock is given by ________.

  1. A) P0 =
  2. B) P0 = +
  3. C) P0 = × 100
  4. D) P0 = × 365

Answer:  A

Diff: 2      Type: MC

Skill:  Recall

Objective:  7.1 Calculate the price of common stock

14) Using the one-period valuation model, assuming a year-end dividend of $0.11, an expected sales price of $110, and a required rate of return of 10 percent, the current price of the stock would be ________.

  1. A) $110.11
  2. B) $121.12
  3. C) $100.10
  4. D) $100.11

Answer:  C

Diff: 3      Type: MC

Skill:  Applied

Objective:  7.1 Calculate the price of common stock

 

15) Using the one-period valuation model, assuming a year-end dividend of $1.00, an expected sales price of $100, and a required rate of return of 5 percent, the current price of the stock would be ________.

  1. A) $110.00
  2. B) $101.00
  3. C) $100.00
  4. D) $96.19

Answer:  D

Diff: 3      Type: MC

Skill:  Applied

Objective:  7.1 Calculate the price of common stock

 

 

16) The analysts predict that the price of corporation’s XYZ stock one year from now will be $20. XYZ announced that is not going to pay dividends next year. You decide that you would be satisfied to earn a 10 percent on the investment on this stock, thus, this stock is worth ________ for you now.

  1. A) $18.00
  2. B) $18.18
  3. C) $21.10
  4. D) $21.00

Answer:  B

Diff: 3      Type: MC

Skill:  Applied

Objective:  7.1 Calculate the price of common stock

 

17) The analysts predict that the price of corporation’s XYZ stock one year from now will be $120. XYZ announced that is not going to pay dividends next year. You decide that you would be satisfied to earn a 12 percent on the investment on this stock, thus, this stock is worth ________ for you now.

  1. A) $100.20
  2. B) $108.80
  3. C) $107.14
  4. D) $132.00

Answer:  C

Diff: 3      Type: MC

Skill:  Applied

Objective:  7.1 Calculate the price of common stock

18) General Electric announces that it is going to cut its dividends by $0.02 per share in the future. This, everything else remaining the same, will cause its current stock price to ________.

  1. A) increase
  2. B) decrease
  3. C) remain the same
  4. D) fluctuate

Answer:  B

Diff: 2      Type: MC

Skill:  Applied

Objective:  7.1 Calculate the price of common stock

 

19) In the generalized dividend model, if the expected sales price is in the distant future ________.

  1. A) it does not affect the current stock price
  2. B) it is more important than dividends in determining the current stock price
  3. C) it is equally important with dividends in determining the current stock price
  4. D) it is less important than dividends but still affects the current stock price

Answer:  A

Diff: 2      Type: MC

Skill:  Recall

Objective:  7.1 Calculate the price of common stock

 

20) In the generalized dividend model, a future sales price far in the future does not affect the current stock price because ________.

  1. A) the present value cannot be computed
  2. B) the present value is almost zero
  3. C) the sales price does not affect the current price
  4. D) the stock may never be sold

Answer:  B

Diff: 2      Type: MC

Skill:  Recall

Objective:  7.1 Calculate the price of common stock

 

21) In the generalized dividend model, the current stock price is the sum of ________.

  1. A) the actual value of the future dividend stream
  2. B) the present value of the future dividend stream
  3. C) the future value of the future dividend stream
  4. D) the present value of the future sales price

Answer:  B

Diff: 2      Type: MC

Skill:  Recall

Objective:  7.1 Calculate the price of common stock

 

22) Using the Gordon growth model, a stock’s price will increase if ________.

  1. A) the dividend growth rate increases
  2. B) the growth rate of dividends falls
  3. C) the required rate of return on equity rises
  4. D) the expected sales price rises

Answer:  A

Diff: 2      Type: MC

Skill:  Recall

Objective:  7.1 Calculate the price of common stock

23) In the Gordon growth model, a decrease in the required rate of return on equity ________.

  1. A) increases the current stock price
  2. B) increases the future stock price
  3. C) reduces the future stock price
  4. D) reduces the current stock price

Answer:  A

Diff: 2      Type: MC

Skill:  Applied

Objective:  7.1 Calculate the price of common stock

 

 

24) Using the Gordon growth formula, if D1 is $2.00, ke is 12 percent or 0.12, and g is 10 percent or 0.10, then the current stock price is ________.

  1. A) $20
  2. B) $50
  3. C) $100
  4. D) $150

Answer:  C

Diff: 2      Type: MC

Skill:  Applied

Objective:  7.1 Calculate the price of common stock

 

25) Using the Gordon growth formula, if D1 is $1.00, ke is 10 percent or 0.10, and g is 5 percent or 0.05, then the current stock price is ________.

  1. A) $10
  2. B) $20
  3. C) $30
  4. D) $40

Answer:  B

Diff: 2      Type: MC

Skill:  Applied

Objective:  7.1 Calculate the price of common stock

 

26) One of the assumptions of the Gordon Growth Model is that dividends will continue growing at ________ rate.

  1. A) an increasing
  2. B) a fast
  3. C) a constant
  4. D) an escalating

Answer:  C

Diff: 2      Type: MC

Skill:  Recall

Objective:  7.1 Calculate the price of common stock

27) In the Gordon Growth Model, the growth rate is assumed to be ________ the required return on equity.

  1. A) greater than
  2. B) equal to
  3. C) less than
  4. D) proportional to

Answer:  C

Diff: 2      Type: MC

Skill:  Recall

Objective:  7.1 Calculate the price of common stock

 

 

28) What is the current price of a telecommunication company’s stock if the current dividend is $0.80, the expected constant growth rate in dividends is 5% and the required return is 10%?

  1. A) $16.00
  2. B) $16.80
  3. C) $8.00
  4. D) $8.40

Answer:  B

Diff: 2      Type: MC

Skill:  Applied

Objective:  7.1 Calculate the price of common stock

 

29) What is the current price of a utility company’s stock if the current dividend is $0.20, the expected constant growth rate in dividends is 2% and the required return is 8%?

  1. A) $2.00
  2. B) $2.20
  3. C) $3.20
  4. D) $3.40

Answer:  D

Diff: 2      Type: MC

Skill:  Applied

Objective:  7.1 Calculate the price of common stock

 

30) A company’s dividend in one year is $1.00 and this is expected to increase at a constant rate of 2%. If the required return on this stock increases from 10% to 12$ by how much will the stock price change?

  1. A) Increase by 20%
  2. B) Decrease by 20%
  3. C) Increase by 16.67%
  4. D) Decrease by 16.67%

Answer:  B

Diff: 2      Type: MC

Skill:  Applied

Objective:  7.1 Calculate the price of common stock

 

31) You believe that a corporation’s dividends will grow 5 percent on average into the foreseeable future. If the company’s last dividend payment was $5 what should be the current price of the stock assuming a 12 percent required return?

Answer:  Use the Gordon Growth Model.

$5(1 + .05)/(.12 – .05) = $75

Diff: 3      Type: ES

Skill:  Applied

Objective:  7.1 Calculate the price of common stock

 

32) What rights does ownership interest give stockholders?

Answer:  Stockholders have the right to vote on issues brought before the stockholders, be the residual claimant, that is, receive a portion of any net earnings of the corporation, and the right to sell the stock.

Diff: 1      Type: ES

Skill:  Recall

Objective:  7.1 Calculate the price of common stock

 

33) Explain the Gordon growth model of stock pricing. Explain how changes in each component affect the current stock price. On what assumptions is the model based?

Answer:  The basic model is

 

0 =

where

P0  =   the current stock price

D1 =   the next period’s dividend

ke   =   the required rate of return

g    =   the dividend growth rate

Increases in the dividend or the dividend growth rate increase the stock price, while an increase in the required rate of return lowers the stock price.

The two assumptions that are the basis of the model are that dividends are assumed to grow at a constant rate, and that the dividend growth rate is less than the required rate of return.

Diff: 1      Type: ES

Skill:  Recall

Objective:  7.1 Calculate the price of common stock

 

34) Explain why the Gordon growth model does not need to incorporate the end period price.

Answer:  Students must explain that since the end period is presumed to be an infinite number of years in the future, the present value of that amount is effectively zero.

Diff: 2      Type: ES

Skill:  Recall

Objective:  7.1 Calculate the price of common stock

 

 

7.2   How the Market Sets Stock Prices

 

1) In asset markets, an asset’s price is ________.

  1. A) set equal to the highest price a seller will accept
  2. B) set equal to the highest price a buyer is willing to pay
  3. C) set equal to the lowest price a seller is willing to accept
  4. D) set by the buyer willing to pay the highest price

Answer:  D

Diff: 1      Type: MC

Skill:  Applied

Objective:  7.2 Recognize the impact of new information on stock prices

2) Information plays an important role in asset pricing because it allows the buyer to more accurately judge ________.

  1. A) liquidity
  2. B) risk
  3. C) capital
  4. D) policy

Answer:  B

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.2 Recognize the impact of new information on stock prices

 

3) New information that might lead to a decrease in an asset’s price might be ________.

  1. A) an expected decrease in the level of future dividends
  2. B) a decrease in the required rate of return
  3. C) an expected increase in the dividend growth rate
  4. D) an expected increase in the future sales price

Answer:  A

Diff: 2      Type: MC

Skill:  Applied

Objective:  7.2 Recognize the impact of new information on stock prices

 

4) A change in perceived risk of a stock changes ________.

  1. A) the expected dividend growth rate
  2. B) the expected sales price
  3. C) the required rate of return
  4. D) the current dividend

Answer:  C

Diff: 2      Type: MC

Skill:  Recall

Objective:  7.2 Recognize the impact of new information on stock prices

 

 

5) A stock’s price will fall if there is ________.

  1. A) a decrease in perceived risk
  2. B) an increase in the required rate of return
  3. C) an increase in the future sales price
  4. D) current dividends are high

Answer:  B

Diff: 2      Type: MC

Skill:  Applied

Objective:  7.2 Recognize the impact of new information on stock prices

 

6) A monetary expansion ________ stock prices due to a decrease in the ________ and an increase in the ________, everything else held constant.

  1. A) reduces; future sales price; expected rate of return
  2. B) reduces; current dividend; expected rate of return
  3. C) increases; required rate of return; future sales price
  4. D) increases; required rate of return; dividend growth rate

Answer:  D

Diff: 3      Type: MC

Skill:  Applied

Objective:  7.2 Recognize the impact of new information on stock prices

7) The subprime financial crisis lead to a decline in stock prices because ________.

  1. A) of a lowered expected dividend growth rate
  2. B) of a lowered required return on investment in equity
  3. C) higher expected future stock prices
  4. D) higher current dividends

Answer:  A

Diff: 2      Type: MC

Skill:  Applied

Objective:  7.2 Recognize the impact of new information on stock prices

 

8) Increased uncertainty resulting from the subprime crisis ________ the required return on investment in equity.

  1. A) raised
  2. B) lowered
  3. C) had no impact on
  4. D) decreased

Answer:  A

Diff: 3      Type: MC

Skill:  Applied

Objective:  7.2 Recognize the impact of new information on stock prices

 

 

9) In October 2008, the stock market crashed, falling by ________ from its peak value a year earlier.

  1. A) over 40 percent
  2. B) over 30 percent
  3. C) over 50 percent
  4. D) over 25 percent

Answer:  A

Diff: 1      Type: MC

Skill:  Applied

Objective:  7.2 Recognize the impact of new information on stock prices

 

10) An increase in uncertainty for the economy will ________.

  1. A) increase stock prices due to a higher required return
  2. B) not affect stock prices
  3. C) increase stock prices due to a lower required return
  4. D) depress stock prices due to a higher required return

Answer:  D

Diff: 2      Type: MC

Skill:  Applied

Objective:  7.2 Recognize the impact of new information on stock prices

 

11) Dishonest corporate accounting procedures would cause stock prices to ________.

  1. A) remain unchanged
  2. B) decrease due to lower expected dividend growth and lower required return
  3. C) decrease due to lower expected dividend growth and higher required return
  4. D) increase due to higher expected dividend growth and lower required return

Answer:  C

Diff: 2      Type: MC

Skill:  Applied

Objective:  7.2 Recognize the impact of new information on stock prices

 

7.3   The Theory of Rational Expectations

 

1) Economists have focused more attention on the formation of expectations in recent years. This increase in interest can probably best be explained by the recognition that ________.

  1. A) expectations influence the behavior of participants in the economy and thus have a major impact on economic activity
  2. B) expectations influence only a few individuals, have little impact on the overall economy, but can have important effects on a few markets
  3. C) expectations influence many individuals, have little impact on the overall economy, but can have distributional effects
  4. D) models that ignore expectations have little predictive power, even in the short run

Answer:  A

Diff: 2      Type: MC

Skill:  Recall

Objective:  7.3 Compare and contrast adaptive expectations and rational expectations

 

2) The view that expectations change relatively slowly over time in response to new information is known in economics as ________.

  1. A) rational expectations
  2. B) irrational expectations
  3. C) slow-response expectations
  4. D) adaptive expectations

Answer:  D

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.3 Compare and contrast adaptive expectations and rational expectations

 

3) If expectations of the future inflation rate are formed solely on the basis of a weighted average of past inflation rates, then economics would say that expectation formation is ________.

  1. A) irrational
  2. B) rational
  3. C) adaptive
  4. D) reasonable

Answer:  C

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.3 Compare and contrast adaptive expectations and rational expectations

 

 

4) If expectations are formed adaptively, then people ________.

  1. A) use more information than just past data on a single variable to form their expectations of that variable
  2. B) often change their expectations quickly when faced with new information
  3. C) use only the information from past data on a single variable to form their expectations of that variable
  4. D) never change their expectations once they have been made

Answer:  C

Diff: 2      Type: MC

Skill:  Recall

Objective:  7.3 Compare and contrast adaptive expectations and rational expectations

5) If during the past decade the average rate of monetary growth has been 5 percent and the average inflation rate has been 5 percent, everything else held constant, when the Bank of Canada announces that the new rate of monetary growth will be 10 percent, the adaptive expectation forecast of the inflation rate is ________.

  1. A) 5 percent
  2. B) between 5 and 10 percent
  3. C) 10 percent
  4. D) more than 10 percent

Answer:  A

Diff: 3      Type: MC

Skill:  Applied

Objective:  7.3 Compare and contrast adaptive expectations and rational expectations

 

6) The major criticism of the view that expectations are formed adaptively is that ________.

  1. A) this view ignores the fact that people use more information than just past data to form their expectations
  2. B) it is easier to model adaptive expectations than it is to model rational expectations
  3. C) adaptive expectations models have no predictive power
  4. D) people are irrational and therefore never learn from past mistakes

Answer:  A

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.3 Compare and contrast adaptive expectations and rational expectations

 

7) In rational expectations theory, the term “optimal forecast” is essentially synonymous with ________.

  1. A) correct forecast
  2. B) the correct guess
  3. C) the actual outcome
  4. D) the best guess

Answer:  D

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.3 Compare and contrast adaptive expectations and rational expectations

 

8) If a forecast is made using all available information, then economists say that the expectation formation is ________.

  1. A) rational
  2. B) irrational
  3. C) adaptive
  4. D) reasonable

Answer:  A

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.3 Compare and contrast adaptive expectations and rational expectations

9) If a forecast made using all available information is not perfectly accurate, then it is ________.

  1. A) still a rational expectation
  2. B) not a rational expectation
  3. C) an adaptive expectation
  4. D) a second-best expectation

Answer:  A

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.3 Compare and contrast adaptive expectations and rational expectations

 

10) If additional information is not used when forming an optimal forecast because it is not available at that time, then expectations are ________.

  1. A) obviously formed irrationally
  2. B) still considered to be formed rationally
  3. C) formed adaptively
  4. D) formed equivalently

Answer:  B

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.3 Compare and contrast adaptive expectations and rational expectations

 

11) An expectation may fail to be rational if ________.

  1. A) relevant information was not available at the time the forecast is made
  2. B) relevant information is available but ignored at the time the forecast is made
  3. C) information changes after the forecast is made
  4. D) information was available to insiders only

Answer:  B

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.3 Compare and contrast adaptive expectations and rational expectations

 

 

12) According to rational expectations theory, forecast errors of expectations ________.

  1. A) are more likely to be negative than positive
  2. B) are more likely to be positive than negative
  3. C) tend to be persistently high or low
  4. D) are unpredictable

Answer:  D

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.3 Compare and contrast adaptive expectations and rational expectations

 

13) Rational expectations forecast errors will on average be ________ and therefore ________ be predicted ahead of time.

  1. A) positive; can
  2. B) positive; cannot
  3. C) negative; can
  4. D) zero; cannot

Answer:  D

Diff: 2      Type: MC

Skill:  Recall

Objective:  7.3 Compare and contrast adaptive expectations and rational expectations

14) People have a strong incentive to form rational expectations because ________.

  1. A) they are guaranteed of success in the stock market
  2. B) it is costly not to do so
  3. C) it is costly to do so
  4. D) everyone wants to be rational

Answer:  B

Diff: 2      Type: MC

Skill:  Applied

Objective:  7.3 Compare and contrast adaptive expectations and rational expectations

 

15) If market participants notice that a variable behaves differently now than in the past, then, according to rational expectations theory, we can expect market participants to ________.

  1. A) change the way they form expectations about future values of the variable
  2. B) begin to make systematic mistakes
  3. C) no longer pay close attention to movements in this variable
  4. D) give up trying to forecast this variable

Answer:  A

Diff: 2      Type: MC

Skill:  Recall

Objective:  7.3 Compare and contrast adaptive expectations and rational expectations

 

 

16) According to rational expectations, ________.

  1. A) expectations of inflation are viewed as being an average of past inflation rates
  2. B) expectations of inflation are viewed as being an average of expected future inflation rates
  3. C) expectations formation indicates that changes in expectations occur slowly over time as past data change
  4. D) expectations will not differ from optimal forecasts that use all available information

Answer:  D

Diff: 2      Type: MC

Skill:  Recall

Objective:  7.3 Compare and contrast adaptive expectations and rational expectations

 

17) Suppose Barbara looks out in the morning and sees a clear sky so decides that a picnic for lunch is a good idea. Last night the weather forecast included a 100 percent chance of rain by midday but Barbara did not watch the local news program. Is Barbara’s prediction of good weather at lunch time rational? Why or why not?

Answer:  No, this prediction does not use rational expectations. Although Barbara based her guess on the information that was available to her at the time, additional information was readily available that could have been used to improve her prediction.

Diff: 3      Type: ES

Skill:  Applied

Objective:  7.3 Compare and contrast adaptive expectations and rational expectations

18) Assume that your economics professor announces to your class that after thirty years of giving exams only on scheduled dates, this semester she will give only surprise quizzes. What is the rational expectation response to this new policy? Why does your self-interest require that you change your behavior? What would the consequences be for students who changed their expectations about exams adaptively?

Answer:  Instead of being able to study for exams on known dates, students must now be prepared for an exam at any possible time. Students must study regularly, before each class. Self-interest dictates that students change their behavior, as their grade depends upon it. Students who change their behavior adaptively don’t adjust until they have experienced one or more surprise quizzes, which in all likelihood hurt their grades.

Diff: 3      Type: ES

Skill:  Applied

Objective:  7.3 Compare and contrast adaptive expectations and rational expectations

 

 

7.4   The Efficient Market Hypothesis: Rational Expectations in Financial Markets

 

1) The theory of rational expectations, when applied to financial markets, is known as ________.

  1. A) monetarism
  2. B) the efficient markets hypothesis
  3. C) the theory of strict liability
  4. D) the theory of impossibility

Answer:  B

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.4 Explain why arbitrage opportunities imply that the efficient market hypothesis holds

 

2) Monetary economists and financial economists developed ________ theories on expectations formations.

  1. A) parallel
  2. B) opposing
  3. C) dissimilar
  4. D) unusual

Answer:  A

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.4 Explain why arbitrage opportunities imply that the efficient market hypothesis holds

 

3) If the optimal forecast of the return on a security exceeds the equilibrium return, then ________.

  1. A) the market is inefficient
  2. B) no unexploited profit opportunities exist
  3. C) the market is in equilibrium
  4. D) the market is myopic

Answer:  A

Diff: 2      Type: MC

Skill:  Recall

Objective:  7.4 Explain why arbitrage opportunities imply that the efficient market hypothesis holds

 

4) Another way to state the efficient markets condition is: in an efficient market, ________.

  1. A) unexploited profit opportunities will be quickly eliminated
  2. B) unexploited profit opportunities will never exist
  3. C) unexploited profit opportunities never existed
  4. D) every financial market participant must be well informed about securities

Answer:  A

Diff: 2      Type: MC

Skill:  Recall

Objective:  7.4 Explain why arbitrage opportunities imply that the efficient market hypothesis holds

 

5) ________ occurs when market participants observe returns on a security that are larger than what is justified by the characteristics of that security and take action to quickly eliminate the unexploited profit opportunity.

  1. A) Arbitrage
  2. B) Mediation
  3. C) Asset capitalization
  4. D) Market intercession

Answer:  A

Diff: 2      Type: MC

Skill:  Recall

Objective:  7.4 Explain why arbitrage opportunities imply that the efficient market hypothesis holds

 

6) The efficient markets hypothesis suggests that if an unexploited profit opportunity arises in an efficient market, ________.

  1. A) it will tend to go unnoticed for some time
  2. B) it will be quickly eliminated
  3. C) financial analysts are your best source of this information
  4. D) prices will reflect the unexploited profit opportunity

Answer:  B

Diff: 2      Type: MC

Skill:  Recall

Objective:  7.4 Explain why arbitrage opportunities imply that the efficient market hypothesis holds

 

7) Financial markets quickly eliminate unexploited profit opportunities through changes in ________.

  1. A) dividend payments
  2. B) tax laws
  3. C) asset prices
  4. D) monetary policy

Answer:  C

Diff: 1      Type: MC

Skill:  Applied

Objective:  7.4 Explain why arbitrage opportunities imply that the efficient market hypothesis holds

8) The elimination of unexploited profit opportunities requires that ________ market participants be well informed.

  1. A) all
  2. B) a few
  3. C) zero
  4. D) many

Answer:  B

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.4 Explain why arbitrage opportunities imply that the efficient market hypothesis holds

 

9) If in an efficient market all prices are correct and reflect market fundamentals, which of the following is a false statement?

  1. A) A stock that has done poorly in the past is more likely to do well in the future
  2. B) One investment is as good as any other because the securities’ prices are correct
  3. C) A security’s price reflects all available information about the intrinsic value of the security
  4. D) Security prices can be used by managers to assess their cost of capital accurately

Answer:  A

Diff: 3      Type: MC

Skill:  Applied

Objective:  7.4 Explain why arbitrage opportunities imply that the efficient market hypothesis holds

 

10) According to the efficient markets hypothesis, purchasing the reports of financial analysts ________.

  1. A) is likely to increase one’s returns by an average of 10 percent
  2. B) is likely to increase one’s returns by about 3 to 5 percent
  3. C) is not likely to be an effective strategy for increasing financial returns
  4. D) is likely to increase one’s returns by an average of about 2 to 3 percent

Answer:  C

Diff: 3      Type: MC

Skill:  Recall

Objective:  7.4 Explain why arbitrage opportunities imply that the efficient market hypothesis holds

 

 

11) You have observed that the forecasts of an investment advisor consistently outperform the other reported forecasts. The efficient markets hypothesis says that future forecasts by this advisor ________.

  1. A) may or may not be better than the other forecasts Past performance is no guarantee of the future
  2. B) will always be the best of the group
  3. C) will definitely be worse in the future What goes up must come down
  4. D) will be worse in the near future, but improve over time

Answer:  A

Diff: 3      Type: MC

Skill:  Recall

Objective:  7.4 Explain why arbitrage opportunities imply that the efficient market hypothesis holds

12) Sometimes one observes that the price of a company’s stock falls after the announcement of favorable earnings. This phenomenon is ________.

  1. A) clearly inconsistent with the efficient markets hypothesis
  2. B) consistent with the efficient markets hypothesis if the earnings were not as high as anticipated
  3. C) consistent with the efficient markets hypothesis if the earnings were not as low as anticipated
  4. D) consistent with the efficient markets hypothesis if the favorable earnings were expected

Answer:  B

Diff: 3      Type: MC

Skill:  Recall

Objective:  7.4 Explain why arbitrage opportunities imply that the efficient market hypothesis holds

 

13) According to the efficient markets hypothesis, the current price of a financial security ________.

  1. A) is the discounted net present value of future interest payments
  2. B) is determined by the highest successful bidder
  3. C) fully reflects all available relevant information
  4. D) is a result of none of the above

Answer:  C

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.4 Explain why arbitrage opportunities imply that the efficient market hypothesis holds

 

 

14) You read a story in the newspaper announcing the proposed merger of Dell Computer and Gateway. The merger is expected to greatly increase Gateway’s profitability. If you decide to invest in Gateway stock, you can expect to earn ________.

  1. A) above average returns since you will share in the higher profits
  2. B) above average returns since your stock price will definitely appreciate as higher profits are earned
  3. C) below average returns since computer makers have low profit rates
  4. D) a normal return since stock prices adjust to reflect expected changes in profitability almost immediately

Answer:  D

Diff: 3      Type: MC

Skill:  Applied

Objective:  7.4 Explain why arbitrage opportunities imply that the efficient market hypothesis holds

 

15) The efficient markets hypothesis indicates that investors ________.

  1. A) can use the advice of technical analysts to outperform the market
  2. B) do better on average if they adopt a “buy and hold” strategy
  3. C) let too many unexploited profit opportunities go by if they adopt a “buy and hold” strategy
  4. D) do better if they purchase loaded mutual funds

Answer:  B

Diff: 2      Type: MC

Skill:  Recall

Objective:  7.4 Explain why arbitrage opportunities imply that the efficient market hypothesis holds

16) The efficient markets hypothesis suggests that investors ________.

  1. A) should purchase no-load mutual funds which have low management fees
  2. B) can use the advice of technical analysts to outperform the market
  3. C) let too many unexploited profit opportunities go by if they adopt a “buy and hold” strategy
  4. D) act on all “hot tips” they hear

Answer:  A

Diff: 2      Type: MC

Skill:  Recall

Objective:  7.4 Explain why arbitrage opportunities imply that the efficient market hypothesis holds

 

17) The advantage of a “buy-and-hold strategy” is that ________.

  1. A) net profits will tend to be higher because there will be fewer brokerage commissions
  2. B) losses will eventually be eliminated
  3. C) the longer a stock is held, the higher will be its price
  4. D) profits are guaranteed

Answer:  A

Diff: 2      Type: MC

Skill:  Recall

Objective:  7.4 Explain why arbitrage opportunities imply that the efficient market hypothesis holds

 

18) For small investors, the best way to pursue a “buy and hold” strategy is to ________.

  1. A) buy and sell individual stocks frequently
  2. B) buy no-load mutual funds with high management fees
  3. C) buy no-load mutual funds with low management fees
  4. D) buy load mutual funds

Answer:  C

Diff: 2      Type: MC

Skill:  Recall

Objective:  7.4 Explain why arbitrage opportunities imply that the efficient market hypothesis holds

 

19) If a corporation announces that it expects quarterly earnings to increase by 25 percent and it actually sees an increase of 22 percent, what should happen to the price of the corporation’s stock if the efficient markets hypothesis holds, everything else held constant?

Answer:  The stock’s price should fall. The price had adjusted based on the statement of expected earnings. When the actual number turned out to be lower than expected, the stock price changes to reflect the additional information.

Diff: 3      Type: ES

Skill:  Applied

Objective:  7.4 Explain why arbitrage opportunities imply that the efficient market hypothesis holds

 

20) Your best friend calls and gives you the latest stock market “hot tip” that he heard at the health club. Should you act on this information? Why or why not?

Answer:  No, if this information is readily available, it will already be reflected in the stock price.

Diff: 1      Type: ES

Skill:  Applied

Objective:  7.4 Explain why arbitrage opportunities imply that the efficient market hypothesis holds

21) If you your stock broker tells you that you should buy stock in Ford as it has devised a new hybrid engine system that will reduce consumption of fuel by 90 percent, would you follow this advice and buy Ford’s stock?

Answer:  The efficient market hypothesis indicates that you should be skeptical of any such information. If the market is efficient then it has already priced Ford’s stock so that its expected return will equal the equilibrium return. The tip is not valuable. But if the tip is based on new information and gives you an edge on the rest of the market, only them it can be valuable to you and you should buy the stock. In any other case Ford stock price will have already reflected the news.

Diff: 2      Type: ES

Skill:  Applied

Objective:  7.4 Explain why arbitrage opportunities imply that the efficient market hypothesis holds

 

 

22) What is a recommended strategy for a small investor and how it is associated with the efficient market hypothesis?

Answer:  Students should be able to explain that a recommended strategy is to purchase no-load mutual funds. EMH suggests that only “extremely clever investors” may be able top outperform a buy-and-hold strategy.

Diff: 3      Type: ES

Skill:  Recall

Objective:  7.4 Explain why arbitrage opportunities imply that the efficient market hypothesis holds

 

7.5   Why the Efficient Market Hypothesis Does Not Imply That Financial Markets are Efficient

 

1) A situation when an asset price differs from its fundamental value is ________.

  1. A) a random walk
  2. B) an inflation
  3. C) a deflation
  4. D) a bubble

Answer:  D

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.5 Identify and explain the implications of the efficient market hypothesis for financial markets

 

2) In a rational bubble, investors can have ________ expectations that a bubble is occurring but continue to hold the asset anyway.

  1. A) irrational
  2. B) adaptive
  3. C) rational
  4. D) myopic

Answer:  C

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.5 Identify and explain the implications of the efficient market hypothesis for financial markets

 

7.6   Behavioral Finance

 

1) ________ is the field of study that applies concepts from social sciences such as psychology and sociology to help understand the behavior of securities prices.

  1. A) Behavioral finance
  2. B) Strategical finance
  3. C) Methodical finance
  4. D) Procedural finance

Answer:  A

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.6 Summarize the reasons why behavioural finance suggests that the efficient market hypothesis may not hold

 

2) If a market participant believes that a stock price is irrationally high, they may try to borrow stock from brokers to sell in the market and then make a profit by buying the stock back again after the stock falls in price. This practice is called ________.

  1. A) short selling
  2. B) double dealing
  3. C) undermining
  4. D) long marketing

Answer:  A

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.6 Summarize the reasons why behavioural finance suggests that the efficient market hypothesis may not hold

 

3) ________ means people are more unhappy when they suffer losses than they are happy when they achieve gains.

  1. A) Loss fundamentals
  2. B) Loss aversion
  3. C) Loss leader
  4. D) Loss cycle

Answer:  B

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.6 Summarize the reasons why behavioural finance suggests that the efficient market hypothesis may not hold

 

 

4) Loss aversion can explain why very little ________ actually takes place in the securities market.

  1. A) short selling
  2. B) bargaining
  3. C) bartering
  4. D) negotiating

Answer:  A

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.6 Summarize the reasons why behavioural finance suggests that the efficient market hypothesis may not hold

5) Psychologists have found that people tend to be ________ in their own judgments.

  1. A) underconfident
  2. B) overconfident
  3. C) indecisive
  4. D) insecure

Answer:  B

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.6 Summarize the reasons why behavioural finance suggests that the efficient market hypothesis may not hold

 

6) ________ and ________ may provide an explanation for stock market bubbles.

  1. A) Overconfidence; social contagion
  2. B) Underconfidence; social contagion
  3. C) Overconfidence; social isolationism
  4. D) Underconfidence; social isolationism

Answer:  A

Diff: 1      Type: MC

Skill:  Recall

Objective:  7.6 Summarize the reasons why behavioural finance suggests that the efficient market hypothesis may not hold

 

 

7.7   Web Appendix: Evidence on the Efficient Market Hypothesis

 

1) If a mutual fund outperforms the market in one period, evidence suggests that this fund is ________.

  1. A) highly likely to consistently outperform the market in subsequent periods due to its superior investment strategy
  2. B) likely to under-perform the market in subsequent periods to average its overall returns
  3. C) not likely to consistently outperform the market in subsequent periods
  4. D) not likely to outperform the market in any subsequent period

Answer:  C

Diff: 2      Type: MC

Skill:  Recall

Objective:  Appendix: Evidence on the Efficient Market Hypothesis

 

2) Studies of mutual fund performance indicate that mutual funds that outperformed the market in one time period usually ________.

  1. A) beat the market in the next time period
  2. B) beat the market in the next two subsequent time periods
  3. C) beat the market in the next three subsequent time periods
  4. D) do not beat the market in the next time period

Answer:  D

Diff: 1      Type: MC

Skill:  Recall

Objective:  Appendix: Evidence on the Efficient Market Hypothesis

3) The number and availability of discount brokers has grown rapidly since the mid-1970s. The efficient markets hypothesis predicts that people who use discount brokers ________.

  1. A) will likely earn lower returns than those who use full-service brokers
  2. B) will likely earn about the same as those who use full-service brokers, but will net more after brokerage commissions
  3. C) are going against evidence suggesting that full-service brokers can help outperform the market
  4. D) are likely to outperform the market by a wide margin

Answer:  B

Diff: 2      Type: MC

Skill:  Recall

Objective:  Appendix: Evidence on the Efficient Market Hypothesis

 

 

4) When Happy Feet Corporation announces that their fourth quarter earnings are up 10 percent, their stock price falls. This is consistent with the efficient markets hypothesis ________.

  1. A) if earnings were not as high as expected
  2. B) if earnings were not as low as expected
  3. C) if a merger is anticipated
  4. D) the company just invented a new bunion product

Answer:  A

Diff: 2      Type: MC

Skill:  Recall

Objective:  Appendix: Evidence on the Efficient Market Hypothesis

 

5) To say that stock prices follow a “random walk” is to argue that stock prices ________.

  1. A) rise, then fall, then rise again
  2. B) rise, then fall in a predictable fashion
  3. C) tend to follow trends
  4. D) cannot be predicted based on past trends

Answer:  D

Diff: 2      Type: MC

Skill:  Recall

Objective:  Appendix: Evidence on the Efficient Market Hypothesis

 

6) The efficient markets hypothesis predicts that stock prices follow a “random walk.” The implication of this hypothesis for investing in stocks is ________.

  1. A) a “churning strategy” of buying and selling often to catch market swings
  2. B) turning over your stock portfolio each month, selecting stocks by throwing darts at the stock page
  3. C) a “buy and hold strategy” of holding stocks to avoid brokerage commissions
  4. D) following the advice of technical analysts

Answer:  C

Diff: 2      Type: MC

Skill:  Recall

Objective:  Appendix: Evidence on the Efficient Market Hypothesis

7) Rules used to predict movements in stock prices based on past patterns are, according to the efficient markets hypothesis, ________.

  1. A) a waste of time
  2. B) profitably employed by all financial analysts
  3. C) the most efficient rules to employ
  4. D) consistent with the random walk hypothesis

Answer:  A

Diff: 2      Type: MC

Skill:  Recall

Objective:  Appendix: Evidence on the Efficient Market Hypothesis

 

 

8) Tests used to rate the performance of rules developed in technical analysis conclude that technical analysis ________.

  1. A) outperforms the overall market
  2. B) far outperforms the overall market, suggesting that stockbrokers provide valuable services
  3. C) does not outperform the overall market
  4. D) does not outperform the overall market, suggesting that stockbrokers do not provide services of any value

Answer:  C

Diff: 2      Type: MC

Skill:  Recall

Objective:  Appendix: Evidence on the Efficient Market Hypothesis

 

9) Which of the following accurately summarizes the empirical evidence about technical analysis?

  1. A) Technical analysts fare no better than other financial analysis—on average they do not outperform the market.
  2. B) Technical analysts tend to outperform other financial analysis, but on average they nevertheless underperform the market.
  3. C) Technical analysts fare no better than other financial analysis, and like other financial analysts they outperform the market.
  4. D) Technical analysts fare no better than other financial analysis, and like other financial analysts they underperform the market.

Answer:  A

Diff: 2      Type: MC

Skill:  Recall

Objective:  Appendix: Evidence on the Efficient Market Hypothesis

 

10) Evidence in support of the efficient markets hypothesis includes ________.

  1. A) the failure of technical analysis to outperform the market
  2. B) the small-firm effect
  3. C) the January effect
  4. D) excessive volatility

Answer:  A

Diff: 1      Type: MC

Skill:  Recall

Objective:  Appendix: Evidence on the Efficient Market Hypothesis

11) Evidence against market efficiency includes ________.

  1. A) failure of technical analysis to outperform the market
  2. B) the random walk behavior of stock prices
  3. C) the inability of mutual fund managers to consistently beat the market
  4. D) the January effect

Answer:  D

Diff: 1      Type: MC

Skill:  Recall

Objective:  Appendix: Evidence on the Efficient Market Hypothesis

 

12) The small-firm effect refers to the ________.

  1. A) negative returns earned by small firms
  2. B) returns equal to large firms earned by small firms
  3. C) abnormally high returns earned by small firms
  4. D) low returns after adjusting for risk earned by small firms

Answer:  C

Diff: 1      Type: MC

Skill:  Recall

Objective:  Appendix: Evidence on the Efficient Market Hypothesis

 

13) The January effect refers to the fact that ________.

  1. A) most stock market crashes have occurred in January
  2. B) stock prices tend to fall in January
  3. C) stock prices have historically experienced abnormal price increases in January
  4. D) the football team winning the Super Bowl accurately predicts the behavior of the stock market for the next year

Answer:  C

Diff: 1      Type: MC

Skill:  Recall

Objective:  Appendix: Evidence on the Efficient Market Hypothesis

 

14) When a corporation announces a major decline in earnings, the stock price may initially decline significantly and then rise back to normal levels over the next few weeks. This impact is called ________.

  1. A) the January effect
  2. B) mean reversion
  3. C) market overreaction
  4. D) the small-firm effect

Answer:  C

Diff: 1      Type: MC

Skill:  Recall

Objective:  Appendix: Evidence on the Efficient Market Hypothesis

 

15) A phenomenon closely related to market overreaction is ________.

  1. A) the random walk
  2. B) the small-firm effect
  3. C) the January effect
  4. D) excessive volatility

Answer:  D

Diff: 1      Type: MC

Skill:  Recall

Objective:  Appendix: Evidence on the Efficient Market Hypothesis

 

16) Excessive volatility refers to the fact that ________.

  1. A) stock returns display mean reversion
  2. B) stock prices can be slow to react to new information
  3. C) stock price tend to rise in the month of January
  4. D) stock prices fluctuate more than is justified by dividend fluctuations

Answer:  D

Diff: 1      Type: MC

Skill:  Recall

Objective:  Appendix: Evidence on the Efficient Market Hypothesis

 

17) Mean reversion refers to the fact that ________.

  1. A) small firms have higher than average returns
  2. B) stocks that have had low returns in the past are more likely to do well in the future
  3. C) stock returns are high during the month of January
  4. D) stock prices fluctuate more than is justified by fundamentals

Answer:  B

Diff: 1      Type: MC

Skill:  Recall

Objective:  Appendix: Evidence on the Efficient Market Hypothesis

 

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