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Exam of 23 pages for the course at U of T (Sample exam)
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SOLUTIONS to Sample Exam Questions – MGEC71Q1. What is barter? Describe how it works highlighting its good and bad features.
Q2. What is fiat money? Describe how it works highlighting its good and bad features.
Q3. Describe the net social welfare impact of the introduction and use of cheques.
Q4. What is financial intermediation? Explain how this activity impacts social
welfare.
Q5. What is money (i.e. define it)? Many assets provide a higher rate of return, given
this explain why people bother to hold money.
Q6. Describe the key features that define something as money. Which feature is the
most important property of money? Explain.
Q7. What is the primary market? Explain and provide an example of a primary
market.
Q8. What is the secondary market? Explain and provide an example of a secondary
market.
Q9. Explain what is meant by the term direct finance. Explain what is meant by
indirect finance.
The solutions to questions 1 – 9 can be found either directly in our
lecture material or in the textbook readings.
Q10. A dollar in the future is worth more than, the same, or less than a dollar today?
Explain why this is so.
ANSWER:
The following are definitions of some important terms or concepts:
PV = Present value = value of something (possibly from the future) measured today in
units of today’s money
FV = Future value = value of something (possibly from the past) measured in the future
in units of money (of some specified future date)
i = nominal interest rate = average annual interest rate paid (or earned) over some time
frame (period of time) = yield to maturity
n = number of years between today and the end of the future period (usually an integer)
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,A dollar today ($1) has a present value of one (i.e. PV = $1).
A dollar in the future (i.e. for n > 0) has a future value (FV = $1) but has a present value
of LESS than $1 (i.e. PV < $1) as the nominal interest rate is almost always positive (it is
never negative unless some sort of mistake has occurred).
Therefore a dollar today is MORE valuable than a dollar in the future (since it has a
larger PV).
Q11. What is asymmetric information? Describe the main ways it impacts financial
markets.
ANSWER:
Asymmetric information is a lack of information that occurs when one party often does
not know enough about the other party to make accurate decisions, which creates
problems in the financial system on two fronts (before the transaction is entered into,
adverse selection, and after, moral hazard).
Adverse selection – problem created by asymmetric information before the transaction
occurs when the potential borrowers in financial markets who are the most likely to
produce an undesirable (adverse) outcome (bad credit risks) are the ones who most
actively seek out a loan (and possibly agree to higher than market borrowing cost) and
are thus most likely to be selected, which results in lenders’ becoming reluctant to make
any loans even though there are good credit risks in the marketplace.
Moral hazard – problem created by asymmetric information after the transaction occurs
in financial markets because of the risk (hazard) that the borrower might engage in
activities that are undesirable (immoral) from the lender’s point of view (ex. funds
borrowed not channeled into stated activities in the loan agreement) because such a
change of behavior makes it less likely that the loan will be paid back, lenders may
decide (ex post) that they would rather not have made a loan.
Q12. The PBS Frontline video posted on the course web page describes the financial
market meltdown that hit the US economy in 2008. Briefly describe how and why
some US financial institutions ran into difficulty (as described in this video).
ANSWER:
Q13. Use mathematics and words to define the concept of yield to maturity, present
value and holding period return of a coupon bond.
ANSWER:
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, The following are definitions of some important terms or concepts:
Pt = Price of the bond (at time t) = PV = the present value (i.e. value in today’s money,
at time t) of the future stream of cash flow coming from this bond (assuming it is
held from time t until maturity)
F = Face value of the bond = the terminal value the bond seller pays the bond holder at
the end of the life of the bond (i.e. at the end of the term or maturity)
C = Annual coupon payment (paid at the end of each year for the whole term/life of the
bond - up and including the bond’s last year)
c = (C/F) = Coupon rate = the size of the coupon payment (per year) expressed as a
percentage of the bond’s face value
i = nominal interest rate = average annual interest rate paid (or earned) from time t until
the bond matures (i.e. assumes we buy it at time t and hold it until it matures) =
yield to maturity
n = term of the bond in number of years = number of years until the bond matures
(usually an integer)
Given i (the n-period market interest rate at time t) and C, F & n (these three are
fixed in advance and over time and can be found in the bond contract)
THEN the price of the bond (at time t) Pt is determined using the (PV)
expression above.
Given Pt (the bond market price at time t) and C, F & n (these three are fixed in
advance and over time and can be found in the bond contract) THEN the
yield to maturity i is determined using the expression above.
The holding period return = rate of return that occurs from buying the bond at time
t & selling it at some later date (possibly prior to maturity) = RET
This would include any interest payments received while holding the bond; plus
Any capital gain or loss that occurs when selling the bond at a later date.
One year holding period return = current yield + capital gain/loss =
Q14. Use mathematics and words to define the concepts of current yield, yield to
maturity and the rate of return for a coupon bond. Which one do investors care
most about? Explain.
ANSWER:
See Q13 above.
Current yield = the coupon payment (per year) expressed as a percentage of the
purchase price of the bond = (C/P)
Rate of return = holding period return
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