Chapter 1 Why Study Financial Markets and Institutions?

Chapter 1 Why Study Financial Markets and Institutions?  Multiple Choice Questions 1. Financial markets and institutions (a) involve the movement of huge quantities of money. (b) affect the profits of businesses. (c) affect the types of goods and services produced in an economy. (d) do all of the above. (e) do only (a) and (b) of the above. Answer: D 2. Financial market activities affect (a) personal wealth. (b)spending decisions by individuals and business firms. (c) the economy’s location in the business cycle. (d) all of the above. Answer: D 3. Markets in which funds are transferred from those who have excess funds available to those who have a shortage of available funds are called (a) commodity markets. (b) funds markets. (c) derivative exchange markets. (d) financial markets. Answer: D 4. The price paid for the rental of borrowed funds (usually expressed as a percentage of the rental of $100 per year) is commonly referred to as the (a) inflation rate. (b) exchange rate. (c) interest rate. (d) aggregate price level. contacts: Answer: C 5. The bond markets are important because (a) they are easily the most widely followed financial markets in the United States. (b) they are the markets where interest rates are determined. (c) they are the markets where foreign exchange rates are determined. (d) all of the above. Answer: B 6. Interest rates are important to financial institutions since an interest rate increase _________ the cost of acquiring funds and _________ the income from assets. (a) decreases; decreases (b) increases; increases (c) decreases; increases (d) increases; decreases Answer: B 7. Typically, increasing interest rates (a) discourage individuals from saving. (b) discourage corporate investments. (c) encourage corporate expansion. (d) encourage corporate borrowing. (e) none of the above. Answer: B 8. Compared to interest rates on long-term U.S. government bonds, interest rates on _________ fluctuate more and are lower on average. (a) medium-quality corporate bonds (b) low-quality corporate bonds (c) high-quality corporate bonds (d) three-month Treasury bills (e) none of the above Answer: D 9. Compared to interest rates on long-term U.S. government bonds, interest rates on threemonth Treasury bills fluctuate _________ and are _________ on average. (a) more; lower (b) less; lower (c) more; higher (d) less; higher Answer: A 10. The stock market is important because (a) it is where interest rates are determined. (b) it is the most widely followed financial market in the United States. (c) it is where foreign exchange rates are determined. (d) all of the above. Answer: B Chapter 2 Overview of the Financial System  Multiple Choice Questions 1. Every financial market performs the following function: (a) It determines the level of interest rates. (b) It allows common stock to be traded. (c) It allows loans to be made. (d) It channels funds from lenders-savers to borrowers-spenders. Answer: D 2. Financial markets have the basic function of (a) bringing together people with funds to lend and people who want to borrow funds. (b) assuring that the swings in the business cycle are less pronounced. (c) assuring that governments need never resort to printing money. (d) both (a) and (b) of the above. (e) both (b) and (c) of the above. Answer: A 3. Which of the following can be described as involving direct finance? (a) A corporation’s stock is traded in an over-the-counter market. (b) People buy shares in a mutual fund. (c) A pension fund manager buys commercial paper in the secondary market. (d) An insurance company buys shares of common stock in the over-the-counter markets. (e) None of the above. Answer: E 4. Which of the following can be described as involving direct finance? (a) A corporation’s stock is traded in an over-the-counter market. (b) A corporation buys commercial paper issued by another corporation. (c) A pension fund manager buys commercial paper from the issuing corporation. (d) Both (a) and (b) of the above. (e) Both (b) and (c) of the above. Answer: B 5. Which of the following can be described as involving indirect finance? (a) A corporation takes out loans from a bank. (b) People buy shares in a mutual fund. (c) A corporation buys commercial paper in a secondary market. (d) All of the above. (e) Only (a) and (b) of the above. Answer: E 6. Which of the following can be described as involving indirect finance? (a) A bank buys a U.S. Treasury bill from one of its depositors. (b) A corporation buys commercial paper issued by another corporation. (c) A pension fund manager buys commercial paper in the primary market. (d) Both (a) and (c) of the above. Answer: D 7. Financial markets improve economic welfare because (a) they allow funds to move from those without productive investment opportunities to those who have such opportunities. (b) they allow consumers to time their purchases better. (c) they weed out inefficient firms. (d) they do all of the above. (e) they do (a) and (b) of the above. Answer: E 8. A country whose financial markets function poorly is likely to (a) efficiently allocate its capital resources. (b) enjoy high productivity. (c) experience economic hardship and financial crises. (d) increase its standard of living. Answer: C 9. Which of the following are securities? (a) A certificate of deposit (b) A share of Texaco common stock (c) A Treasury bill (d) All of the above (e) Only (a) and (b) of the above Answer: D 10. Which of the following statements about the characteristics of debt and equity are true? (a) They both can be long-term financial instruments. (b) They both involve a claim on the issuer’s income. (c) They both enable a corporation to raise funds. (d) All of the above. (e) Only (a) and (b) of the above. Answer: D 11. The money market is the market in which _________ are traded. (a) new issues of securities (b) previously issued securities (c) short-term debt instruments (d) long-term debt and equity instruments Answer: C 12. Long-term debt and equity instruments are traded in the _________ market. (a) primary (b)secondary (c) capital (d) money Answer: C 13. Which of the following are primary markets? (a) The New York Stock Exchange (b) The U.S. government bond market (c) The over-the-counter stock market (d) The options markets (e) None of the above Answer: E 14. Which of the following are secondary markets? (a) The New York Stock Exchange (b) The U.S. government bond market (c) The over-the-counter stock market (d) The options markets (e) All of the above Answer: E 15. A corporation acquires new funds only when its securities are sold in the (a) secondary market by an investment bank. (b) primary market by an investment bank. (c) secondary market by a stock exchange broker. (d)secondary market by a commercial bank. Answer: B 16. Intermediaries who are agents of investors and match buyers with sellers of securities are called (a) investment bankers. (b) traders. (c) brokers. (d) dealers. (e) none of the above. Answer: C 17. Intermediaries who link buyers and sellers by buying and selling securities at stated prices are called (a) investment bankers. (b) traders. (c) brokers. (d) dealers. (e) none of the above. Answer: D 18. An important financial institution that assists in the initial sale of securities in the primary market is the (a) investment bank. (b) commercial bank. (c) stock exchange. (d) brokerage house. Answer: A 19. Which of the following statements about financial markets and securities are true? (a) Most common stocks are traded over-the-counter, although the largest corporations have their shares traded at organized stock exchanges such as the New York Stock Exchange. (b) A corporation acquires new funds only when its securities are sold in the primary market. (c) Money market securities are usually more widely traded than longer-term securities and so tend to be more liquid. (d) All of the above are true. (e) Only (a) and (b) of the above are true. Answer: D 20. Which of the following statements about financial markets and securities are true? (a) A bond is a long-term security that promises to make periodic payments called dividends to the firm’s residual claimants. (b) A debt instrument is intermediate term if its maturity is less than one year. (c) A debt instrument is long term if its maturity is ten years or longer. (d) The maturity of a debt instrument is the time (term) that has elapsed since it was issued. Answer: C 21. Which of the following statements about financial markets and securities are true? (a) Few common stocks are traded over-the-counter, although the over-the-counter markets have grown in recent years. (b) A corporation acquires new funds only when its securities are sold in the primary market. (c) Capital market securities are usually more widely traded than longer term securities and so tend to be more liquid. (d) All of the above are true. (e) Only (a) and (b) of the above are true. Answer: B 22. Which of the following markets is sometimes organized as an over-the-counter market? (a) The stock market (b) The bond market (c) The foreign exchange market (d) The federal funds market (e) all of the above Answer: E 23. Bonds that are sold in a foreign country and are denominated in that country’s currency are known as (a) foreign bonds. (b) Eurobonds. (c) Eurocurrencies. (d) Eurodollars. Answer: A 24. Bonds that are sold in a foreign country and are denominated in a currency other than that of the country in which they are sold are known as (a) foreign bonds. (b) Eurobonds. (c) Eurocurrencies. (d) Eurodollars. Answer: B 25. Financial intermediaries (a) exist because there are substantial information and transaction costs in the economy. (b) improve the lot of the small saver. (c) are involved in the process of indirect finance. (d) do all of the above. (e) do only (a) and (b) of the above. Answer: D 26. The main sources of financing for businesses, in order of importance, are (a) financial intermediaries, issuing bonds, issuing stocks. (b) issuing bonds, issuing stocks, financial intermediaries. (c) issuing stocks, issuing bonds, financial intermediaries. (d) issuing stocks, financial intermediaries, issuing bonds. Answer: A 27. The presence of transaction costs in financial markets explains, in part, why (a) financial intermediaries and indirect finance play such an important role in financial markets. (b) equity and bond financing play such an important role in financial markets. (c) corporations get more funds through equity financing than they get from financial intermediaries. (d) direct financing is more important than indirect financing as a source of funds. Answer: A 28. Financial intermediaries can substantially reduce transaction costs per dollar of transactions because their large size allows them to take advantage of (a) poorly informed consumers. (b)standardization. (c) economies of scale. (d) their market power. Answer: C 29. The purpose of diversification is to (a) reduce the volatility of a portfolio’s return. (b) raise the volatility of a portfolio’s return. (c) reduce the average return on a portfolio. (d) raise the average return on a portfolio. Answer: A 30. An investor who puts all her funds into one asset _________ her portfolio’s _________. (a) increases; diversification (b) decreases; diversification (c) increases; average return (d) decreases; average return Answer: B 31. Through risk-sharing activities, a financial intermediary _________ its own risk and _________ the risks of its customers. (a) reduces; increases (b) increases; reduces (c) reduces; reduces (d) increases; increases Answer: B 32. The presence of _________ in financial markets leads to adverse selection and moral hazard problems that interfere with the efficient functioning of financial markets. (a) noncollateralized risk (b) free-riding (c) asymmetric information (d) costly state verification Answer: C 33. When the lender and the borrower have different amounts of information regarding a transaction, _________ is said to exist. (a) asymmetric information (b) adverse selection (c) moral hazard (d) fraud Answer: A 34. When the potential borrowers who are the most likely to default are the ones most actively seeking a loan, _________ is said to exist. (a) asymmetric information (b) adverse selection (c) moral hazard (d) fraud Answer: B 35. When the borrower engages in activities that make it less likely that the loan will be repaid, _________ is said to exist. (a) asymmetric information (b) adverse selection (c) moral hazard (d) fraud Answer: C 36. The concept of adverse selection helps to explain (a) which firms are more likely to obtain funds from banks and other financial intermediaries, rather than from the securities markets. (b) why indirect finance is more important than direct finance as a source of business finance. (c) why direct finance is more important than indirect finance as a source of business finance. (d) only (a) and (b) of the above. (e) only (a) and (c) of the above. Answer: D 37. Adverse selection is a problem associated with equity and debt contracts arising from (a) the lender’s relative lack of information about the borrower’s potential returns and risks of his investment activities. (b) the lender’s inability to legally require sufficient collateral to cover a 100 percent loss if the borrower defaults. (c) the borrower’s lack of incentive to seek a loan for highly risky investments. (d) none of the above. Answer: A 38. When the least desirable credit risks are the ones most likely to seek loans, lenders are subject to the (a) moral hazard problem. (b) adverse selection problem. (c) shirking problem. (d) free-rider problem. (e) principal-agent problem. Answer: B 39. Financial institutions expect that (a) moral hazard will occur, as the least desirable credit risks will be the ones most likely to seek out loans. (b) opportunistic behavior will occur, as the least desirable credit risks will be the ones most likely to seek out loans. (c) borrowers will commit moral hazard by taking on too much risk, and this is what drives financial institutions to take steps to limit moral hazard. (d) none of the above will occur. Answer: C 40. Successful financial intermediaries have higher earnings on their investments because they are better equipped than individuals to screen out good from bad risks, thereby reducing losses due to (a) moral hazard. (b) adverse selection. (c) bad luck. (d) financial panics. Answer: B 41. In financial markets, lenders typically have inferior information about potential returns and risks associated with any investment project. This difference in information is called (a) comparative informational disadvantage. (b) asymmetric information. (c) variant information. (d) caveat venditor. Answer: B 42. The largest depository institution at the end of 2004 was (a) life insurance companies. (b) pension funds. (c) state retirement funds. (d) none of the above. Answer: D 43. Which of the following financial intermediaries are depository institutions? (a) A savings and loan association (b) A commercial bank (c) A credit union (d) All of the above (e) Only (a) and (c) of the above Answer: D 44. Which of the following is a contractual savings institution? (a) A life insurance company (b) A credit union (c) A savings and loan association (d) A mutual fund Answer: A Chapter 3 What Do Interest Rates Mean and What Is Their Role in Valuation?  Multiple Choice Questions 1. A loan that requires the borrower to make the same payment every period until the maturity date is called a (a) simple loan. (b) fixed-payment loan. (c) discount loan. (d) same-payment loan. (e) none of the above. Answer: B 2. A coupon bond pays the owner of the bond (a) the same amount every month until maturity date. (b) a fixed interest payment every period and repays the face value at the maturity date. (c) the face value of the bond plus an interest payment once the maturity date has been reached. (d) the face value at the maturity date. (e) none of the above. Answer: B 3. A bond’s future payments are called its (a) cash flows. (b) maturity values. (c) discounted present values. (d) yields to maturity. Answer: A 4. A credit market instrument that pays the owner the face value of the security at the maturity date and nothing prior to then is called a (a) simple loan. (b) fixed-payment loan. (c) coupon bond. (d) discount bond. Answer: D 5. (I) A simple loan requires the borrower to repay the principal at the maturity date along with an interest payment. (II) A discount bond is bought at a price below its face value, and the face value is repaid at the maturity date. (a) (I) is true, (II) false. (b) (I) is false, (II) true. (c) Both are true. (d) Both are false. Answer: C 6. Which of the following are true of coupon bonds? (a) The owner of a coupon bond receives a fixed interest payment every year until the maturity date, when the face or par value is repaid. (b) U.S. Treasury bonds and notes are examples of coupon bonds. (c) Corporate bonds are examples of coupon bonds. (d) All of the above. (e) Only (a) and (b) of the above. Answer: D 7. Which of the following are generally true of all bonds? (a) The longer a bond’s maturity, the lower is the rate of return that occurs as a result of the increase in an interest rate. (b) Even though a bond has a substantial initial interest rate, its return can turn out to be negative if interest rates rise. (c) Prices and returns for long-term bonds are more volatile than those for shorter-term bonds. (d) All of the above are true. (e) Only (a) and (b) of the above are true. Answer: D 8. (I) A discount bond requires the borrower to repay the principal at the maturity date plus an interest payment. (II) A coupon bond pays the lender a fixed interest payment every year until the maturity date, when a specified final amount (face or par value) is repaid. (a) (I) is true, (II) false. (b) (I) is false, (II) true. (c) Both are true. (d) Both are false. Answer: B 9. If a $5,000 coupon bond has a coupon rate of 13 percent, then the coupon payment every year is (a) $650. (b) $1,300. (c) $130. (d) $13. (e) None of the above. Answer: A 10. An $8,000 coupon bond with a $400 annual coupon payment has a coupon rate of (a) 5 percent. (b) 8 percent. (c) 10 percent. (d) 40 percent. Answer: A 11. The concept of _________ is based on the common-sense notion that a dollar paid to you in the future is less valuable to you than a dollar today. (a) present value (b) future value (c) interest (d) deflation Answer: A 12. Dollars received in the future are worth _________ than dollars received today. The process of calculating what dollars received in the future are worth today is called _________ (a) more; discounting. (b) less; discounting. (c) more; inflating. (d) less; inflating. Answer: B 13. The process of calculating what dollars received in the future are worth today is called (a) calculating the yield to maturity. (b) discounting the future. (c) compounding the future. (d) compounding the present. Answer: B 14. With an interest rate of 5 percent, the present value of $100 received one year from now is approximately (a) $100. (b) $105. (c) $95. (d) $90. Answer: C 15. With an interest rate of 10 percent, the present value of a security that pays $1,100 next year and $1,460 four years from now is approximately (a) $1,000. (b) $2,000 (c) $2,560. (d) $3,000. Answer: B 16. With an interest rate of 8 percent, the present value of $100 received one year from now is approximately (a) $93. (b) $96. (c) $100. (d) $108. Answer: A 17. With an interest rate of 6 percent, the present value of $100 received one year from now is approximately (a) $106. (b) $100. (c) $94. (d) $92. Answer: C 18. The interest rate that equates the present value of the cash flow received from a debt instrument with its market price today is the (a) simple interest rate. (b) discount rate. (c) yield to maturity. (d) real interest rate. Answer: C 19. The interest rate that financial economists consider to be the most accurate measure is the (a) current yield. (b) yield to maturity. (c) yield on a discount basis. (d) coupon rate. Answer: B 20. Financial economists consider the _________ to be the most accurate measure of interest rates. (a) simple interest rate (b) discount rate (c) yield to maturity (d) real interest rate Answer: C 21. For a simple loan, the simple interest rate equals the (a) real interest rate. (b) nominal interest rate. (c) current yield. (d) yield to maturity. Answer: D 22. For simple loans, the simple interest rate is _________ the yield to maturity. (a) greater than (b) less than (c) equal to (d) not comparable to Answer: C 23. The yield to maturity of a one-year, simple loan of $500 that requires an interest payment of $40 is (a) 5 percent. (b) 8 percent. (c) 12 percent. (d) 12.5 percent. Answer: B 24. The yield to maturity of a one-year, simple loan of $400 that requires an interest payment of $50 is (a) 5 percent. (b) 8 percent. (c) 12 percent. (d) 12.5 percent. Answer: D 25. A $10,000, 8 percent coupon bond that sells for $10,000 has a yield to maturity of (a) 8 percent. (b) 10 percent. (c) 12 percent. (d) 14 percent. Answer: A 26. Which of the following $1,000 face value securities has the highest yield to maturity? (a) A 5 percent coupon bond selling for $1,000 (b) A 10 percent coupon bond selling for $1,000 (c) A 12 percent coupon bond selling for $1,000 (d) A 12 percent coupon bond selling for $1,100 Answer: C 27. Which of the following $1,000 face value securities has the highest yield to maturity? (a) A 5 percent coupon bond selling for $1,000 (b) A 10 percent coupon bond selling for $1,000 (c) A 15 percent coupon bond selling for $1,000 (d) A 15 percent coupon bond selling for $900 Answer: D 28. Which of the following are true for a coupon bond? (a) When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate. (b) The price of a coupon bond and the yield to maturity are negatively related. (c) The yield to maturity is greater than the coupon rate when the bond price is below the par value. (d) All of the above are true. (e) Only (a) and (b) of the above are true. Answer: D 29. Which of the following are true for a coupon bond? (a) When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate. (b) The price of a coupon bond and the yield to maturity are negatively related. (c) The yield to maturity is greater than the coupon rate when the bond price is above the par value. (d) All of the above are true. (e) Only (a) and (b) of the above are true. Answer: E 30. Which of the following are true for a coupon bond? (a) When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate. (b) The price of a coupon bond and the yield to maturity are positively related. (c) The yield to maturity is greater than the coupon rate when the bond price is above the par value. (d) All of the above are true. (e) Only (a) and (b) of the above are true. Answer: A 31. A consol bond is a bond that (a) pays interest annually and its face value at maturity. (b) pays interest in perpetuity and never matures. (c) pays no interest but pays face value at maturity. (d) rises in value as its yield to maturity rises. Answer: B 32. The yield to maturity on a consol bond that pays $100 yearly and sells for $500 is (a) 5 percent. (b) 10 percent. (c) 12.5 percent. (d) 20 percent. (e) 25 percent. Answer: D 33. The yield to maturity on a consol bond that pays $200 yearly and sells for $1000 is (a) 5 percent. (b) 10 percent. (c) 20 percent. (d) 25 percent. Answer: C 34. A frequently used approximation for the yield to maturity on a long-term bond is the (a) coupon rate. (b) current yield. (c) cash flow interest rate. (d) real interest rate. Answer: B 35. The current yield on a coupon bond is the bond’s _________ divided by its _________. (a) annual coupon payment; price (b) annual coupon payment; face value (c) annual return; price (d) annual return; face value Answer: A 36. When a bond’s price falls, its yield to maturity _________ and its current yield _________. (a) falls; falls (b) rises; rises (c) falls; rises (d) rises; falls Answer: B 37. The yield to maturity for a one-year discount bond equals (a) the increase in price over the year, divided by the initial price. (b) the increase in price over the year, divided by the face value. (c) the increase in price over the year, divided by the interest rate. (d) none of the above. Answer: A 38. If a $10,000 face value discount bond maturing in one year is selling for $8,000, then its yield to maturity is (a) 10 percent. (b) 20 percent. (c) 25 percent. (d) 40 percent. Answer: C 39. If a $10,000 face value discount bond maturing in one year is selling for $9,000, then its yield to maturity is (a) 9 percent. (b) 10 percent. (c) 11 percent. (d) 12 percent. Answer: C 40. If a $10,000 face value discount bond maturing in one year is selling for $5,000, then its yield to maturity is (a) 5 percent. (b) 10 percent. (c) 50 percent. (d) 100 percent. Answer: D 41. If a $5,000 face value discount bond maturing in one year is selling for $5,000, then its yield to maturity is (a) 0 percent. (b) 5 percent. (c) 10 percent. (d) 20 percent. Answer: A 42. The Fisher equation states that (a) the nominal interest rate equals the real interest rate plus the expected rate of inflation. (b) the real interest rate equals the nominal interest rate less the expected rate of inflation. (c) the nominal interest rate equals the real interest rate less the expected rate of inflation. (d) both (a) and (b) of the above are true. (e) both (a) and (c) of the above are true. Answer: D 43. If you expect the inflation rate to be 15 percent next year and a one-year bond has a yield to maturity of 7 percent, then the real interest rate on this bond is (a) 7 percent. (b) 22 percent. (c) –15 percent. (d) –8 percent. (e) none of the above. Answer: D 44. If you expect the inflation rate to be 5 percent next year and a one-year bond has a yield to maturity of 7 percent, then the real interest rate on this bond is (a) –12 percent. (b) –2 percent. (c) 2 percent. (d) 12 percent. Answer: C 45. The nominal interest rate minus the expected rate of inflation (a) defines the real interest rate. (b) is a better measure of the incentives to borrow and lend than is the nominal interest rate. (c) is a more accurate indicator of the tightness of credit market conditions than is the nominal interest rate. (d) all of the above. (e) only (a) and (b) of the above. Answer: D 46. The nominal interest rate minus the expected rate of inflation (a) defines the real interest rate. (b) is a less accurate measure of the incentives to borrow and lend than is the nominal interest rate. (c) is a less accurate indicator of the tightness of credit market conditions than is the nominal interest rate. (d) defines the discount rate. Answer: A 47. In which of the following situations would you prefer to be making a loan? (a) The interest rate is 9 percent and the expected inflation rate is 7 percent. (b) The interest rate is 4 percent and the expected inflation rate is 1 percent. (c) The interest rate is 13 percent and the expected inflation rate is 15 percent. (d) The interest rate is 25 percent and the expected inflation rate is 50 percent. Answer: B 48. In which of the following situations would you prefer to be borrowing? (a) The interest rate is 9 percent and the expected inflation rate is 7 percent. (b) The interest rate is 4 percent and the expected inflation rate is 1 percent. (c) The interest rate is 13 percent and the expected inflation rate is 15 percent. (d) The interest rate is 25 percent and the expected inflation rate is 50 percent. Answer: D 49. What is the return on a 5 percent coupon bond that initially sells for $1,000 and sells for $1,200 one year later? (a) 5 percent (b) 10 percent (c) –5 percent (d) 25 percent (e) None of the above Answer: D 50. What is the return on a 5 percent coupon bond that initially sells for $1,000 and sells for $900 one year later? (a) 5 percent (b) 10 percent (c) –5 percent (d) –10 percent (e) None of the above Answer: C 51. The return on a 5 percent coupon bond that initially sells for $1,000 and sells for $1,100 one year later is (a) 5 percent. (b) 10 percent. (c) 14 percent. (d) 15 percent. Answer: D 52. The return on a 10 percent coupon bond that initially sells for $1,000 and sells for $900 one year later is (a) –10 percent. (b) –5 percent. (c) 0 percent. (d) 5 percent. Answer: C 53. Which of the following are generally true of all bonds? (a) The only bond whose return equals the initial yield to maturity is one whose time to maturity is the same as the holding period. (b) A rise in interest rates is associated with a fall in bond prices, resulting in capital losses on bonds whose term to maturities are longer than the holding period. (c) The longer a bond’s maturity, the greater is the price change associated with a given interest rate change. (d) All of the above are true. (e) Only (a) and (b) of the above are true. Answer: D 54. Which of the following are true concerning the distinction between interest rates and return? (a) The rate of return on a bond will not necessarily equal the interest rate on that bond. (b) The return can be expressed as the sum of the current yield and the rate of capital gains. (c) The rate of return will be greater than the interest rate when the price of the bond falls between time t and time t + 1. (d) All of the above are true. (e) Only (a) and (b) of the above are true. Answer: E 55. If the interest rates on all bonds rise from 5 to 6 percent over the course of the year, which bond would you prefer to have been holding? (a) A bond with one year to maturity (b) A bond with five years to maturity (c) A bond with ten years to maturity (d) A bond with twenty years to maturity Answer: A 56. Suppose you are holding a 5 percent coupon bond maturing in one year with a yield to maturity of 15 percent. If the interest rate on one-year bonds rises from 15 percent to 20 percent over the course of the year, what is the yearly return on the bond you are holding? (a) 5 percent (b) 10 percent (c) 15 percent (d) 20 percent Answer: C 57. (I) Prices of longer-maturity bonds respond more dramatically to changes in interest rates. (II) Prices and returns for long-term bonds are less volatile than those for shortterm bonds. (a) (I) is true, (II) false. (b) (I) is false, (II) true. (c) Both are true. (d) Both are false. Answer: A 58. (I) Prices of longer-maturity bonds respond less dramatically to changes in interest rates. (II) Prices and returns for long-term bonds are less volatile than those for shorter-term bonds. (a) (I) is true, (II) false. (b) (I) is false, (II) true. (c) Both are true. (d) Both are false. Answer: D 59. The riskiness of an asset’s return that results from interest rate changes is called (a) interest-rate risk. (b) coupon-rate risk. (c) reinvestment risk. (d) yield-to-maturity risk. Answer: A 60. If an investor’s holding period is longer than the term to maturity of a bond, he or she is exposed to (a) interest-rate risk. (b) reinvestment risk. (c) bond-market risk. (d) yield-to-maturity risk. Answer: B 61. Reinvestment risk is the risk that (a) a bond’s value may fall in the future. (b) a bond’s future coupon payments may have to be invested at a rate lower than the bond’s yield to maturity. (c) an investor’s holding period will be short and equal in length to the maturity of the bonds he or she holds. (d) a bond’s issuer may fail to make the future coupon payments and an investor will have no cash to reinvest. Answer: B 62. (I) The average lifetime of a debt security’s stream of payments is called duration. (II) The duration of a portfolio is the weighted average of the durations of the individual securities, with the weights reflecting the proportion of the portfolio invested in each. (a) (I) is true, (II) false. (b) (I) is false, (II) true. (c) Both are true. (d) Both are false. Answer: C 63. The duration of a ten-year, 10 percent coupon bond when the interest rate is 10 percent is 6.76 years. What happens to the price of the bond if the interest rate falls to 8 percent? (a) it rises 20 percent (b) it rises 12.3 percent (c) it falls 20 percent (d) it falls 12.3 percent Answer: B  True/False 1. A bond’s current market value is equal to the present value of the coupon payments plus the present value of the face amount. Answer: TRUE 2. Discounting the future is the procedure used to find the future value of a dollar received today. Answer: FALSE 3. The current yield is the best measure of an investor’s return from holding a bond. Answer: FALSE 4. Unless a bond defaults, an investor cannot lose money investing in bonds. Answer: FALSE 5. The current yield is the yearly coupon payment divided by the current market price. Answer: TRUE 6. Prices for long-term bonds are more volatile than for shorter-term bonds. Answer: TRUE 7. A long-term bond’s price is less affected by interest rate movements than is a short-term bond’s price. Answer: FALSE 8. Increasing duration implies that interest-rate risk has increased. Answer: TRUE 9. All else being equal, the greater the interest rate the greater is the duration. Answer: FALSE 10. Interest-rate risk is the uncertainty that an investor faces because the interest rate at which a bond’s future coupon payments can be invested is unknown. Answer: FALSE 11. The real interest rate is equal to the nominal rate minus inflation. Answer: TRUE 12. The current yield goes up as the price of a bond falls. Answer: TRUE  Essay 1. Distinguish between coupon rate, yield to maturity, and current yield. 2. Describe the cash flows received from owning a coupon bond. 3. What concept is used to value a bond? 4. How is a bond’s current yield calculated? Why is current yield a more accurate approximation of yield to maturity for a long-term bond than for a short-term bond? 5. Why are long-term bonds more risky than short-term bonds? 6. What is interest-rate risk and how is it measured? 7. Why may a bond’s rate of return differ from its yield to maturity? 8. How does reinvestment risk differ from interest-rate risk? 9. What is the distinction between the nominal interest rate and the real interest rate? Which is a better indicator of incentives to borrow and lend? Why? 10. Describe how Treasury Inflation Protection Securities (TIPS) work and how they help policymakers estimate expected inflation. Chapter 4 Why Do Interest Rates Change?  Multiple Choice Questions 1. As the price of a bond _________ and the expected return _________, bonds become more attractive to investors and the quantity demanded rises. (a) falls; rises (b) falls; falls (c) rises; rises (d) rises; falls Answer: A 2. The supply curve for bonds has the usual upward slope, indicating that as the price _________, ceteris paribus, the _________ increases. (a) falls; supply (b) falls; quantity supplied (c) rises; supply (d) rises; quantity supplied Answer: D 3. When the price of a bond is above the equilibrium price, there is excess _________ in the bond market and the price will _________. (a) demand; rise (b) demand; fall (c) supply; fall (d) supply; rise Answer: C 4. When the price of a bond is below the equilibrium price, there is excess _________ in the bond market and the price will _________. (a) demand; rise (b) demand; fall (c) supply; fall (d) supply; rise Answer: A 5. When the price of a bond is _________ the equilibrium price, there is an excess supply of bonds and the price will _________. (a) above; rise (b) above; fall (c) below; fall (d) below; rise Answer: B 6. When the price of a bond is _________ the equilibrium price, there is an excess demand for bonds and the price will _________. (a) above; rise (b) above; fall (c) below; fall (d) below; rise Answer: D 7. When the interest rate on a bond is above the equilibrium interest rate, there is excess _________ in the bond market and the interest rate will _________. (a) demand; rise (b) demand; fall (c) supply; fall (d) supply; rise Answer: B 8. When the interest rate on a bond is below the equilibrium interest rate, there is excess _________ in the bond market and the interest rate will _________. (a) demand; rise (b) demand; fall (c) supply; fall (d) supply; rise Answer: D 9. When the interest rate on a bond is _________ the equilibrium interest rate, there is excess _________ in the bond market and the interest rate will _________. (a) above; demand; fall (b) above; demand; rise (c) below; supply; fall (d) above; supply; rise Answer: A 10. When the interest rate on a bond is _________ the equilibrium interest rate, there is excess _________ in the bond market and the interest rate will _________. (a) below; demand; rise (b) below; demand; fall (c) below; supply; rise (d) above; supply; fall Answer: C 11. When the demand for bonds _________ or the supply of bonds _________, interest rate rise. (a) increases; increases (b) increases; decreases (c) decreases; decreases (d) decreases; increases Answer: D 12. When the demand for bonds _________ or the supply of bonds _________, interest rates fall. (a) increases; increases (b) increases; decreases (c) decreases; decreases (d) decreases; increases Answer: B 13. When the demand for bonds _________ or the supply of bonds _________, bond prices rise. (a) increases; decreases (b) decreases; increases (c) decreases; decreases (d) increases; increases Answer: A 14. When the demand for bonds _________ or the supply of bonds _________, bond prices fall. (a) increases; increases (b) increases; decreases (c) decreases; decreases (d) decreases; increases Answer: D 15. Factors that determine the demand for an asset include changes in the (a) wealth of investors. (b) liquidity of bonds relative to alternative assets. (c) expected returns on bonds relative to alternative assets. (d) risk of bonds relative to alternative assets. (e) all of the above. Answer: E 16. The demand for an asset rises if _________ falls. (a) risk relative to other assets (b) expected return relative to other assets (c) liquidity relative to other assets (d) wealth Answer: A 17. The higher the standard deviation of returns on an asset, the _________ is the asset’s _________. (a) greater; risk (b) smaller; risk (c) greater; expected return (d) smaller; expected return Answer: A 18. Diversification benefits an investor by (a) increasing wealth. (b) increasing expected return. (c) reducing risk. (d) increasing liquidity. Answer: C 19. In a recession when income and wealth are falling, the demand for bonds _________ and the demand curve shifts to the _________. (a) falls; right (b) falls; left (c) rises; right (d) rises; left Answer: B 20. During business cycle expansions when income and wealth are rising, the demand for bonds _________ and the demand curve shifts to the _________. (a) falls; right (b) falls; left (c) rises; right (d) rises; left Answer: C 21. For a holding period of one year, the expected return on a consol is _________ the higher is the price of the consol today, and _________ the higher is the price of the consol next year. (a) higher; higher (b) higher; lower (c) lower; higher (d) lower; lower Answer: C 22. Higher expected interest rates in the future _________ the demand for long-term bonds and shift the demand curve to the _________. (a) increase; left (b) increase; right (c) decrease; left (d) decrease; right Answer: C 23. Lower expected interest rates in the future _________ the demand for long-term bonds and shift the demand curve to the _________ (a) increase; left. (b) increase; right. (c) decrease; left. (d) decrease; right. Answer: B 24. When people begin to expect a large stock market decline, the demand curve for bonds shifts to the _________ and the interest rate _________. (a) right; falls (b) right; rises (c) left; falls (d) left; rises Answer: A 25. When people begin to expect a large run up in stock prices, the demand curve for bonds shifts to the _________ and the interest rate _________. (a) right; rises (b) right; falls (c) left; falls (d) left; rises Answer: D 26. An increase in the expected rate of inflation will _________ the expected return on bonds relative to that on _________ assets, and shift the _________ curve to the left. (a) reduce; financial; demand (b) reduce; real; demand (c) raise; financial; supply (d) raise; real; supply Answer: B 27. A decrease in the expected rate of inflation will _________ the expected return on bonds relative to that on _________ assets. (a) reduce; financial (b) reduce; real (c) raise; financial (d) raise; real Answer: D 28. When the expected inflation rate increases, the demand for bonds _________, the supply of bonds _________, and the interest rate _________. (a) increases; increases; rises (b) decreases; decreases; falls (c) increases; decreases; falls (d) decreases; increases; rises Answer: D 29. When the expected inflation rate decreases, the demand for bonds _________, the supply of bonds _________, and the interest rate __________. (a) increases; increases; rises (b) decreases; decreases; falls (c) increases; decreases; falls (d) decreases; increases; rises Answer: C 30. When bond interest rates become more volatile, the demand for bonds _________ and the interest rate _________. (a) increases; rises (b) increases; falls (c) decreases; falls (d) decreases; rises Answer: D 31. When bond interest rates become less volatile, the demand for bonds _________ and the interest rate _________. (a) increases; rises (b) increases; falls (c) decreases; falls (d) decreases; rises Answer: B 32. When prices in the stock market become more uncertain, the demand curve for bonds shifts to the _________ and the interest rate _________. (a) right; rises (b) right; falls (c) left; falls (d) left; rises Answer: B 33. When stock prices become less volatile, the demand curve for bonds shifts to the _________ and the interest rate _________. (a) right; rises (b) right; falls (c) left; falls (d) left; rises Answer: D 34. When bonds become more widely traded, and as a consequence the market becomes more liquid, the demand curve for bonds shifts to the _________ and the interest rate _________. (a) right; rises (b) right; falls (c) left; falls (d) left; rises Answer: B 35. When bonds become less widely traded, and as a consequence the market becomes less liquid, the demand curve for bonds shifts to the _________ and the interest rate _________. (a) right; rises (b) right; falls (c) left; falls (d) left; rises Answer: D 36. Factors that cause the demand curve for bonds to shift to the left include (a) an increase in the inflation rate. (b) an increase in the liquidity of stocks. (c) a decrease in the volatility of stock prices. (d) all of the above. (e) none of the above. Answer: D 37. Factors that cause the demand curve for bonds to shift to the left include (a) a decrease in the inflation rate. (b) an increase in the volatility of stock prices. (c) an increase in the liquidity of stocks. (d) all of the above. (e) only (a) and (b) of the above. Answer: C 38. During an economic expansion, the supply of bonds _________ and the supply curve shifts to the _________. (a) increases, left (b) increases, right (c) decreases, left (d) decreases, right Answer: B 39. During a recession, the supply of bonds _________ and the supply curve shifts to the _________. (a) increases, left (b) increases, right (c) decreases, left (d) decreases, right Answer: C 40. An increase in expected inflation causes the supply of bonds to _________ and the supply curve to shift to the _________. (a) increase, left (b) increase, right (c) decrease, left (d) decrease, right Answer: B 41. When the federal government’s budget deficit increases, the _________ curve for bonds shifts to the _________. (a) demand; right (b) demand; left (c) supply; left (d) supply; right Answer: D 42. When the federal government’s budget deficit decreases, the _________ curve for bonds shifts to the _________. (a) demand; right (b) demand; left (c) supply; left (d) supply; right Answer: C 43. When the inflation rate is expected to increase, the expected return on bonds relative to real assets falls for any given interest rate; as a result, the _________ bonds falls and the _________ curve shifts to the left. (a) demand for; demand (b) demand for; supply (c) supply of; demand (d) supply of; supply Answer: A 44. When the inflation rate is expected to increase, the real cost of borrowing declines at any given interest rate; as a result, the _________ bonds increases and the _________ curve shifts to the right. (a) demand for; demand (b) demand for; supply (c) supply of; demand (d) supply of; supply Answer: D Figure 4.1 45. In Figure 4.1, the most likely cause of the increase in the equilibrium interest rate from i1 to i2 is (a) an increase in the price of bonds. (b) a business cycle boom. (c) an increase in the expected inflation rate. (d) a decrease in the expected inflation rate. Answer: C 46. In Figure 4.1, the most likely cause of the increase in the equilibrium interest rate from i1 to i2 is a(n) _________ in the _________. (a) increase; expected inflation rate (b) decrease; expected inflation rate. (c) increase; government budget deficit (d) decrease; government budget deficit Answer: A 47. In Figure 4.1, the most likely cause of a decrease in the equilibrium interest rate from i2 to i1 is (a) an increase in the expected inflation rate. (b) a decrease in the expected inflation rate. (c) a business cycle expansion. (d) a combination of both (a) and (c) of the above. Answer: B 48. Factors that can cause the supply curve for bonds to shift to the right include (a) an expansion in overall economic activity. (b) a decrease in expected inflation. (c) a decrease in government deficits. (d) all of the above. (e) only (a) and (b) of the above. Answer: A 49. Factors that can cause the supply curve for bonds to shift to the left include (a) an expansion in overall economic activity. (b) a decrease in expected inflation. (c) an increase in government deficits. (d) only (a) and (c) of the above. Answer: B 50. The economist Irving Fisher, after whom the Fisher effect is named, explained why interest rates _________ as the expected rate of inflation _________. (a) rise; increases (b) rise; stabilizes (c) rise; decreases (d) fall; increases (e) fall; stabilizes Answer: A 51. An increase in the expected rate of inflation causes the demand for bonds to _________ and the supply for bonds to _________. (a) fall; fall (b) fall; rise (c) rise; fall (d) rise; rise Answer: B 52. A decrease in the expected rate of inflation causes the demand for bonds to _________ and the supply of bonds to _________. (a) fall; fall (b) fall; rise (c) rise; fall (d) rise; rise Answer: C 53. When the economy slips into a recession, normally the demand for bonds _________, the supply of bonds _________, and the interest rate _________. (a) increases; increases; rises (b) decreases; decreases; falls (c) increases; decreases; falls (d) decreases; increases; rises Answer: B 54. When the economy enters into a boom, normally the demand for bonds _________, the supply of bonds _________, and the interest rate _________. (a) increases; increases; rises (b) decreases; decreases; falls (c) increases; decreases; rises (d) decreases; increases; rises Answer: A Figure 4.2 55. In Figure 4.2, one possible explanation for the increase in the interest rate from i1 to i2 is a(n) _________ in _________. (a) increase; the expected inflation rate (b) decrease; the expected inflation rate (c) increase; economic growth (d) decrease; economic growth Answer: C 56. In Figure 4.2, one possible explanation for the increase in the interest rate from i1 to i2 is (a) an increase in economic growth. (b) an increase in government budget deficits. (c) a decrease in government budget deficits. (d) a decrease in economic growth. (e) a decrease in the riskiness of bonds relative to other investments. Answer: A 57. In Figure 4.2, one possible explanation for a decrease in the interest rate from i2 to i1 is (a) an increase in government budget deficits. (b) an increase in expected inflation. (c) a decrease in economic growth. (d) a decrease in the riskiness of bonds relative to other investments. Answer: C Questions for Chapter 4, Web Appendix 2: Supply and Demand in the Market for Money: The Liquidity Preference Framework 58. In Keynes’s liquidity preference framework, individuals are assumed to hold their wealth in two forms: (a) real assets and financial assets. (b) stocks and bonds. (c) money and bonds. (d) money and gold. Answer: C 59. In his liquidity preference framework, Keynes assumed that money has a zero rate of return; thus, when interest rates _________ the expected return on money falls relative to the expected return on bonds, causing the demand for money to _________. (a) rise; fall (b) rise; rise (c) fall; fall (d) fall; rise Answer: A 60. The loanable funds framework is easier to use when analyzing the effects of changes in _________, while the liquidity preference framework provides a simpler analysis of the effects from changes in income, the price level, and the supply of _________ (a) expected inflation; bonds. (b) expected inflation; money. (c) government budget deficits; bonds. (d) the supply of money; bonds. Answer: B 61. When comparing the loanable funds and liquidity preference frameworks of interest rate determination, which of the following is true? (a) The liquidity preference framework is easier to use when analyzing the effects of changes in expected inflation. (b) The loanable funds framework provides a simpler analysis of the effects of changes in income, the price level, and the supply of money. (c) In most instances, the two approaches to interest rate determination yield the same predictions. (d) All of the above are true. (e) Only (a) and (b) of the above are true. Answer: C 62. A higher level of income causes the demand for money to _________ and the interest rate to _________ (a) decrease; decrease. (b) decrease; increase. (c) increase; decrease. (d) increase; increase. Answer: D 63. A lower level of income causes the demand for money to _________ and the interest rate to _________ (a) decrease; decrease. (b) decrease; increase. (c) increase; decrease. (d) increase; increase. Answer: A 64. A rise in the price level causes the demand for money to _________ and the demand curve to shift to the _________ (a) decrease; right. (b) decrease; left. (c) increase; right. (d) increase; left. Answer: C 65. A decline in the price level causes the demand for money to _________ and the demand curve to shift to the _________ (a) decrease; right. (b) decrease; left. (c) increase; right. (d) increase; left. Answer: B 66. A decline in the expected inflation rate causes the demand for money to _________ and the demand curve to shift to the _________ (a) decrease; right. (b) decrease; left. (c) increase; right. (d) increase; left. Answer: B 67. Holding everything else constant, an increase in the money supply causes (a) interest rates to decline initially. (b) interest rates to increase initially. (c) bond prices to decline initially. (d) both (a) and (c) of the above. (e) both (b) and (c) of the above. Answer: A 68. Holding everything else constant, a decrease in the money supply causes (a) interest rates to decline initially. (b) interest rates to increase initially. (c) bond prices to increase initially. (d) both (a) and (c) of the above. (e) both (b) and (c) of the above. Answer: B Figure 4.3 69. In Figure 4.3, the factor responsible for the decline in the interest rate is (a) a decline in the price level. (b) a decline in income. (c) an increase in the money supply. (d) a decline in the expected inflation rate. Answer: C 70. In Figure 4.3, the decrease in the interest rate from i1 to i2 can be explained by (a) a decrease in money growth. (b) an increase in money growth. (c) a decline in the expected price level. (d) only (a) and (b) of the above. Answer: B 71. In Figure 4.3, an increase in the interest rate from i2 to i1 can be explained by (a) a decrease in money growth. (b) an increase in money growth. (c) a decline in the price level. (d) an increase in the expected price level. Answer: A 72. Of the four effects on interest rates from an increase in the money supply, the one that works in the opposite direction of the other three is the (a) liquidity effect. (b) income effect. (c) price level effect. (d) expected inflation effect. Answer: A 73. Of the four effects on interest rates from an increase in the money supply, the initial effect is, generally, the (a) income effect. (b) liquidity effect. (c) price level effect. (d) expected inflation effect. Answer: B 74. If the liquidity effect is smaller than the other effects, and the adjustment of expected inflation is slow, then the (a) interest rate will fall. (b) interest rate will rise. (c) interest rate will initially fall but eventually climb above the initial level in response to an increase in money growth. (d) interest rate will initially rise but eventually fall below the initial level in response to an increase in money growth. Answer: C 75. When the growth rate of the money supply increases, interest rates end up being permanently lower if (a) the liquidity effect is larger than the other effects. (b) there is fast adjustment of expected inflation. (c) there is slow adjustment of expected inflation. (d) the expected inflation effect is larger than the liquidity effect. Answer: A 76. When the growth rate of the money supply decreases, interest rates end up being permanently lower if (a) the liquidity effect is larger than the other effects. (b) there is fast adjustment of expected inflation. (c) there is slow adjustment of expected inflation. (d) the expected inflation effect is larger than the liquidity effect. Answer: D 77. When the growth rate of the money supply is decreased, interest rates will rise immediately if the liquidity effect is _________ than the other effects and if there is _________ adjustment of expected inflation. (a) larger; rapid (b) larger; slow (c) smaller; slow (d) smaller; rapid Answer: B 78. When the growth rate of the money supply is increased, interest rates will rise immediately if the liquidity effect is _________ than the other effects and if there is _________ adjustment of expected inflation. (a) larger; rapid (b) larger; slow (c) smaller; slow (d) smaller; rapid Answer: D 79. If the Fed wants to permanently lower interest rates, then it should lower the rate of money growth if (a) there is fast adjustment of expected inflation. (b) there is slow adjustment of expected inflation. (c) the liquidity effect is smaller than the expected inflation effect. (d) the liquidity effect is larger than the other effects. Answer: C 80. If the Fed wants to permanently lower interest rates, then it should raise the rate of money growth if (a) there is fast adjustment of expected inflation. (b) there is slow adjustment of expected inflation. (c) the liquidity effect is smaller than the expected inflation effect. (d) the liquidity effect is larger than the other effects. Answer: D 81. Milton Friedman contends that it is entirely possible that when the money supply rises, interest rates may _________ if the _________ effect is more than offset by changes in income, the price level, and expected inflation. (a) fall; liquidity (b) fall; risk (c) rise; liquidity (d) rise; risk Answer: C Figure 4.4 82. Figure 4.4 illustrates the effect of an increased rate of money supply growth. From the figure, one can conclude that the liquidity effect is _________ than the expected inflation effect and interest rates adjust _________ to changes in expected inflation. (a) smaller; quickly (b) larger; quickly (c) larger; slowly (d) smaller; slowly Answer: A 83. Figure 4.4 illustrates the effect of an increased rate of money supply growth. From the figure, one can conclude that the (a) Fisher effect is dominated by the liquidity effect and interest rates adjust slowly to changes in expected inflation. (b) liquidity effect is dominated by the Fisher effect and interest rates adjust slowly to changes in expected inflation. (c) liquidity effect is dominated by the Fisher effect and interest rates adjust quickly to changes in expected inflation. (d) Fisher effect is smaller than the expected inflation effect and interest rates adjust quickly to changes in expected inflation. Answer: C Figure 4.5 84. Figure 4.5 illustrates the effect of an increased rate of money supply growth. From the figure, one can conclude that the liquidity effect is _________ than the expected inflation effect and interest rates adjust _________ to changes in expected inflation. (a) smaller; quickly (b) larger; quickly (c) larger; slowly (d) smaller; slowly Answer: C 85. Figure 4.5 illustrates the effect of an increased rate of money supply growth. From the figure, one can conclude that the (a) Fisher effect is dominated by the liquidity effect and interest rates adjust slowly to changes in expected inflation. (b) liquidity effect is dominated by the Fisher effect and interest rates adjust slowly to changes in expected inflation. (c) liquidity effect is dominated by the Fisher effect and interest rates adjust quickly to changes in expected inflation. (d) Fisher effect is smaller than the expected inflation effect and interest rates adjust quickly to changes in expected inflation. Answer: A  True/False 1. When interest rates decrease, the demand curve for bonds shifts to the left. Answer: FALSE 2. When an economy grows out of a recession, normally the demand for bonds increases and the supply of bonds increases. Answer: TRUE 3. When the federal government’s budget deficit decreases, the demand curve for bonds shifts to the right. Answer: FALSE 4. Investors make their choices of which assets to hold by comparing the expected return, liquidity, and risk of alternative assets. Answer: TRUE 5. A person who is risk averse prefers to hold assets that are more, not less, risky. Answer: FALSE 6. Interest rates are procyclical in that they tend to rise during business cycle expansions and fall during recessions. Answer: TRUE 7. When income and wealth are rising, the demand for bonds rises and the demand curve shifts to the right. Answer: TRUE 8. An increase in the inflation rate will cause the demand curve for bonds to shift to the right. Answer: FALSE 9. The Fisher Effect predicts that an incease in expected inflation will lower the interest rate on bonds. Answer: FALSE 10. An increase in the federal government budget deficit will raise the interest rate on bonds. Answer: TRUE  Essay 1. Identify and explain the four factors that influence asset demand. Which of these factors affect total asset demand and which influence investors to demand one asset over another? 2. How is the equilibrium interest rate determined in the bond market? Explain why the interest rate will move toward equilibrium if it is temporarily above or below the equilibrium rate. 3. Use the bond demand and supply framework to explain the Fisher effect and why it occurs. 4. If investors perceive greater interest rate risk, what will happen to the equilibrium interest rate in the bond market? Explain using the bond demand and supply framework. 5. How will a decrease in the federal government’s budget deficit affect the equilibrium interest rate in the bond maket? Explain using the bond demand and supply framework. 6. What is the expected return on a bond if the return is 9% two-thirds of the time and 3% one-third of the time? What is the standard deviation of the returns on this bond? Would you prefer this bond or one with an identical expected return and a standard deviation of 4.5? Why? Chapter 5 How Do Risk and Term Structure Affect Interest Rates?  Multiple Choice Questions 1. The term structure of interest rates is (a) the relationship among interest rates of different bonds with the same maturity. (b) the structure of how interest rates move over time. (c) the relationship among the terms to maturity of different bonds. (d) the relationship among interest rates on bonds with different maturities. Answer: D 2. The risk structure of interest rates is (a) the structure of how interest rates move over time. (b) the relationship among interest rates of different bonds with the same maturity. (c) the relationship among the terms to maturity of different bonds. (d) the relationship among interest rates on bonds with different maturities. Answer: B 3. Which of the following long-term bonds should have the lowest interest rate? (a) Corporate Baa bonds (b) U.S. Treasury bonds (c) Corporate Aaa bonds (d) Municipal bonds Answer: D 4. Which of the following long-term bonds should have the highest interest rate? (a) Corporate Baa bonds (b) U.S. Treasury bonds (c) Corporate Aaa bonds (d) Municipal bonds Answer: A 5. The risk premium on corporate bonds becomes smaller if (a) the riskiness of corporate bonds increases. (b) the liquidity of corporate bonds increases. (c) the liquidity of corporate bonds decreases. (d) the riskiness of corporate bonds decreases. (e) either (b) or (d) occur. Answer: E 6. Bonds with relatively low risk of default are called (a) zero coupon bonds. (b) junk bonds. (c) investment grade bonds. (d) none of the above. Answer: C 7. Bonds with relatively high risk of default are called (a) Brady bonds. (b) junk bonds. (c) zero coupon bonds. (d) investment grade bonds. Answer: B 8. A corporation suffering big losses might be more likely to suspend interest payments on its bonds, thereby (a) raising the default risk and causing the demand for its bonds to rise. (b) raising the default risk and causing the demand for its bonds to fall. (c) lowering the default risk and causing the demand for its bonds to rise. (d) lowering the default risk and causing the demand for its bonds to fall. Answer: B 9. (I) If a corporation suffers big losses, the demand for its bonds will rise because of the higher interest rates the firm must pay. (II) The spread between the interest rates on bonds with default risk and default-free bonds is called the risk premium. (a) (I) is true, (II) false. (b) (I) is false, (II) true. (c) Both are true. (d) Both are false. Answer: B 10. Holding everything else constant, if a corporation begins to suffer large losses, then the default risk on its bonds will _________ and the expected return on those bonds will _________. (a) increase: increase (b) decrease; increase (c) increase; decrease (d) decrease; decrease Answer: C 11. Holding everything else the same, if a corporation’s earnings rise, then the default risk on its bonds will _________ and the expected return on those bonds will _________. (a) increase; decrease (b) decrease; decrease (c) increase; increase (d) decrease; increase Answer: D 12. If a corporation begins to suffer large losses, then the default risk on its bonds will _________ and the equilibrium interest rate on these bonds will _________. (a) increase; decrease (b) decrease; increase (c) increase; increase (d) decrease; decrease Answer: C 13. If a corporation’s earnings rise, then the default risk on its bonds will _________ and the equilibrium interest rate on these bonds will _________. (a) increase; decrease (b) decrease; decrease (c) increase; increase (d) decrease; increase Answer: B 14. When the default risk on corporate bonds decreases, other things equal, the demand curve for corporate bonds shifts to the _________ and the demand curve for Treasury bonds shifts to the _________. (a) right; right (b) right; left (c) left; left (d) left; right Answer: B 15. (I) An increase in default risk on corporate bonds shifts the demand curve for corporate bonds to the right. (II) An increase in default risk on corporate bonds shifts the demand curve for Treasury bonds to the left. (a) (I) is true, (II) false. (b) (I) is false, (II) true. (c) Both are true. (d) Both are false. Answer: D 16. (I) An increase in default risk on corporate bonds shifts the demand curve for corporate bonds to the left. (II) An increase in default risk on corporate bonds shifts the demand curve for Treasury bonds to the right. (a) (I) is true, (II) false. (b) (I) is false, (II) true. (c) Both are true. (d) Both are false. Answer: C 17. When budget talks between congressional Republicans and President Clinton occurred in late 1995, fear of a government default _________, Treasury bond values _________, and interest rates on Treasury bonds _________. (a) rose; fell; rose (b) rose; rose; rose (c) fell; rose; fell (d) fell; fell; fell Answer: A 18. The spread between interest rates on low quality corporate bonds and U.S. government bonds _________ during the Great Depression. (a) was reversed (b) narrowed significantly (c) widened significantly (d) did not change Answer: C 19. As a result of the Enron collapse and bankruptcy, the demand for low quality corporate bonds _________, the demand for high quality corporate bonds _________, and the risk spread _________. (a) increased; decreased; was unchanged (b) decreased; increased; increased (c) increased; decreased; decreased (d) decreased; increased; was unchanged Answer: B 20. Moody’s and Standard and Poo