Money, Banking, and Financial Markets (Econ 353) Midterm Examination I June 27, Name Univ. Id #

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1 Money, Bankng, and Fnancal Markets (Econ 353) Mdterm Examnaton I June 27, 2005 Name Unv. Id # Note: Each multple-choce queston s worth 4 ponts. Problems 20, 21, and 22 carry 10, 8, and 10 ponts, respectvely. 1) Whch of the followng are true statements? A) Income s a flow of earnngs per unt of tme. B) Wealth s the total collecton of peces of property that are a store of value. C) Money s a stock; t s a certan amount at a gven pont n tme. D) All of the above are true. 2) The present value of a lottery prze payng $1 mllon each year for twenty years, dscounted at a rate of 10 percent, s worth A) exactly $20 mllon. B) less than $10 mllon. C) between $20 mllon and $30 mllon. D) $18 mllon. E) more then $30 mllon. 3) For a bond sellng for $4000, wth a par value of $5000 and a coupon rate of 10 percent, the current yeld s A) 5 percent. B) 10 percent. C) 12.5 percent. D) 20 percent. E) 25 percent. 4) Whch of the followng statements about fnancal markets and securtes are true? A) A corporaton acqures new funds only when ts securtes are frst sold n the prmary market. B) Money market securtes are usually more wdely traded than longer-term securtes and so tend to be more lqud. C) Many common stocks are traded over-the-counter, although the largest corporatons usually have ther shares traded at organzed stock exchanges such as the New York Stock Exchange.

2 D) All of the above are true. E) Only A and B of the above are true. 5) Prces and returns for bonds are more volatle than those for bonds. A) long-term; long-term B) short-term; long-term C) long-term; short-term D) short-term; short-term 6) If an ndvdual moves money from a small-denomnaton tme depost to a checkng depost account, A) M1 ncreases and M2 stays the same. B) M1 stays the same and M2 ncreases. C) M1 stays the same and M2 stays the same. D) M1 ncreases and M2 decreases. 7) (Bonus queston) The purpose of the dsclosure requrements of the Securtes and Exchange Commsson s to A) prevent bank pancs. B) protect nvestors aganst fnancal losses. C) ncrease the nformaton avalable to nvestors. D) mprove monetary control. E) all of the above. 8) Whch of the followng s most lkely to result from a stronger dollar? A) Amercans wll purchase fewer foregn goods. B) U.S. goods exported abroad wll cost more n foregn countres, and so foregners wll buy fewer of them. C) U.S. goods exported aboard wll cost less n foregn countres, and so foregners wll buy more of them. D) U.S. goods exported aboard wll cost more n foregn countres and so foregners wll buy more of them.

3 9) A rsng stock market ndex due to hgher share prces A) decreases the amount of funds that busness frms can rase by sellng newly-ssued stock. B) ncreases people's wealth and as a result may ncrease ther wllngness to spend. C) ncreases people's wealth, but s unlkely to ncrease ther wllngness to spend. D) both A and C of the above. 10) If the nterest rates on all bonds fall from 7 to 6 percent over the course of the year, whch bond would you prefer to have been holdng? A) A bond wth one year to maturty B) A bond wth ten years to maturty C) A bond wth fve years to maturty D) A bond wth twenty years to maturty 11) An example of economes of scale n the provson of fnancal servces s A) provdng depostors wth a varety of savngs certfcates. B) spreadng the cost of borrowed funds over many customers. C) spreadng the cost of wrtng a standardzed contract over many borrowers. D) nvestng n a dversfed collecton of assets. E) all of the above. 12) Increasng transactons costs of sellng an asset make the asset A) more valuable. B) more fungble. C) less lqud. D) more moneylke. E) more lqud. 13) An mportant functon of secondary markets s to A) make t easer for governments to rase taxes. B) rase funds for corporatons through the sale of securtes. C) create a market for bank demand deposts. D) make t easer to sell fnancal nstruments to rase cash. E) create a market for newly constructed houses.

4 14) If the level of prces falls by 50 percent, the value of money A) falls by 100%. B) doubles. C) falls by 50%. D) rses by 50%. E) remans unchanged. 15) In the early 1980s, a partcular bank n Oklahoma developed a reputaton of readly provdng loans to borrowers for the purpose of explorng for ol deposts. Many of these loans were never repad, because ths bank faled to address the A) rsk-sharng problem. B) regulatory avodance problem. C) moral hazard problem. D) adverse selecton problem. E) free-rder problem. 16) Adverse selecton s a problem assocated wth equty and debt contracts arsng from A) the lender's nablty to legally requre suffcent collateral to cover a 100% loss f the borrower defaults. B) the borrower's lack of ncentve to seek a loan for hghly rsky nvestments. C) the lender's relatve lack of nformaton about the borrower's potental returns and rsks of hs nvestment actvtes. D) none of the above. 17) Of the followng measures of nterest rates, whch s consdered by economsts to be the most accurate? A) The yeld to maturty B) The coupon rate C) The yeld on a dscount bass D) The current yeld 18) Whch of the followng are true statements? A) The converson of a barter economy to one that uses money ncreases effcency by ncreasng the cost of exchange. B) The converson of a barter economy to one that uses money ncreases effcency by reducng transactons costs. C) The converson of a barter economy to one that uses money ncreases effcency by ncreasng the cost to those who wsh to specalze. D) All of the above are true.

5 19) Whch of the followng are true statements? A) The average prce of goods and servces n an economy s called the nflaton rate. B) When the average prce of goods and servces n an economy ncreases, the nflaton rate ncreases. C) Those countres wth the hghest nflaton rates are also the ones wth the hghest money growth rates. D) All of the above are true statements. E) Only A and B of the above are true statements.

6 KEY 1) D 2) B 3) C 4) D 5) C 6) A 7) C 8) B 9) B 10) E 11) C 12) C 13) D 14) B 15) D 16) C 17) A 18) B 19) C

7 20. a)you are consderng two nvestment opportuntes for a perod of 2 years: Opton A - you can nvest n a 2-year tme depost n your bank at the annual nterest rate of 9.5%. Opton B - you can purchase one-year dscount bond wth a Face Value of $10,000 and then renvest the proceeds nto another one-year dscount bond. The current nterest rate s 9%. At the end of the frst year you expect that the nterest rates wll rse to 11%. (Hnt: assume that at the end of the frst year, someone wll sell you a bond wth such Face Value that you can renvest all your avalable funds). Calculate the expected annual nterest rate on your nvestment for the entre 2-year perod (wth the renvestment) and decde whch opton would you prefer. (6 ponts) b) Now, assume that the nterest rates after the frst year rose only to 9.8%. Are you stll better off than f you would have nvested n the bank? Why? (Hnt: t s possble to answer ths queston wthout any calculatons). (4 ponts)

8 21. A 1-month treasury note wth a face value of $1000 s sellng at $990 on a dscount bass. (a) If the annual rate of nflaton s expected to be 5%, what s the expected annual real nterest rate? (6 ponts) (b) Wll the nvestor (person buyng the note) be better off, f the actual nflaton turns out to be 6% nstead? (2 ponts)

9 22. Suppose you buy a consol wth a coupon of $100, and the current nterest rate s 7%. (a) What s ts sellng prce? (4 ponts) (b) Exactly 1 year later, the nterest rates rse to 10%. If your holdng perod s 1 year.e., you have to sell ths bond after one year, what prce wll you end up sellng at? Show your work. (2 ponts) (c) What s your effectve rate of return n part (b)? Show your work. (4 ponts)

10 SOLUTIONS 20. a)you are consderng two nvestment opportuntes for a perod of 2 years: Opton A - you can nvest n a 2-year tme depost n your bank at the annual nterest rate of 9.5%. Opton B - you can purchase one-year dscount bond wth a Face Value of $10,000 and then renvest all the proceeds nto another one-year dscount bonds. The current nterest rate s 9%. At the end of the frst year you expect that the nterest rates wll rse to 11%. Calculate the expected annual nterest rate on your nvestment for the entre 2-year perod (wth the renvestment) and decde whch opton would you prefer. (6 ponts) Answer: There are several ways to approach ths queston. Intutvely, f you look at the two nterest rates (frst year 9%, second year 11%) we can see that the annual nterest rate for the entre 2-year perod should be very close to ther average, 10%. As a result, we may already conclude that the opton B s better. To be more precse, we may do the followng calculatons: FV = PV *(1+ 1 ) *(1+ 2 ) = $1*( )*( ) = $ Now, we calculate annual rate for the entre 2-year perod: FV $ PV = => = 1 = 9.99% ~ 10% 2 (1+ ) $1 Note that I haven t used anywhere the fact that we are nvestng n a bond. If we do use that nformaton, the calculatons wll look as follows: Frst, we calculate the prce of the frst bond: $10,000 PV = = $9,174.3 ( ) and future value at the end of year two after renvestng all of the proceeds: Future Value = 2= Face Value*(1+ 2 ) = $10,000*( ) t = Now, we obtan the annual nterest rate: Future Value $11,100 PV = => = 1 = 9.99% ~ 10% 2 (1+ ) $9,174.3 $11,100

11 b) Now, assume that the nterest rates after the frst year rose only to 9.8%. Are you stll better off than f you would have nvested n the bank? Why? (Hnt: t s possble to answer ths queston wthout any calculatons). (4 ponts) In part a) we saw that when nterest rates are 9% and 10% the 2-year annual nterest was very close to 10%. We can nfer that when the nterest rates wll be 9% and 9.8% the 2- year annual rate wll be very close to ther average 9.4%, As a result, the bank would have been a better choce.

12 21. A 1-month treasury note wth a face value of $1000 s sellng at $990 on a dscount bass. (a) If the annual rate of nflaton s expected to be 5%, what s the expected real nterest rate? (6 ponts) Answer: We can use one of the followng formulas (Although they produce smlar results, the frst one does not assume compoundng and thus the resultng nterest rate s smaller): FV $1000 Prce = PV = => = 12( 1) = 12.12% $990 (1+ ) 12 or the alternatve formula: FV $1000 Prce = PV = => = ( 1) = 12.81% 1 $ (1+ ) Then the real nterest rate s: Expected real = nomnal π = 12% 5% = 7% 12 (b) Wll the nvestor (person buyng the note) be better off, f the actual nflaton turns out to be 6% nstead? (2 ponts) Actual real = nomnal π = 12% 6% = 6% Then nvestor wll be worse off (wll receve less n real terms).

13 22. Suppose you buy a consol wth a coupon of $100, and the current nterest rate s 7%. (a) What s ts sellng prce? (4 ponts) C $100 Prce = => Prce = = $ (b) Exactly 1 year later, the nterest rates rse to 10%. If your holdng perod s 1 year.e., you have to sell ths bond after one year, what prce wll you end up sellng at? Show your work. (2 ponts) C $100 Prce = => Prce = = $ (c) What s your effectve rate of return n part (b)? Show your work. (4 ponts) C + Pt Return = P + 1 t P t $100 + $1000 $ = $ = 23%