1-1. Chapter 1: Basic Concepts

Transcription

1 TEST BANK

2 1-1 Chapter 1: Basic Concepts 1. Which of the following statements is (are) true? a. A risk-preferring individual always prefers the riskier of two gambles that involve different expected value. b. A risk neutral individual is indifferent between receiving with certainty the expected value of a gamble and the uncertainty of the gamble itself. c. A risk neutral individual has a utility function which is linear in wealth. d. Both a and b. e. Both b and c. 2. Which of the following statements is (are) false? a. A risk-averse individual demands a premium for bearing risk. b. A risk-averse individual prefers a certain amount to a gamble with the same expected value. c. A risk-averse individual has a convex utility function. d. All of the above. e. None of the above. 3. With diversification, an investor can a. reduce risk and increase his return from holding risky assets. b. reduce risk due to imperfect correlation of returns among risky assets in his portfolio. c. reduce the market risk associated with holding a portfolio of risky assets. d. Both a and c. e. Both b and c. 4. There are two assets, A and B, with a standard deviation of 10 and 15, respectively. If the correlation coefficient between the two assets is 0.5, then a portfolio that consists of 0.4 of A and 0.6 of B has a standard deviation of a b c

3 1-2 Ans: a. d e Solution: ( ) ( ) ( ) ( ) ( )( )( )( )( ) = In problem 4, if the correlation coefficient is 1 and you want to completely eliminate the risk of the portfolio, then you will invest a. 0.3 in A and 0.7 in B b. 0.4 in A and 0.6 in B c. 0.6 in A and 0.4 in B d. 0.8 in A and 0.2 in B e. any combination will eliminate the risk completely since the correlation coefficient is 1 Solution: Let x be the proportion invested in A. Then, ( ) ( ) ( ) ( )( )( )( ) x x 15 2 x 1 x = 0 x= Suppose there are two risky assets, X and Y, and a riskless bond, B. There are two possible states (H and L) of the economy over the next period. X provides a payoff of $0 in state H and $50 in state L, while Y provides a payoff of $50 in state H and $0 in state L. B provides a payoff of $50 regardless of the states. X, Y, and B are currently selling for $30, $30, and $25, respectively. A possible riskless arbitrage opportunity is to a. buy one unit each of X and Y and sell one unit of B to get a riskless profit of $35 b. buy one unit of B and sell one unit each of X and Y to get a riskless profit of $35 c. buy one unit each of X and B and sell one unit of Y to get a riskless profit of $25 d. buy one unit each of Y and B and sell one unit of X to get a riskless profit of $25 e. there is no riskless arbitrage opportunity. Solution: One needs to have one unit of each X and Y (which costs $60) to replicate B s payoff. This suggests that selling a unit of X and Y and buy one unit of B will generate an arbitrage profit of $ Which of the following statements is (are) false about options? a. A call option is more valuable when the value of the underlying security is more volatile.

4 Arts: d. 1-3 b. An American option can never be worth less than a European option. c. An option buyer has the right, not the obligation, to buy or sell an asset at a predetermined price over a fixed time interval. d. A put option is more valuable when the value of the underlying security is less volatile. e. All of the above is false. 8. The efficient market hypothesis implies that a. investors have perfect forecasting ability. b. prices do not fluctuate. c. the market is irrational. d. competition among investors is such that one can earn only a normal return. e. all of the above. 9. If the role of financial intermediaries is to produce and process information, then they are least needed when a. the capital market is weak-form efficient. b. the capital market is semi strong-form efficient. c. the capital market is strong-form efficient. d. information is costly for individuals to obtain and process. e. none of the above. 10. A market is considered complete if a. there are more number of states of nature than there are securities. b. there are fewer number of states of nature than there are securities. c. there are as many securities as there are states of nature. d. it is frictionless. e. both b and d. 11. When a market is incomplete, a. subject to his budget constraint, an individual can achieve any desired distribution of income. b. an individual has a limited ability to manage uncertainty.

5 1-4 c. the introduction of new securities generally make individuals better off. d. both a and c. e. both b and c. Use the following information for questions There are two possible states of nature, s = 1, and s = 2, over the next period. There are two securities (i and j) whose current prices are $10 and $15, respectively. Security i has a payoff of $10 in state s = 1, and $16 in state s = 2, while security j provides $25 in state s = 1 and $8 in state s = What are the prices of the Arrow-Debreu securities in the two states? a in state s = 1 and in state s = 2. b. 0.3 in state s = 1 and 0.6 in state s = 2. c. 0.4 in state s = 1 and 0.75 in state s = 2. d. 0.5 in state s = 1 and in state s = 2. e. insufficient information. Solution: This involves solving two equations with two unknowns: 10 = 10p s1 + 16p s2 and 15 = 25p s1 + 8p s2, where p s1 and p s2 are the Arrow-Debreu prices in state s = 1 and s = 2, respectively. 13. A third security is introduced. It generates a payoff of $16 in state s = 1 and $24 in state s = 2. How many units of this new security can you buy if your initial wealth is $3,100? a. 200 units. b. 162 units. c. 154 units. d. 127 units. e. More information is needed. Ans: a. Solution: The price of this security is $15.5 (from the answer to #12 above). Thus, you can buy 200 units. 14. If you want to get a payoff of $16 in state s = 1 and $12.8 in state s = 2, how would you allocate your wealth between the two securities i and j? a. 10% in i and 80% in j.

6 1-5 b. 10% in j and 90% in j. c. 80% in i and 20% in j. d. 70% in i and 20% in j. e. 60% in i and 40% in j. Solution: Set 10x + 25(1 x) = 16 or 16x + 8(1 x) = 12.8 where x is the proportion invested in i. 15. In a market with asymmetric information, Ans: a. a. market failure may occur and therefore regulation may be needed b. individuals are unable to prevent market failure c. first-best outcome can always be achieved d. both a and c e. both b and c 16. Adverse selection is a situation where a. a party of a transaction undertakes an unobservable action at the detriment of the second party after contracting takes place b. a party of a transaction possesses an unobservable attribute which is unknown to the second party prior to contracting c. the informed party must send a costless signal to prevent market break down d. both a and c e. both b and c 17. An incentive compatibility condition is one where a. an agent must be offered at least his reservation utility in order to agree to a contract with the principal b. an agent must offer the principal at least her reservation utility in order to induce her to write a mutually beneficial contract c. an agent with a certain type does not have an incentive to mimic the action of another agent of different type d. both a and b e. both a and c

7 18. In order for a signal to be informative, 1-6 a. it has to be costly for the sender b. the cost of signal should be positively related to quality c. the first-best outcome must be attainable d. all of the above e. none of the above Use the following information for questions There are three types of cars, the good (G), the bad (B), and the ugly (U). A G car is worth $30, a B car is worth $15, and a U car is worth $0. A buyer cannot distinguish the quality of cars offered for sale, but the seller does. If there is equal probability of a car being G, B, or U, 19. Which car is offered for sale in equilibrium and at what price? a. B and U, at a price = $15 b. U only, at a price = $15 c. U only, at a price = $0 d. All cars will be offered for sale, at a price = $30 e. No cars will be offered for sale 20. Suppose the type G seller offers a warranty of $g and the type B seller offers $b. If the probability of failure is 0.1, 0.5, and 1 for types G, B, and U, respectively, what is the warranty offered by type G and B sellers to ensure incentive compatibility? a. $20, $15 b. $25, $15 c. $30, $30 d. $37.5, $30 e. $37.5, $37.5 Solution: Incentive compatibility requires g 0.5g 15 and b 0.1b 30. Solving these simultaneously generates g = $37.5 and b = $30. Use the following information for questions There are three types of cars, the good (G), the bad (B), and the ugly (U). A G car is worth $40, a B car is worth $20, and a U car is worth $15. The seller knows the precise quality of his car, but the buyer cannot distinguish the difference in the quality of a car offered for sale. There is an equal probability of a car being G, B, or U.

8 In equilibrium, which car is offered for sale and at what price? a. B and U, at a price = $25 b. U only, at a price = $17.5 c. U only, at a price = $15 d. U only, at a price = $0 e. No car will be offered for sale since the rational expectations price is $0 22. Suppose the seller of type G offers a warranty of $g, the type B seller offers $b, and the type U seller offers $u if the car fails. The probability of failure is 0.1, 0.6, and 0.9 for the G, B, and U types, respectively. An incentive compatibility condition is a. $40 0.4($g) $20 and $20 0.6($b) $15 b. $40 0.5($b) $20 and $20 0.6($u) $15 c. $40 0.5($g) $20 and $20 $u $15 d. $40 0.6($g) $20 and $20 0.9($b) $15 e. $40 0.5($g) $20 and $20 0.3($b) $15 Solution: The incentive compatibility conditions are as follows: (1) b 0.1b 40 and u 0.1u 40 for G not to mimic B and U, (2) g 0.6g 20 and u 0.6u 20 for B not to mimic G and U, (3) g 0.9g 15 and b 0.9b 15 for U not to mimic G and B. 23. A possible warranty scheme that can ensure incentive compatibility in question 20 is ($g, $b, $u) a. $50, $45, $5 b. $45, $15, $0 c. $45, $35, $0 d. $50, $5, $0 e. $25, $12.5, $0 Solution: This requires solving the incentive compatibility conditions described in the solution to question 22 above. The solution establishes g 31.25, g 40, 17 b 40, u 31.25, and u 17. Thus, c is the correct answer to ensure no mimicry. 24. With a dissipative signal, a. there is no social deadweight loss in the aggregate b. the receiver compensates the sender for the cost of the signal

9 1-8 c. the incentive compatibility condition will always be restored d. the sender absorbs some of the cost of signaling e. all of the above 25. Moral hazard is a situation where a. a self-interested agent has an attribute that is unknown to the principal prior to contracting b. the principal undertakes an action at the expense of the agent c. a self-interested agent undertakes an unobservable action at the expense of the principal and the outcome of that action contains some noise d. both a and b e. both b and c 26. Consider a firm with risky debt outstanding which requires a repayment one period hence. There are no taxes and the firm has a risky project that can be financed using retained earnings. Assume that the firm s manager acts in the best interest of the shareholders. In this scenario, moral hazard exists if a. the project has a positive net present value and is undertaken so as to maximize the firm s total value b. the project has a positive net present value and is undertaken to maximize the shareholders wealth c. the project has a negative net present value and is undertaken to maximize the shareholders wealth d. the project has a zero net present value and is undertaken e. moral hazard never exists 27. When there is moral hazard between a firm s shareholders and bondholders, the cost of moral hazard is borne by in equilibrium. a. the bondholders b. the firm s manager c. the government d. the shareholders e. both a and b

10 1-9 Use the following information for questions Consider a firm with $100 retained earnings. It has risky debt outstanding which requires a payment of $100 one period hence. The firm has a risky project which requires an investment of $50 today. If the project is undertaken, the shareholders get a liquidating dividend of $50 today. The state of nature one period hence is either High (H) or Low (L) with equal probability. If no investment is made today, the firm has a total value of $120 in state H or $80 in state L. If the investment is made, the firm s total value is $250 in state H or $10 in state L. Assume a discount rate of zero. 28. The firm s expected total value with the investment is a. $250 b. $200 c. $180 d. $110 e. $100 Solution: 0.5(250) + 0.5(10) + 50 = To maximize the shareholders wealth, the firm should a. Reject the project since it has a value = $40 to the shareholders b. Reject the project since it has a value = $15 to the shareholders c. Accept the project since it has a value = $110 to the shareholders d. Accept the project since it has a value = $125 to the shareholders e. Indifferent since the project has a zero net present value Solution: With no investment, the shareholders wealth is ( ) = 110. With the investment, the shareholders wealth is ( ) = What is the expected payoff to the bondholders if the project is undertaken? a. $85 b. $55 c. $30 d. $30 e. $55 Solution: 0.5(100) + 0.5(10) = 55.

11 A moral hazard problem can exist between a. a firm s shareholders and bondholders who hold riskless debt claim b. a firm s shareholders and managers c. a bank and a potential borrower who is applying for a loan d. all of the above e. none of the above 32. A time-consistent policy is one where a. the parties to a contract are free to renegotiate the contract at a later date b. the agent has no incentive to take an action to the detriment of the principal once the contract is agreed upon c. the principal can contract directly on the effort level chosen by the agent d. the parties to a contract has no incentive to renegotiate it at a later date e. both b and c 33. In a two-players (1 and 2) non-cooperative game, a strategy constitutes a Nash equilibrium when a. holding fixed the strategy of player 2, player 1 is better off choosing other strategies other than his equilibrium strategy b. holding fixed the strategy of player 1, player 2 is better off choosing other strategies other than his equilibrium strategy c. holding fixed the strategy of player 2, player 1 is better off with his equilibrium strategy than with other strategies d. holding fixed the strategy of player 1, player 2 is better off with his equilibrium strategy than with other strategies e. both c and d 34. Consider a game involving two players (1 and 2). Both players have two choices of actions, Left (L) or Right (R). If both players choose L, the payoff to both players is 5. If both choose R, they each get a payoff of 2. If player 1 chooses L and player 2 chooses R, the payoff is 2 for player 1 and 0 for player 2. If player 1 chooses R and player 2 chooses L, the payoff is 0 for player 1 and 2 for player 2. What is a Nash Equilibrium of this game?

12 1-11 a. Both players choose L b. Player 1 chooses L and player 2 chooses R c. Player 1 chooses R and player 2 chooses L d. All of the above e. None of the above Ans: a. Solution: A straightforward Prisoner s Dilemma game. Use the following information for questions Suppose you are a bank lending officer and you are trying to determine if it is worthwhile giving a loan to a potential borrower. You have a prior belief that a borrower is good or bad with equal probability. By gathering information you can determine, albeit imperfectly, whether an applicant is good or bad. If the applicant is good, there is a probability of 0.7 (0.3) that your signal reveals that he is good (bad). If the applicant is bad, there is a 0.4 (0.6) probability that your signal reveals that he is good (bad). 35. What is your posterior belief that an applicant is good when your signal tell you that he is good? a b c d e. Insufficient information Solution: ( ) 0.7( 0.5) ( ) + ( ) P G G = = What is your posterior belief that an applicant is bad when your signal tells you that he is goof? a b c d e Solution: ( ) 0.3( 0.5) ( ) + ( ) P G B = =

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14 2-1 Chapter 2: The Nature and Variety of Financial Intermediation 1. Broadly classified, a financial intermediary performs a. a brokerage function b. a qualitative asset transformation function c. as a monetary policy stabilizer d. a securities underwriting function e. both a and b 2. Which of the following statements is (are) true about the brokerage function? a. bringing together transactors of financial claims with complementary needs b. the broker has special information and can reuse that information c. the cost of using a brokerage service to an individual is the same as that which he must spend without the help of a broker d. the brokerage function usually results in a mismatch of assets and liabilities e. both a and b 3. Special information possessed by a broker a. can be used across different users b. can be used over time across the same borrower c. depreciates over time through consumption d. both a and b e. all of the above 4. Qualitative Asset Transformation involves Ans: a. a. a mismatch of assets and liabilities b. transforming a liquid asset into an illiquid one c. originating a loan d. screening a borrower e. all of the above 5. An investment banker who underwrites securities through a firm commitment contract performs

15 2-2 a. a brokerage function b. a qualitative asset transformation function c. both a and b d. a funding function e. a loan-originating function 6. With a best-efforts contract, an investment banker performs Ans: a. a. a brokerage function b. a qualitative asset transformation function c. both a and b d. a monitoring function e. as a firm s guarantor 7. Which of the following statements is (are) false about the qualitative asset transformation function? a. a financial intermediary monitors the borrower s compliance with loan covenants b. a financial intermediary creates liquidity through asset transformation c. a financial intermediary buys and sell securities d. a financial intermediary originates a loan e. a financial intermediary fluids a loan 8. Commercial banks a. serve as a monetary policy stabilizer b. serve as a provider and servicer of demand deposits c. usually have a high leverage ratio d. specialize mostly on residential mortgages e. a, b, and c are all correct 9. The federally-chartered banks are not regulated by a. The Federal Reserve System b. The Office of the Comptroller of the Currency c. The Federal Deposit Insurance Corporation

16 2-3 d. The Federal Home Loan Bank Board e. All of the above regulate banks 10. Which of the following statements is (are) not true? a. Commercial banks are all shareholder-owned b. The ownership of thrifts is often mutual c. Credit Unions are shareholder-owned d. Credit Unions typically have specialized asset portfolios e. Thrifts cannot conduct an underwriting business 11. Which of the following services is not currently offered by commercial banks? a. risk shifting services such as swaps b. working capital loan c. residential and commercial mortgages d. automobile loans e. management expertise 12. Which federal agency regulates insured state banks that choose not to join the Federal Reserve System? a. Office if Thrifts Supervision b. The U.S. Treasury c. The Resolution Trust Corporation d. The Federal Deposit Insurance Corporation e. The Office of The Comptroller of the Currency 13. Which of the following statements is (are) not true about thrifts? Ans: a. a. Thrifts have kept their capital ratios lower than banks following the thrift failures in the 1980s b. thrifts assets are mostly home mortgages c. thrifts are regulated by the Office of Thrifts Supervision d. FDIC provides a deposit insurance for thrifts e. thrifts ownership is usually mutual

17 Which of the following statements is (are) true? a. mutual savings banks are cooperatively owned b. like thrifts, mutual savings banks mostly invest in mortgage loans c. mutual savings banks were regulated by the FDIC d. both a and b e. a, b, and c are all correct 15. Thrifts specialize in mortgage lending because a. of tax incentives provided by Congress b. they have the management expertise to specialize in mortgage lending c. they are mandated under the FIRREA of 1989 to invest in mortgages d. both a and b e. a, b, and c are all correct 16. In terms of funding, thrifts are different from commercial banks in that Ans: a. a. thrifts rely on savings deposits as a source of funds b. rely on commercial loans as a source of funds c. rely on checking deposits as a source of funds d. rely on short-term money market securities as a source of funds e. rely on commercial banks as a source of funds 17. Which of the following statements is (are) not true? a. The formation of a credit union requires a common bond b. Federally chartered credit unions are regulated by the National Credit Union Administration c. Credit unions, due to their small size, cannot match the extent of services offered by a commercial bank d. To use the services of a credit union, one must be a member e. Credit unions have better ability to control credit risks due to their homogeneous borrower base

18 Typically, venture capitalists provide financing for companies. a. debt, start-up b. equity, start-up c. debt, prominent d. equity, established e. both debt and equity, start-up 19. Which of the following feature(s) characterize a typical venture capital contract? a. an earnout arrangement b. no de novo financing c. buyout option d. performance requirement e. all of the above 20. No de novo financing means a. that the entrepreneur can walk away after obtaining the financing to arrange a better deal with another financier b. that the entrepreneur is not allowed to continue to be in control of the company after the financing is obtained c. that the entrepreneur must satisfy a certain capital contribution requirement in order to obtain the financing d. that the entrepreneur cannot walk away after obtaining the financing to negotiate a better deal with another financier e. that the entrepreneur cannot be in control of the company until the financing is paid off 21. With the buyout option, the entrepreneur can a. buy out the venture capitalist in order to maintain control b. buy out the venture capitalist through a financing arrangement with a more sophisticated financier c. be bought out at a fixed amount by the venture capitalist and is relieved of control

19 2-6 d. be bought out by outside investors that the venture capitalist has a financing arrangement with e. buy out the venture capitalist and then sell the company to the general public 22. Which of the following statements is (are) true about the earnout arrangement? a. If the entrepreneur remains in control, the venture capitalist receives an equity payoff while the entrepreneur receives a flat payment b. If the entrepreneur remains in control, the venture capitalist receives a flat payment while the entrepreneur receives an equity payoff c. If the entrepreneur remains in control, both the venture capitalist and the entrepreneur receive a flat payment and outside investors receive an equity payoff d. If the entrepreneur remains in control, both the venture capitalist and the entrepreneur receive an equity payoff e. The entrepreneur is relieved of control and is given a flat payment while the equity payoff goes to the venture capitalist 23. The performance requirement specifies that a. the entrepreneur will be relieved of control by the venture capitalist if certain performance standard is not met b. the entrepreneur may be relieved of control by the venture capitalist if certain performance standard is not met c. the entrepreneur can be relieved of control by the venture capitalist at any time during the contract d. the entrepreneur will be given an equity payoff provided that a certain performance standard is met e. after a certain performance standard is met, the company can be sold to the general public 24. The reasons why the start-up companies obtain financing from a venture capitalist rather than a bank are a. the venture capitalist knows more about the firm s business than does a bank b. the venture capitalist has cheaper financing sources than a bank c. the venture capitalist has developed a considerable management skills in dealing with numerous ventures

20 2-7 d. the bank is prohibited by regulation to lend to start-up ventures e. both b and d 25. Which of the following functions is not usually performed by a finance company? a. a funding function b. a screening function c. a liquidity creation function d. a loan originating function e. a claim transformation function 26. Typical sources of financing for finance companies are a. demand deposits b. secured loans from banks c. unsecured loans from banks d. commercial paper e. all of the above 27. The major assets of finance companies are a. cash to be lent out b. loan receivables c. commercial paper d. certificates of deposit e. marketable securities 28. The difference between a commercial bank and a finance company is that a commercial is, while a finance company is ; and a bank lends on basis, while a finance company lends on basis. a. unregulated, unregulated, secured, unsecured b. regulated, largely unregulated, secured, secured c. regulated, regulated, unsecured, secured d. unregulated, regulated, unsecured, secured e. regulated, largely unregulated, both secured and unsecured, secured

21 29. Which of the following statements is (are) false about insurance companies? 2-8 a. Insurance companies are organized as mutuals b. Insurance companies have the same liabilities structure as commercial banks c. Insurance companies hold mostly the same kinds of assets as commercial banks d. Insurance companies perform a certification function e. all of the above are false 30. Commercial banks and insurance companies are different in that a. the duration of the insurance companies liabilities is much shorter than that of the commercial banks b. the duration of the insurance companies liabilities is the same as that of the commercial banks c. the duration of the insurance companies liabilities is much longer than that of the commercial banks d. commercial banks do not perform a certification function but insurance companies do e. both c and d 31. Which of the following functions is the key intermediary service performed by a pension fund? a. liquidity creation b. guaranteeing c. claim transformation d. funding e. both b and c 32. The primary difference between open-end and closed-end mutual funds is a. a closed-end fund does not stand ready to purchase its own shares when one of its owners sell them while an open-end fund does b. both a closed-end and open-end funds stand ready to purchase their own shares when one of their owners sell them c. a closed-end fund is typically traded on an organized exchange while an openend fund is not

22 2-9 d. both a and c e. both b and c 33. Which of the following services is not performed by a closed-end mutual fund? a. transaction b. risk diversification c. maturity transformation d. sharing the costs of investment management e. all of the above 34. The tremendous growth in the mutual funds industry can be attributed to a. an attempt to circumvent Regulation Q b. futile effort to beat the stock market c. an attempt to diversify internationally d. all of the above e. none of the above 35. Which of the following is not the key functions performed by an investment bank? a. screening b. origination c. transaction services d. guaranteeing e. liquidity creation 36. Which of the following was not the objective of the Glass-Steagall Act? a. discourage speculation in the financial markets b. restore confidence in the banking system c. promote a safe and sound investment banking environment d. prevention of conflicts of interest and self-dealing e. all of the above

23 Which of the following services is not offered by an investment bank? a. bringing new issues to the market b. making commercial loans c. trading and brokerage d. arranging a syndicate selling group e. financial advice 38. The key function provided by pawnbrokers are a. origination b. funding c. market completeness d. screening e. a, b, and c are correct 39. Loan sharks perform the following key function, except Ans: a. a. screening b. originating c. funding d. monitoring e. claim transformation 40. The following intermediaries perform a qualitative asset transformation function, except a. commercial banks b. finance companies c. insurance companies d. investment banks e. thrifts

24 3-1 Chapter 3: The What, How, and Why of Financial Intermediaries 1. Fractional reserve system means that a. an intermediary funds itself with demand deposits and holds all of those liabilities in the form of liquid assets b. an intermediary funds itself with demand deposits and holds only a fraction of those liabilities in the form of liquid assets c. an intermediary funds itself with all equity and holds only a fraction of it in the form of liquid assets d. an intermediary funds itself with commercial papers and holds a substantial portion of them in the form of liquid assets e. none of the above 2. Due to the nature of the fractional reserve banking, a bank a. is always exposed to interest rate risk b. is always exposed to credit risk c. is always exposed to a risk that the amount withdrawn by depositors exceeds the amount of cash available d. is never exposed to withdrawal risk e. can always hedge its risk exposure 3. Why would a goldsmith ever want to print more receipts than the amount of gold deposited? a. in a rational expectations equilibrium, gold was never withdrawn by the depositors b. the goldsmith had acquired a good reputation and therefore was allowed by the depositors to print more receipts c. the gold inventory was relatively stable over time so there was little withdrawal risk d. the goldsmith simply wanted to save the depositors the unnecessary needs to convert receipts to gold e. all of the above

25 What is the key service performed by a goldsmith? a. screening b. liquidity transformation c. monitoring d. funding e. origination 5. The trade-off faced by a goldsmith when deciding to print more receipts than the amount of gold available is a. between insolvency risk and interest rate risk b. between profitability and interest rate risk c. between interest rate risk and credit risk d. between profitability and credit risk e. between profitability and insolvency risk 6. The vulnerability of the fractional banking system is due to a. the volatility of interest rates b. the nature of demand deposits c. the illiquidity of loans d. both b and c e. a, b, and c are all correct 7. A possible solution to reduce the vulnerability of the fractional banking system is a. to create a private arrangement whereby banks agree to put their combined resources to help their members in difficult times b. to create a central bank as a lender of last resort c. to require all banks to invest in Treasury bills d. all of the above e. both a and b

26 Which of the following statements is (are) false? a. In the absent of the lender of last resort facility, the goldsmith would print unlimited volume of receipts. b. In the absent of the lender of last resort facility, the goldsmith would have an incentive to build his reputation and therefore the volume of receipts would be limited. c. The presence of the lender of the last resort facility strengthens the goldsmith s incentive to maintain his reputation. d. The presence of the lender of the last resort facility weakens the goldsmith s incentive to maintain his reputation e. both a and c **Use the following information for questions Suppose there is one depositor who earns an income of $100 in each period. She spends $50 for consumption and the remainder goes to her savings account. Assume that a bank doesn t do anything with this money except safeguards it. The bank charges $5 for safeguarding fee. 9. If the probability of theft is 0.2, what is the necessary and sufficient condition for personal safeguarding to be optimal? a. The personal safeguarding fee is $5 b. The personal safeguarding fee is less than $5 c. The personal safeguarding fee is greater than $5 d. The personal safeguarding fee is between $5 and $10 e. Any fee would make personal safeguarding optimal Solution: The personal safeguarding cost must be greater than $5. It also has to satisfy 50 personal safeguarding cost > 0.8(50) personal safeguarding cost < $ Suppose that there are now five depositors with the same pattern of income and consumption as in the original problem. There is a known fraction of 0.4 of the depositors who wish to withdraw at the end of the first period. The remaining depositors will withdraw at the end of the second period. What is the amount of money that the bank must have available at the end of the first period? a. $50 b. $90 c. $150

27 3-4 d. $180 e. $225 Solution: 0.4(5)(50 5) = $ Assume that there is a merchant who needs $100 to open a shop at t = 0. There are five depositors. The shop can generate a cash flow of $130 at t = 2. The bank charges the merchant a loan rate of 18%. However, due to moral hazard, the merchant must be monitored, and this costs $3. The merchant will a. borrow directly from the depositors since his expected payoff is $9 compared to borrowing from the bank which gives him an expected payoff of $6 b. borrow directly from the depositors since his expected payoff is $6 compared to borrowing from the bank which gives him an expected payoff of $9 c. borrow from the bank since his expected payoff is $9 compared to borrowing directly from the depositors which gives him an expected payoff of $6 d. borrow from the bank since his expected payoff is $6 compared to borrowing directly from the depositors which gives him an expected payoff of $9 e. not open his shop since his expected payoff is negative Solution: If the merchant approaches the depositors directly, his expected payoff is ( ) 3(100/50) = $6. If the merchant approaches the bank, his expected payoff is ( ) 3 = $ Suppose that there are two merchants who wish to borrow $100 at t = 0. There are five depositors who have the same pattern of income and consumption as in the original problem. How much can the bank promise to pay to the depositors in the aggregate if it does not pass along any profits it receives from the loan? a. $50 b. $75 c. $155 d. $225 e. $245 Solution: The amount to be safeguarded = $250, the cost of safeguarding = 50(5/50) = $5. Thus, the bank can promise to pay 250 ( )(5/50) = $245 in the aggregate.

28 A known fraction of 0.4 of the depositors will withdraw at t = 1. How much will they receive? a. $45 b. $90 c. $98 d. $135 e. $196 Solution: 0.4(250 ( )(5/50)) = $ Given that there are five depositors, 40% of them will withdraw at t = 1, and 2 merchants who need $100 each, will the bank have sufficient funds at t = 1 if the safeguarding fee is $5, and the monitoring cost is $3? a. No, it will only have $39 while it must pay $98 b. No, it will only have $98 while it must pay $135 c. Yes, it will have $98 to pay $98 d. Yes, it will have $135 to pay $135 e. Yes, it will have $196 to pay $135 Ans: a. Solution: The bank will have ( )(5/50) 2(3) = $39, but must pay $98 (question 13). 15. There are five depositors with the same pattern of income and consumption as in the original problem, a fraction of them (0.4) will withdraw at t = 1. If the bank charges $5 for safeguarding fee and it costs $3 to monitor a merchant, what is the minimum number of merchants that the bank can lend to without exposing itself to withdrawal risk at t = 1? a. zero b. one c. two d. three e. four Solution: The bank can lend to ( )( ( ) ( ( ) ) + ( ) = merchants.

29 16. If there are two merchants who wish to borrow $100 at t = 0, and the bank charges 18% loan rate, what is the bank s aggregate profit from lending? a. $66 b. $42 c. $36 d. $18 e. $0 Solution: 2(100)(0.18) = $ Suppose the banking industry is competitive. If the bank charges a loan rate of 18%, safeguarding fee of $5, and there are five depositors and two merchants, what would be the deposit interest rate that the bank can offer to the depositors? a. 18% b. 15.6% c. 13.5% d. 12.4% e. 10% Solution: ( )( ) ( ) ( ) ( ) 550 ( ) / 50 = 12.4%. 18. Suppose a bank doesn t have sufficient fund to meet the depositors withdrawal In this case, to maintain stability and public confidence in the banking system the government can a. close the bank, sell it, and distribute the proceeds to the depositors b. provide deposit insurance facility to prevent bank runs c. let the bank merge with another solvent bank which will then pay the depositors d. ask the bank to raise more equity to pay off the depositors e. both c and d 19. Why does the provision of deposit insurance weaken the incentive of the private market to discipline the banks? a. The banks no longer feel necessary to monitor the borrower since the withdrawal risk is practically eliminated. b. The banks no longer feel necessary to monitor the borrower since the credit risk has been eliminated.

30 3-7 c. The depositors no longer feel necessary to monitor the banks as the depositors payoff is now independent of the banks action. d. both a and c. e. both b and c. Use the following information for questions Suppose that the banking industry is competitive and it has zero equity. The effective legal reserve requirement is 25%. Assume that there are three banks, A, B, and C. Bank A initially receives $2,500 in deposits. 20. According to the Fixed Coefficient Model, what is the amount of excess reserves in Bank A? a. $500 b. $625 c. $1,250 d. $1,875 e. $2,500 Solution: (1 0.25)2,500 = $1, Suppose that the effective legal reserve requirement is now 40%. Bank A loans out its excess reserves, which are deposited in Bank B. How much excess reserves does Bank B have? a. $1,500 b. $1,000 c. $900 d. $750 e. $600 Solution: A s excess reserves = (1 0.4)2,500 = $1,500. B s excess reserves = (1 0.4)1,500 = $ The legal reserve requirement is now changed to 20%. Bank A receives an initial deposit of $2,500. Bank A has excess reserves which will be deposited in Bank B, which in turn, has excess reserves which will be deposited in Bank C. What does Bank C have in excess reserves?

31 3-8 a. $2,000 b. $1,600 c. $1,280 d. $1,000 e. $880 Solution: A s excess reserves = (1 0.2)2,500 = $2,000. B s excess reserves = (1 0.2)2,000 = $1,600. C s excess reserves = (1 0.2)1,600 = $1, The following are major tools of monetary policy, except a. reserve requirement changes b. open market operations c. discount rate changes d. sales and purchases of government securities e. controlling a borrower s credit risk 24. Suppose the government uses open market operations to buy Treasury securities from public. This will result in a. the increase in the public confidence about the stability of the monetary system b. the increase in the bank s incentive to hold Treasury securities c. the decrease in the batik s incentive to hold Treasury securities d. the increase in the amount of lending by the private sectors or banks e. the increase in the depositors incentive to withdraw from the banks and invest in the Treasury securities 25. When the government sell Treasury securities via open market operations, there will be a. an increase in the banks incentive to lend b. a decrease in the banks incentive to lend c. an increase in the investors incentive to buy the Treasury securities d. a general increase in the volatility of the banks stock price e. both c and d

32 With respect to the discount rate policy, an increase in the discount rate, other things equal, will a. increase the amount of lending by banks b. decrease the amount of lending by banks c. not change the amount of lending by banks d. reduce the borrower s credit risk e. make the banks more prone to withdrawal risk 27. Other things equal, a decrease in the discount rate will a. reduce the amount of lending by banks b. not change the amount of lending by banks c. spur lending by banks d. signal to the general public that the stock market is too volatile e. induce the banks to hold Treasury securities 28. Other thing equal, an increase in the reserve requirement will a. induce the depositors to withdraw money from the banks b. increase the amount of deposits available for lending c. reduce the amount of deposits available for lending d. not change the amount of funds available for lending e. induce the banks to invest in Treasury securities 29. A reduction in the legal reserve requirement will, other things equal, a. reduce the depositors incentive to run the banks b. reduce the amount of funds available for lending c. induce the banks to buy back their stocks d. increase the amount of lending by banks e. both b and c Use the following information for questions Suppose there are assets whose owners wish to attract capital. Due to adverse selection problem, a cost must be incurred in order to learn the value of those assets. There are

33 3-10 individuals who specialize in producing information about firms. It costs the information producer (i.p.) $5 to produce information. The i.p. is risk averse and has a utility function of X where X is the i.p. s wealth. Each i.p. has an alternative employment which provides a minimum level of expected utility of $30. Suppose that the owners of the assets approach the i.p. directly, and assume that they can monitor the i.p. to learn if the i.p. has invested in information production. The monitoring is noisy and it says that the i.p. produced information with probability 0.6 and did not produce information with probability 04. If the i.p. did not produce information, the signal says that he did with probability 0.5, and that he did not with probability 0.5. Suppose the asset owners tell the i.p. that they will pay $H if the i.p. produced information and $L if he did not. 30. What is the incentive compatibility condition for the i.p. compensation (i.e., that induces the i.p. to produce information)? a. 0.2 H L 30 b. 0.6 H L 35 c. 0.4 H L 35 d. 0.5 H L 5 e. 0.1 H 0.1 L 5 Solution: The expected utility if the i.p. produces information is 0.6 H L 5. If the i.p does not produce information, the expected utility is 0.5 H L. Thus, e is the correct answer. 31. To make sure that the i.p. has an incentive to produce information, his compensation must satisfy a. 0.5 H L 25 b. 0.4 H L 25 c. 0.4 H L 30 d. 0.6 H L 30 e. 0.6 H L 35 Solution: 0.6 H L Therefore, e is the correct answer. 32. What is the amount of compensation (H and L) that will solve this problem? a. H = $2,000 and L = $150 b. H = $2,500 and L = $50

34 3-11 c. H = $3,025 and L = $25 d. H = $3,600 and L = $0 e. H = $3,600 and L = $25 Solution: Solve answer e (question 30) and answer e (question 31) simultaneously to get L = $25, and H = $3, What is the expected cost of information production? a. $1,825 b. $1, c. $2,160 d. $2, e. $2,500 Solution: 0.6(3,025) + 0.5(25) = $1, When two or more information producers coalesce by forming a financial intermediary to cooperatively generate information about particular firms, a. there is a diversification effect which serves to reduce the risk of individual information producers b. there is an increase in the expected cost of information production since the firm that hires the information producers have to pay more c. the individual information producers can increase their expected utility and to the extent that the benefits of this increased utility is shared with the firm, there is a reduction in the expected cost of information production d. both a and b e. both a and c 35. What is the benefit of having a large financial intermediary consisting of many information producers? a. information reusability b. information reliability c. reduction in the expected cost of information d. both b and c e. a, b, and c are correct

35 Inside debt is a. debt incurred by the firm s insiders b. the amount of money raised by the firm s insiders c. a contract giving the creditor access to the firm s inside information d. the amount of money owed to the firm s employees e. a contract that empowers the creditor to seize the firm s assets in the event that the firm defaults 37. What are (is) special features of bank loans that make non-bank financial contracting more efficient? a. Bank loans are always secured. b. Bank.loans are usually short-term. c. Bank loans require periodic evaluations and renewals. d. There is a lower financing cost associated with bank loans. e. Both b and c. 38. Which of the following statements is (are) true? a. The owners of a mutual S&L are its depositors, whereas the owners of a stock S&L are its shareholders. b. A stock S&L can raise its capital by selling equity, whereas a mutual cannot. c. Both a mutual S&L and a stock S&L can increase capital by selling equity. d. Both a and b. e. Both a and c. 39. The differences in the ownership structure of a stock S&L and a mutual S&L can lead to a. a higher incidence of an agency problem between the owners and managers in a stock S&L than a mutual S&L b. a higher incidence of an agency problem between the owners and managers in a mutual S&L than a stock S&L c. a diseconomy of scope in mutual S&Ls d. both a and c e. both b and c

36 The increased number of conversion from mutual S&Ls to stock S&Ls in recent years can be attributed to a. an increase in competition as the stock S&Ls are more efficient than mutual S&Ls b. managers of mutual S&Ls found it more costly to consume perks excessively c. the deposit insurance eliminated the agency cost of debt advantage of the mutuals d. all of the above e. both a and c 41. Which of the following statements is (are) false? a. When a firm is young, it usually has an entrepreneur with no established management expertise b. When a firm is young, it may find it in the best interest to approach a bank that can provide a secured loan c. When a firm is mature and has established credit histories, it may find it easier to raise money from the capital market d. When a firm is young, approaching a venture capitalist is usually the preferred way to raise a financing e. All of the above

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38 1. Default risk for a bank is 4-1 Chapter 4: Major Risks Faced by Banks a. the risk that the bank fails to make a contractual payment to the depositors b. the risk that the depositors fail to make a deposit to the bank c. the risk that the bank s borrowers fail to fulfill their repayment obligations on a timely basis d. the risk of bank failure that can cause the government to bail it out e. none of the above 2. The source(s) of default risk is (are) a. theft b. cash flow variations beyond the borrower s control c. moral hazard d. both b and c e. a, b, and c 3. To control default risk, the bank can a. buy or sell futures contracts to hedge b. screen the borrowers c. write covenants in the loan contract d. all of the above e. both b and c 4. Interest rate risk is a. the risk that arises from lending to a borrower below the market interest rate b. the risk that arises from the movement of general interest rates which cause the bank s publicly traded assets and liabilities to be revalued by the market. c. the risk that the depositors get a smaller amount when they withdraw their deposits d. both a and b e. both b and c

39 When interest rate goes up, a. the bank may lose money as some borrowers will refinance their loans b. the bank may make a profit as some borrowers will refinance their loans c. if the borrowers have an option to prepay, the borrowers are less likely to refinance their loans d. the bank will charge lower borrowing rate to attract new borrowers e. both b and d 6. One way to control interest rate risk is a. to have the FDIC insurance b. to engage in a hedging strategy c. to have a private arrangement with an insurance company d. to finance loans with equity e. all of the above 7. For a given change in the market interest rates, a portfolio consisting of a proportion of long-term assets will have a price fluctuations a. greater, smaller b. smaller, greater c. greater, greater d. smaller, smaller e. both c and d 8. In banking, liquidity risk is a. the risk faced by a borrower that the lender may not renew a loan that the borrower wishes to renew b. the risk faced by a bank that the depositors would unexpectedly withdraw their deposits and it has less than sufficient amount to meet the withdrawals c. the risk that the bank cannot raise more deposits or equity to meet withdrawals made by the depositors d. both a and b e. both b and c

40 Liquidity risk can manifest in a. an inability to sell an asset at any price b. an inability to borrow from the bank regardless to what the price a borrower is willing to offer c. an inability to hedge against fluctuations in the deposit interest rates d. both a and b e. both b and c 10. The central element(s) of liquidity risk is(are) a. the speed at which deposits can be raised b. the speed at which an asset can be sold c. the asset sold should not lose much of its value at the time of conversion d. the asset can be sold at any price e. both b and c 11. The term structure of interest rates a. describes the relationship between the holding period yield of debt instruments with similar interest rate risk characteristics b. describes the relationship between the yield to maturity of debt instruments with similar default risk characteristics c. describes the relationship between the holding period yield of debt instruments with similar default risk characteristics d. describes the relationship between the yield to maturity of debt instruments with similar interest rate risk characteristics e. both b and c 12. An inverted yield curve indicates that a. the short-term yields are higher than the long-term yields b. the short-term yields are lower than the long-term yield c. the yield to maturity increases with maturity d. the yield to maturity decreases with maturity e. both a and d