Compare and contrast the characteristics of the securities of the money market with those of the cap

CHAPTER 6 TRUE/FALSE QUESTIONS (T) 1. If interest rates are expected to increase in the future, one would expect to see an upward sloping yield curve (F) 2. The major reason that municipal bonds have lower yields than corporate bonds is that, as a class, municipal debt has less marketability than corporate debt. (F) 3. A downward sloping yield curve forecasts higher future interest rates. (F) 4. A downward sloping yield curve is typically seen just before an economic expansion. (T) 5. The less marketable a security, the higher its yield. (T) 5. Default risk premiums are usually smaller during periods of high economic growth. (F) 6. Bonds rated Baa would have higher yields than Aaa bonds, and higher prices, everything else the same. (T) 7. Callable bonds have higher market yields than noncallable bonds. (F) 8. The call price of a bond is usually below the bond's par value. (T) 9. Expected higher rates of inflation will lead to an upward sloping yield curve. (F) 10. The higher the marginal tax rate of an investor, the lower the after-tax return on any security.

(F) 11. Liquidity premiums cause an observed yield curve to be less upward sloping than that predicted by the expectations theory (T) 12. A delay in the coupon payment on a bond would imply an increase in default risk. (T) 13. An investor in the 33 percent tax bracket will buy a 6 percent municipal bond rather than a similarly rated 8.5 percent corporate bond. (F) 14. A put option sets a "floor" or minimum price of a bond at the exercise price, which is generally at or above par value. (F) 15. A convertible bond will generally have a higher market yield relative to similar, nonconvertible bonds. (F) 16. Treasury and corporate security yields may be combined when plotting a yield curve. (F) 17. Putable bonds offer higher yields than similar non-putable bonds (F) 18. A descending yield curve forecasts higher short-term rates in the future. (T) 19. The market segmentation theory allows for the possibility of a discontinuous yield curve. (T) 20. According to the preferred habitat theory, investors may change their preferred maturity in response to expected yield premiums. MULTIPLE CHOICE QUESTIONS (b) 1. Which of the following statements about bonds is not true? a. The greater the default risk, the greater the yield. b. Bonds selling at premium are especially high quality. c. The less marketable a bond, the higher the yield. d. Municipal bonds have lower yields than similar corporate bonds. (b) 2. Which of the following statements is true? a. Interest rates move inversely with economic activity. b. Default risk premiums vary inversely with economic activity. c. Municipal bond yields are usually higher than similar risk corporate yields.

d. Treasury bond yields are always higher than Treasury bill yields. (a) 3. A bond investor is more likely to exercise a put option in a bond contract if a. interest rates increase. b. interest rates decrease. c. the default risk of a bond decreases. d. tax-free municipals are now available.

(a) 4. The term structure of interest rates a. describes the relationship between maturity and yield for similar securities. b. ranks security yield according to the default risk structure. c. describes how interest rates vary over time. d. describes the pattern of interest rates over the business cycle. (c) 5. The yield curve is a plot of a. maturity changes as risk changes. b. yields by varied risk-taking of varied bond issuers. c. yields by maturity of securities with similar default risk. d. interest rates over time past. (d) 6. The source of data for a yield curve might be a. bond yield by issuers over time. b. historical Treasury security yields. c. realized Treasury security yields by time. d. outstanding Treasury security yields by maturity. (c) 7. An upward sloping yield curve indicates that security investors expect future interest rates to _____ and security prices to ______. a. fall; fall. b. fall; rise. c. rise; fall. d. rise; rise. (a) 8. A downward sloping yield curve indicates that future short-term rates are expected to ______ and outstanding security prices will _______. a. fall; rise. b. fall; fall. c. rise; rise. d. rise; fall. (b) 9. According to the expectation theory of the term structure of interest rates a. investors prefer holding short-term securities. b. the shape of the yield curve is determined by investors' expectations of future short-term interest rates. c. institutional investors' maturity preferences determine the shape of the yield curve. d. both a and b are true. (c) 10. Calculate the one-year forward rate three years from now if three- and four-year rates are 5.50% and 5.80%, respectively? a. The rate cannot be calculated from the information above. b. 6.2% c. 6.7% d. 5.6% (b) 11. If three-year securities are yielding 6% and two-year securities are yielding 5.5%, future short-term rates are expected to ______, and outstanding security prices are expected to ______. a. fall; fall. b. rise; fall. c. fall; rise. d. rise; rise

(c) 12. With reference to the question above, what is the expected one-year rate two years from now as implied by the two actual rates above? a. 6.4% b 4.7% c. 7.0% d. 5.8% (d) 13. The major determinants of the bond ratings assigned by Moody's or Standard and Poor is a. marketability. b. tax treatment. c. term to maturity. d. default risk. (a) 14. Default risk premiums vary _______ with the ________ of the security? a. directly; default risk b. inversely; default risk c. similar; price d. forward; size The following interest rates prevail in the market and are used to answer the next three questions. 90-dayTreasury bills8.36 percent180-dayTreasury bills8.48 percent3-yearTreasury securities9.25 percent2-yearTreasury securities 9.10 percent90-dayCommercial paper9.15 percent3-yearCorporate bonds (AA) 10.1 percent3-yearMunicipal (AA) 7.10 percentExpected 2-year inflation rate3.50 percent(d) 15. With reference to the data above, which security below did the market view as having the greatest default risk? a. 90-day Treasury securities b. 180-day Treasury securities c. 10-year Treasury securities d. 90-day Commercial paper (c) 16. With reference to the data above what is the expected real rate of return on the 2-year Treasury security? a. 12.6% b. 3.5% c. 5.6% d. 4.2% (c) 17. With reference to the data above, what is the default risk premium on commercial paper? a. 9.15% b. 0.95% c. 0.79% d. 0.55% (b) 18. With reference to the data above, calculate the one-year forward rate on Treasury securities two years from now? a. 8.86% b. 9.55% c. 9.10% d. 9.18% (d) 19. At what tax rate would an investor be indifferent between holding the 3-year municipal or 3-year corporate bond? a. 33% b. 18% c. 3% d. 30% (b) 20. With reference to the data above, calculate the default risk premium on the 3year corporate bond. a. 0.95% b. 0.85% c. 10.10% d. There is no default risk on the bond. (d) 21. With reference to the data above, the yield curve slopes _______, indicating the market expectation of ______ future short-term rates. a. downward; falling b. downward; rising c. upward; falling d. upward; rising (d) 22. Which of the following statements about interest rates is true? a. Interest rates generally tend to move together. b. The expected rate of inflation influences the level of interest rates. c. At the bottom of the business cycle, the yield curve is typically upward sloping. d. all the above are true (d) 23. Which of the following statements is true? a. The more marketable a security, the higher its yield. b. The longer the term to maturity, the greater its yield. c. Putable bonds offer higher yields than similar non-putable bonds d. Taxable bonds have to offer higher before tax yields than comparable taxexempt bonds. (c) 24. Which of the following statements about callable bonds is not true? a. Callable bonds have higher yields than comparable noncallable bonds. b. The call price is usually above the bond's par value. c. The shorter the term to maturity, the greater the call interest premium. d. Investors are notified when bonds are called. (c) 25. Bond A is not callable; bond B is callable. Investors will want a higher yield on bond __ and will pay ____ for the bond. a. A; less b. A; more c. B; less d. B; more

(d) 26. Federal Agency securities have higher yields than similar Treasury securities because they a. have greater default risk. b. have greater tax liability. c. are less marketable. d. both a and c (b) 27. Current interest rates are 7 percent. If inflationary expectations increased from the current 5 percent to 3 percent, what would be the new market interest rates? a. 9 percent b. 5 percent c. 10 percent d. 4 percent Answer the following questions with reference to the following data. Treasury Bills, 90 days 4.20% Commercial Paper, 90 days 4.84% Treasury Bill, 1 year 4.67% Treasury Note, 2 year 5.25% Corporate Bond AA, 20 year 8.23% Municipal Bond AA, 20 year 6.42% Expected Annual Inflation Rate 3.00% (d) 28. With reference to the data above, the default risk premium on the 90-day commercial paper above is a. 4.03%. b. 3.39%. c. 0.17%. d. 0.64%. (b) 29. With reference to the above data, what is the expected default loss rate on the 90-day commercial paper? a. 403 basis points b. 64 basis points c. 17 basis points d. zero basis points (b) 30. With reference to the data above, the implied one-year forward rate (expected one-year rate one year from now) on Treasuries is a. 4.67%. b. 5.83%. c. 0.58%. d. 4.09%. (a) 31. With reference to the above data, at what marginal tax rate would an investor be indifferent between owning the corporate bond and the municipal bond? a. 22% b. 28% c. 18% d. 20% (b) 32. With reference to the above data, what is the approximate expected pre-tax real rate of return on the one-year Treasury bill? a. 3.00 b. 1.67% c. 4.67% d. 0.13% (c) 33. With reference to the data above, what is the expected after-tax real rate of return on the one-year Treasury Bill for an investor in the 33 percent marginal tax bracket? a. 1.11% b. 3.13% c. 0.13% d. -1.11% (e) 34. Yield differences between two securities may be explained by differences in a. maturity. b. default risk. c. marketability. d. call provision. e. all of the above (c) 35. Yield difference in Treasury securities of varied maturities may be explained by a. marketability. b. default risk. c. expectations of future inflation. d. all of the above (c) 36. Applying the expectations theory, a bank depositor has the option of purchasing a oneyear CD at 5 percent and a 5.5 percent two-year CD. If indifferent between the two, the depositor must expect one-year CDs one year from now to have a rate of a. 6.5 percent. b. 4.5 percent. c. 6 percent. d. 5 percent. (c) 37 The liquidity premium theory of the term structure of interest rates is best supported by what type of yield curve? a. a decreasing curve over time. b. a flat yield curve. c. an increasing yield curve over time. d. none of the above. (a) 38. What actions by bond investors, given their expectations of increasing interest rates, results in an upward sloping yield curve? a. selling long-term securities and buying short-term securities. b. buying long-term securities and selling short-term securities. c. selling short-term securities and holding cash.

d. selling long-term securities and holding cash. (c) 39. A bondholder in the 30 percent tax bracket owns a $1000 Treasury bond with an 8 percent coupon rate. Calculate the after-tax return on the bond. a. 8 percent b. 2.4 percent c. 5.6 percent d. 30 percent (c) 40. The yield differentials between an AAA corporate bond and a BAA corporate bond of the same maturity may be explained by a. marketability. b. tax treatment. c. default risk. d. term to maturity.

(b) 41. Which of the following bonds probably has the highest call interest premium? a. a low coupon, short-term corporate note in an increasing rate market b. a high coupon rate bond in a falling interest rate market c. a high coupon rate bond in a rising interest rate market d. a low coupon rate bond in an increasing interest rate market (c) 42. Which of the following statements explains the liquidity premium theory of the term structure of interest rates? a. Investors will pay higher prices for longer-term securities. b. Investors demand a higher yield for securities that cannot be sold quickly at high prices. c. Investors demand a higher return on longer-term securities with greater price risk and less marketability. d. Investors will pay higher prices for securities with greater price risk and less marketability. (a) 43. Which of the following theories of the term structure of interest rates best explains discontinuities in the yield curve? a. the market segmentation theory b. the liquidity premium theory c. the expectations theory d. the loanable funds theory (c) 44. Commercial banks, savings and loan associations, and finance companies traditionally have better profits when a. the level of interest rates were expected to fall sharply. b. the yield curve had a descending slope. c. the yield curve had an ascending slope. d. loan losses were increasing. (a) 45. Historically, high default premiums have been associated with a. economic recessions. b. economic boom periods. c. generally rising interest rates. d. the number of bonds rated by Moody's and Standard & Poor's. (b) 46. Bonds are called speculative grade or junk bond if their Moody's and Standard & Poor's rating is a. above Baa (BBB). b. Baa (BBB) and below. c. B1 (B+) and below. d. A1 (A+) and below (c) 47. All but one of the following are considered when assigning a bond rating? a. the variability of earnings b. the expected cash flow c. the rating on the prior issue of securities sold d. the amount of the fixed contractual cash payments (a) 48. An investor is more likely to exercise a put option on a bond when a. interest rates are expected to increase. b. interest rates are expected to decrease. c. the security's price is expected to increase. d. the security's rating is upgraded by Moody's. (b) 49. A convertible bond is most likely to be converted when a. stock price levels are declining. b. stock price levels are increasing. c. the interest levels are decreasing. d. the company's rating have been downgraded by Standard & Poor's. (c) 50. Which of the following is true? a. Convertible bonds offer higher yields than similar nonconvertible bonds. b. Putable bonds offer higher yields than similar nonputable bonds. c. Bonds with call options must offer higher interest rates than similar noncallable bonds. d. All Treasury securities offer lower rates than any securities issued by business firms. (c) 51. Contingent Convertible bonds (CoCos) are not similar to ordinary convertible bonds because: a. CoCos are convertible to the firm’s preferred stock while the ordinary convertible bonds are convertible to the firm’s common stock. b. CoCos offer a higher coupon than ordinary convertible bonds. c. Cocos are convertible into stock only if the firm’s stock price hits a certain level. d. Ordinary convertible bonds are converted to the firm’s stock if the firm’s stock falls below a certain level. (a) 52. Suppose we consider a yield curve that has taken into consideration both the expectations theory and the liquidity premium theory. Assume the yield curve is initially downward sloping. If liquidity premium theory is no longer important, the yield curve you would expect to see would be: a. more steeply downward sloping b. more upward sloping c. less steeply downward sloping d. none of the above. (b) 53. According to expectations theory, an investor who believes that interest rates are likely to decrease in the near future would a. would invest in short-term securities immediately. b. would invest in long-term securities immediately. c. would sell long-term securities from her portfolio. d. would sell short-term securities from her portfolio. (b) 54. According to expectations theory, if the market believes that interest rates are likely to decrease in the near future, it would lead to: a. An increase in the demand for short-term securities. b. An increase in the demand for long-term securities. c. A decrease in the supply of short-term securities. d. An increase in the supply of long-term securities. (c) 55. According to expectations theory, if the market believes that interest rates are expected to increase in the near future, a. borrowers would immediately increase their supply of short-term securities. b. investors would immediately increase their demand for long-term securities. c. borrowers would immediately increase their supply of long-term securities. d. neither borrowers nor investors would do anything until the interest rates actually increased.

ESSAY QUESTIONS 1. List and discuss five basic factors which explain the differences in interest rates on different securities at any point in time. Answer: Five basic factors, which may explain yield differences include term to maturity, default risk, tax treatment of income of security, marketability, call, put, or convertible options associated with the security. 2. Explain how the term structure of interest rates can be used to help forecast future economic activities. Answer: The greater weight give to the expectations theory, that long-term yield represent the geometric average of current and expected short-term rates, for explaining the shape of the yield curve, the greater the interest rate forecasting ability of the yield curve. An upward sloping yield curve predicts higher short-term rates in the future. 3. Explain why municipal bonds have lower yields than comparable corporate taxable bonds. Answer: An investor is concerned with the after-tax yield earned, so will bid up the prices (lower yields). The message: lower taxes; lower interest rates. 4. Define the term default risk premium. Why does the "premium" represent the "expected default loss rate"? Explain how and why default risk premiums vary over the business cycle. Answer: The default risk premium, the difference between a risky security and a U.S. Treasury security of similar term, is the investors’ expected default loss rate on a portfolio of similarly rated securities. If the investor in a portfolio of similarly rated securities lost the default risk premium every year, the realized yield would equal an investment in a similar term U.S. Treasury security. Default risk premium vary directly with the business cycle, narrowing with growth and expansion of the economy; widening during recession and business restructuring. 5. How do bond options such as a call, put, and convertibility influence the yields on securities relative to bonds without such options? Answer: Options in bond contracts are valuable for the holder of the option. A call option, the option to redeem the bond issue early, is a valuable option to the bond issuer. Because of call risk, investor will price the callable bond lower or price to yield a higher yield. CHAPTER 7 TRUE-FALSE QUESTIONS (T) 1. Many diverse institutions borrow in the money markets, while relatively few invest. (T) 2. All money market instruments are short-term debt. (F) 3. Treasury bills are sold on a discount basis, with interest paid separately at maturity. (T) 4. Commercial banks act as dealers and are major investors in Treasury securities. (F) 5. For large corporations, commercial paper is more expensive but is a more assured alternative to bank borrowing. (T) 6. Commercial paper is more likely to be placed directly by large finance companies. (F) 7. The Federal Funds market is not available for the smaller, regional bank. (T) 8. Bankers' acceptances are used primarily for financing international trade. (F) 9. Eurodollars are dollar denominated, foreign-owned deposits in U.S. banks. (T) 10. The 24-hours-a-day market for U. S. Treasury securities is an example of the globalization of financial markets. (F) 11. Consumers most often have only indirect access to the money market through commercial banks. (T) 12. The money market is a dealer market, not an exchange, and has no specific location. (T) 13. Money market borrowers are small in number compared to money market lenders. (T) 14. The money market is a market where liquidity is bought and sold. (T) 15. Commercial banks are the major issuer and investor of money market securities. (T) 16. Federal Reserve open market operations, reserve requirement changes, and discount rate policy first impact the economy in the money market. (F) 17. Dealers bring buyer and seller together; brokers make a market. (F) 18. Much of the added yield provided investors in "agency" issues is attributed to their higher default risk. (T) 19. Commercial banks are important indirect guarantors of commercial paper. (F) 20. Interest arbitrage keeps the interest rates of the many money market securities equal. (F) 21. Lower marginal tax rates increase the demand for tax-exempt securities. (T) 22. The money market provides liquidity for deficit units; the capital market finances economic growth. (F) 23. Competitive bids in T-bill auctions require the bidder to specify only the quantity desired. (T) 24. Non-competitive bidders in the U. S. Treasury security auctions pay the weighted average price of all accepted competitive bids. (F) 25. Reverse repos are contracts that require a firm to first sell securities with the agreement to buy them back in a short period at a higher price.

MULTIPLE-CHOICE QUESTIONS (b) 1. Which of the following is not a characteristic of money market instruments? a. short-term to maturity b. small denomination c. low default risk d. high marketability (d) 2. Small investors are likely to invest in the money market through . a. directly; commercial paper b. locally; their credit union c. indirectly; negotiable CDs d. indirectly; money market mutual funds (a) 3. Which of the following statements about the money market is true? a. The money market is a dealer market linked by efficient communications systems. b. Money market transactions are seldom over $1 million. c. Market transactions include more "primary market" trades for a security than secondary market trades. d. Most money market transactions are conducted by mail. (d) 4. Which statement is nottrue about Treasury bills? a. They have maturities less than one year. b. Most are sold by "book-entry" method. c. They are sold at a discount. d. They are tax free. (a) 5. Which of the following may be a liability of a non-financial business corporation? a. commercial paper b. Federal Funds c. Treasury securities d. agency securities (d) 6. Federal Funds are typically a. Treasury deposits. b. Federal Reserve assets. c. commercial bank deposits at the Federal Reserve. d. overnight loans settled in immediately available funds. (c) 7. The most important money market instrument utilized in the Fed's open market operation is a. Federal Funds. b. commercial paper. c. Treasury bills. d. Agency securities. (d) 8. Banks can satisfy their short-term borrowing needs by a. Federal Funds purchased. b. Federal Funds sold. c. issuing negotiable CDs. d. both a and c (c) 9. Which of the following statements is not true about repurchase agreements? a. These are a form of secured borrowing by a bank. b. They are settled in federal funds. c. These are seldom used by the Federal Reserve for making temporary reserve positions adjustments. d. Treasury securities are often used in this type of transaction. (b) 10. Which of the following money market instruments would typically be used in international transactions? a. a Treasury bill b. a banker's acceptance c. commercial paper d. a negotiable CD (d) 11. The money market is an important financial market because a. the money market is the world's liquidity market. b. it is the market in which the Fed conducts monetary policy. c. the federal government finances most of its credit needs in the money market. d. all of the above (a) 12. Which of the following money market securities is usually not found on a commercial bank's balance sheet? a. Ba rated corporate bonds b. Treasury bills c. certificates of deposit d. banker's acceptance

(d) 13. The money market security represented by the largest dollar amount outstanding is a. commercial paper. b. federal agency issues. c. negotiable CDs. d. Treasury bills. (c) 14. Which of the following bank money market securities is backed by specified collateral? a. negotiable CDs b. banker's acceptances c. repurchase agreements d. commercial paper (d) 15. Money market securities have very little a. default risk. b. price risk. c. marketability risk. d. all of the above. (d) 16. An important economic function of the U.S. government security dealer is to a. underwrite Treasury securities. b. "make a market" for Treasury securities. c. support open market operations of the Federal Reserve. d. all of the above (d) 17. Large industrial U.S. corporations are involved in the money market by a. investing excess cash balances. b. buying and selling goods on credit in international trade. c. issuing commercial paper. d. all of the above (d) 18. Banks invest in government securities for a variety of reasons except a. income. b. safety. c. acceptable for collateral. d. high relative yield. (a) 19. Even a small bank can even finance in the money market by a. investing in negotiable CDs. b. selling federal funds. c. purchasing federal funds. d. buying banker's acceptances. (a) 20. Which of the following money market rates is studied closely for indicators of changes in Federal Reserve monetary policy? a. Federal Funds b. Treasury bills c. commercial paper d. banker's acceptances (b) 21. When firms issuing commercial paper use a backup line of credit, it: a. increases the credit risk for investors b. decreases the credit risk for investors c. has no impact on investors d. decreases the marketability of commercial paper

(b) 22. The bank discount rate on a $100,000 face value T-bill priced at $97,500, maturing in 181 days is:

a. 4.84%

b. 4.97%

c. 5.10%

d. 5.17%

(b) 23. The bank discount rate (ask) on a 91-day T-bill is 5.35%. What is the price of the $1000 T-bill?

a. $976.40

b. $986.48

c. $981.20

d. $989.45

(c) 24. The bank discount rate (ask) on a 71-day T-bill is 4.86%. What is the bond equivalent yield on the T-bill?

a. 4.86%

b. 4.92%

c. 4.98%

d. 5.14%

(b) 25. Calculate the holding period return on a 52-day T-bill selling for 98.555% of

its face value.

a. 10.85%

b. 10.75%

c. 10.54%

d. 10.29%

(c) 26. The following yield calculation on a Treasury bill provides the best comparison yield for competing coupon bearing securities of the same maturity?

a.

bank discount rate

b.

CD equivalent rate

c.

bond equivalent rate

d.

the true rate.

(a)

27.

The T-bill rate quoted by the Federal Reserve banks is the

a.

bank discount rate.

b.

the true rate.

c.

effective annual rate.

d.

bond equivalent rate.

(c)

28.

The Wall Street Journal publishes T-bill price (bid/ask) based on the

___________ rate; with the __________ rate provided as the quoted (ask) yield on the T-bill?

a. bond equivalent; bank discount

b. effective annual; bank discount

c. bank discount; bond equivalent

d. bank equivalent; bank discount

(c) 29. Which of the following will give the higher yield given the price and maturity of a T-bill?

a. the true rate

b. bond equivalent rate

c. bank discount rate

d. none of the above.

(b) 30. Purchasing T-bill via a computerized account without actually receiving the securities is achieved through

a. a Direct Purchase Account.

b. a Treasury Direct Account.

c. a Fed Purchase Account.

d. a Clinton Benefit Account.

(a) 31. Federal Agency securities have higher yields than equivalent Treasury securities because

a. there are less marketable than Treasury securities.

b. they have higher exchange rate risk than Treasuries.

c. they are more affected by interest rate risk.

d. they are associated with mortgages that are riskier securities.

(c) 32. Yields on three-month T-bills are more similar to

a. Two-year Treasury notes rates.

b. Ninety-day commercial paper rates.

c. federal funds rates.

d. Aaa-rated corporate bond rates.

(b) 33. A repurchase agreement is like a secured loan because

a. it involves two parties.

b. it involves collateral, in this case the sale of a security under agreement to repurchase.

c. it is backed by a mortgage on real property.

d. it is like the secured lending in that a mortgage is effected by the lender.

(d) 34. A bank agrees to buy T-bills from a securities dealer for $997,250, and promises to sell the securities back to the dealer in 4 days for $997,575. The yield on this reverse repo for the bank is:

a. 2.97%

b. 2.91%

c. 2.86%

d. 2.93%

(a) 35. A firm buys $1,000,000 of a 30-day commercial paper issue $995,450. The yield on this commercial paper is:

a. 5.56%

b. 5.46%

c. 5.49%

d. 5.54%

(b) 36. A reverse repurchase agreement calls for

a. a firm to first sell securities with the agreement to buy them back in a short period at a higher price.

b. a firm to first buy securities with the agreement to sell them back in a short period at a higher price.

c. a firm to first sell securities with the agreement to buy them back in a short period at a lower price.

d. a firm to first buy securities with the agreement to sell them back in a short period at a lower price.

(a) 37. A repurchase agreement calls for

a. a firm to first sell securities with the agreement to buy them back in a short period at a higher price.

b. a firm to first buy securities with the agreement to sell them back in a short period at a higher price.

c. a firm to first sell securities with the agreement to buy them back in a short period at a lower price.

d. a firm to first buy securities with the agreement to sell them back in a short period at a lower price.

(d) 38. A competitive bid in the Treasury securities auction market has all of the following characteristics except:

a. the bidder specifying the quantity of bills desired

b. the price the investor wishes to pay

c. large, institutional investors

d. bids for a maximum of $1,000,000.

(d) 39. A non-competitive bid in the Treasury securities auction market is characterized by:

a. the bidder specifying the quantity of bills desired

b. bids less than $1,000,000

c. the bidders paying a price equal to the weighted average price of all competitive bids accepted.

d. all of the above.

(d) 40. The fed funds rate is very important to the economy because:

a. it measures the return on the most liquid of all the financial assets traded

b. it is closely related to the conduct of monetary policy

c. it measures directly the availability of excess reserves in the banking system

d. all of the above

ESSAY QUESTIONS

1. What are the fundamental characteristics of money market debt instruments? Explain why these characteristics are important to money market participants who are investing and financing.

Answer: Money market securities are attractive to investors for three reasons. They are high quality (low default risk), marketable, and short-term. They protect the investor’s principal and offer liquidity via a ready market or maturity in the near future. Lastly they provide income. For the borrower, the money market is a constant source of relatively cheap funds, available with very low financing costs.

2. Explain the economic function of money markets.

Answer: The money market is a “liquidity” market. Liquidity of many of the world’s investors is stored there; liquidity for high quality borrowers is provided there.

3. Explain why most short- and long-term interest rates tend to move together over time.

Answer: To the extent that securities with various terms are substitutable (investors are willing to hold up and down the term scale), as a particular maturity offers a relatively high rate (low security price) investors will rush in and purchase the security. This is especially true of the U.S. Treasury market, where the yield curve is relatively smooth, reflecting the substitutability of various terms.

4. What is a banker's acceptance? Why are banker's acceptances ideally suited for foreign trade transactions?

Answer: A banker’s acceptance is a trade bill of exchange (draft on a counter party in a transaction) that has been “accepted” (liability of the bank) by a third party with an excellent credit rating, in this case a large commercial bank. With limited knowledge of counter parties in transactions, a third party “accepter” or guarantor is welcome. Banks and competitors that participate in acceptances “grease the wheels” of international trade.

5. In the stock market crashes of 1987, 1989, and shortly after “September 11th,” money market yields dropped. What caused this drop in money market interest rates? Discuss.

Answer: There were a couple major factors. First the Fed opened the discount window and purchased large amount of Treasuries expanding bank reserves expanding the supply of loanable funds, but the major factor was the surge of funds from around the world and out of more risky security markets into money market instruments, bidding up the price and lowering yields.

CHAPTER 8

TRUE/FALSE QUESTIONS

(T) 1. Capital market securities are used to finance real capital investments.

(F) 2. Capital market securities have better liquidity than capital market securities.

(T) 3. Money market securities are all debt securities, while capital market securities are either debt or equity securities.

(T) 4. Capital market interest rates tend to be higher than money market rates for any issuer.

(T) 5. Life insurance companies are more likely to invest in corporate capital market securities than commercial banks.

(T) 6. Investors may invest in capital market securities either directly or indirectly.

(F) 7. Both governments and businesses issue both debt and equity capital market securities.

(F) 8. Households owe more financially than they own.

(T) 9. Financial institutions and households own about the same amount of financial assets.

(T) 10. In the U.S. there are more mortgages outstanding than corporate bonds.

(F) 11. Yields on U.S. Treasury "ask" prices are higher than yields quoted on "bid" prices.

(T) 12. A U.S. Treasury STRIP is a zero-coupon bond.

(T) 13. Most State and Local government bonds are sold to finance education.

(T) 14. A serial bond issue matures over a period of years.

(T) 15. Households are the major investor in municipal bonds.

(F) 16. U.S. Treasury TIPS protect investors primarily from default risk.

(T) 17. A state turnpike authority is more likely to issue revenue bonds than general obligation bonds.

(F) 18. Lower marginal tax rates increase the demand for tax-exempt securities.

(T) 19. The money market provides liquidity for deficit units; the capital market finances economic growth.

(T) 20. The primary market for junk bonds expanded for higher risk firms as the secondary market for junk bonds developed.

(T) 21. Capital market borrowing by businesses is generally repaid from the cash flow generated by the assets financed.

(F) 22. Commercial banks purchase more tax-exempt securities when loan losses increase.

(F) 23. One of the fastest growing loan areas for commercial banks in the 1980s was financial guarantees.

(T) 24. Revenue bonds are generally considered more risky than general obligation bonds.

(F) 25. The after-tax return on a 9 percent tax-exempt municipal bond to a commercial bank in the 34 percent tax bracket is 5.94 percent.

MULTIPLE-CHOICE QUESTIONS

(c) 1. Which of the following is not an example of capital market securities?

a. common stocks

b. convertible bonds

c. commercial paper

d. mortgages

(c) 2. Most general obligation bonds are sold through

a. direct placement.

b. negotiated bids.

c. competitive bids.

d. all of the above.

(b) 3. Which of the following firms is least likely to hold tax-exempt municipal bonds?

a. commercial banks

b. pension funds

c. mutual funds

d. households

(d) 4. The secondary markets for capital market securities have facilitated economic growth in our country because

a. they help provide marketability for capital market claims.

b. they have increased people's willingness to buy capital market claims.

c. they make people more willing to invest because they can more easily diversify their risk.

d. all of the above

(a) 5. Everything else being equal, a bond will sell at a higher yield if it

a. has a call provision.

b. has low default risk.

c. can be converted to stock.

d. is listed on an exchange.

(d) 6. Which of the following would be least likely to purchase a tax-exempt municipal bond?

a. commercial bank

b. casualty insurance company

c. mutual fund

d. individuals in low tax brackets

(d) 7. The biggest supplier of funds in the capital markets are

a. financial institutions

b. state and local governments

c. federal government

d. households and non profits

(d) 8. Regulators provide a valuable function for the capital markets because they

a. try to keep the market participants honest.

b. try to prevent excessive speculation from destabilizing the market.

c. make sure all pertinent information about publicly traded securities is disclosed.

d. all of the above

(b) 9. In the 1980s low credit quality businesses were able to first issue their new bond securities in which market?

a. municipal bond market

b. junk bond market

c. stock market

d. secondary market

(a) 10. A capital market financing is most likely to finance

a. new plant and equipment.

b. seasonal inventory needs.

c. a quarterly dividend payment.

d. the sale of common stock.

(d) 11. The household sector is the largest surplus sector and invests in the capital market

a. directly by purchasing stocks and bonds.

b. directly by issuing assets payable in the capital market.

c. both directly (owning stocks) and indirectly (pension fund reserves, etc.)

d. both a and c above

(a) 12. Letters of credit are mostly associated with

a. financial guarantees.

b. investment banking.

c. a bond indenture.

d. a commercial bank seasonal loan.

(c) 13. Life insurance companies and pension funds buy corporate bonds for which two major reasons?

a. tax sheltering and high yield

b. liquidity and high after-tax returns

c. liability maturity matching and high after-tax returns

d. low risk and liquidity

(b) 14. All of the following bond terms relate to maturity except

a. serial.

b. indenture.

c. sinking fund.

d. call provision.

(c) 15. An investor in the 34 percent federal tax bracket would probably select what investment (all with similar default risk)?

a. 7% municipal bond

b. 10% corporate bond

c. 11% mortgage

d. 9% Treasury bond

(d) 16. If average corporate bond and tax-exempt municipal bond rates were 8.33% and 6.25% respectively, at what marginal tax rate would an investor be indifferent between the two?

a. 30%

b. 18%

c. 33%

d. 25%

(a) 17. With reference to the question above, an investor in the 34 percent marginal corporate tax bracket would purchase

a. the tax-exempt bond.

b. the corporate bond.

c. neither security.

d. the higher pre-tax yield.

(c) 18. The three major investors in municipal bonds are

a. casualty insurance companies, pension funds, and individual investors.

b. commercial banks, casualty insurance companies, and life insurance companies.

c. individual investors, commercial banks, and casualty insurance companies.

d. mutual funds, pension funds, and commercial banks.

(d) 19. The incentive to securitize a portfolio of loans is

a. the profit from the loan revenue.

b. the profit from the interest on the asset-backed securities issued.

c. the profit from the fees paid for financial guarantees.

d. the profit from the difference between the loan revenue and the costs of guarantees and return on the asset-backed securities.

(c) 20. Securitization of loan portfolios, such as credit card loans and mortgage loans, will occur if

a. the financial market will pay more for the loan portfolio than the issued assetbacked securities.

b. a financial guarantee is obtained from a commercial bank.

c. the financial market will pay more for the issued asset-backed securities than the loan portfolio.

d. the borrowers permit their loan to be securitized.

(d) 21. All but one of the following are associated with credit enhancements for asset-backed securities?

a. Cash-collateral accounts that are deposits set aside to cover losses.

b. Financial guarantees from bond insurance companies.

c. Standby letters of credit from major commercial banks.

d. A guarantee to pay from the borrowers.

(b) 22. Credit-rating agency ratings are associated with which of the following investor risks?

a. interest rate risk

b. default risk

c. purchasing power risk

d. reinvestment risk

(c) 23. Bonds issued by foreign entities in the United States are called:

a. foreign bonds

b. American depository receipts

c. Yankee bonds

d. Samurai bonds

(d) 24. All but one of the following may be associated with the increased globalization of bond markets?

a. the globalization of business activity

b. increased volatility in foreign exchange rates

c. Improved computer and telecommunications technology

d. the reduction in trade barriers and standardization of regulations.

(c) 25. Investors in U.S. Treasury STRIPS are primarily interested in eliminating which of the following bond investor risks?

a. default risk

b. price risk

c. reinvestment risk

d. foreign exchange risk

(c) 26. Industrial development bonds (IDBs) are debt securities issued by:

a. the federal government

b. non profit organizations

c. state and local government agencies

d. non financial businesses.

(d) 27. The largest investor in municipal bonds is:

a. commercial banks

b. property and casualty insurance companies

c. life insurance companies

d. households

(b) 28. The fastest growing debt sector in the U. S. is:

a. Treasury debt

b. federal agency debt

c. mortgage debt

d. corporate debt

(d) 29. The demand for junk bonds came primarily from

a. life insurance companies

b. savings & loans association

c. pension funds

d. all of the above

(a) 30. The quality of a financial guarantee depends on the reputation and financial strength of the

a. the guarantor

b. the investor

c. the borrower

d. none of the above

ESSAY QUESTIONS

1. Compare and contrast the characteristics of the securities of the money market with those of the capital market.

Answer: Money market securities are short-term, usually less than nine months, while capital market securities are from five to one hundred years. The money market is largely a “primary” market with secondary market activity. The capital market is a secondary market with some primary market additions. All money market securities are unsecured debt, while equities and debt, some collateralized, make up the capital market.

2. What might determine whether an individual investor buys corporate or municipal bonds? Give an example.

Answer: Everything else being the same, an individual investor would select the higher aftertax return; so the relative yields and marginal tax rate of the investor will likely determine the choice of corporate bonds or muni’s. For example with a 7% yield available on a corporate bond, for an individual in the 28% marginal tax bracket would have to find an equivalent (term and rating) 5.04% municipal or state bond. For individuals’ pension money in a tax-deferred program, one would invest in the taxable securities.

3. List and discuss the risks faced by bond investors.

Answer: Bond investors may face a variety of risk including default risk, inflation risk, price risk and reinvestment risk (coupon bond), foreign exchange risk and/or political risk if an international investment, and market risk (risk of a constant ready market).

4. U.S. Treasury STRIPS are of interest to individuals with IRA's or $401k pension plans. Why?

Answer: Zero coupon bonds are of interest to individuals investing via tax deferred pension plans for a couple reasons. One, an individual, buying a STRIP outside a qualified pension plan will pay annual interest on the imputed rate on the zeros, but not if in a qualified plan. Second, zeros held to maturity earn the expected yield to maturity and are not subject to reinvestment risk. One will know the “pile” of cash in the plan at the end of the maturity.

5. What factors have contributed to the increased globalization of bond markets?

Answer: There have been a number of cumulative factors that, overtime, has contributed to the increased globalization of bond markets. The development of standardized legal remedies, the development of markets in more stable economies, and a vast amount of quality government debt has attracted investors into financial investment. Exchange rate stability, computerization, and information processing technology have provided the ability for markets to develop as well.

CHAPTER 9

TRUE-FALSE QUESTIONS

(T) 1. Mortgage insurance was an important factor in the development of secondary mortgage markets.

(T) 2. Commercial banks are the largest institutional investor of mortgages.

(T) 3. Mortgage borrowers expecting interest rates to fall significantly are likely to find ARM mortgages at rates very close to FRM mortgage rates.

(T) 4. FNMA is a privately owned corporation with a line of credit from the U.S. Treasury.

(T) 5. The cash flow to investors by CMO securities can be predicted with certainty.

(T) 6. Mortgage originators may retain the servicing right and fees even though the mortgage has been sold to a governmental agency.

(T) 7. A lender with a fixed-rate mortgage bears the risk of future inflation.

(F) 8. Mortgages are issued in standard denominations like corporate and municipal bonds.

(T) 9. Most mortgage loans are amortized over the maturity of the loan with interest computed on the declining principal.

(T) 10. In a conventional mortgage agreement the borrower owns the mortgaged home;

the lender takes a lien against the home.

(F) 11. An ARM, compared to a FRM, shifts the interest rate risk from the borrower to the lender.

(F) 12. CMO residual tranches have the first claim on the cash flow from a pool of mortgages.

(F) 13. Mortgage-backed securities have improved mortgage liquidity for home buyers.

(T) 14. Mortgage pool securities have encouraged individuals, insurance companies, and pension funds to provide indirect mortgage financing.

(T) 15. Home equity credit lines are a form of second mortgage financing.

(T) 16. Pass-through mortgage securities have standard denominations but uncertain cash flow.

(F) 17. Pass-through securities pass through all principal and interest payments collected from homeowners, providing a predictable stream of cash flow to the investor.

(F) 18. REMIC securities are a form of collateralized mortgage obligation that provide tax-free income to investor.

(F) 19. The residual investor in a CMO issue will always earn a higher return than the CMO debt investor.

(F) 20. FHMLC buys FHA/VA insured mortgages from loan originators.