Money, Banking, and the Financial System (Hubbard/O’Brien)
Chapter 11 Investment Banks, Mutual Funds, Hedge Funds, and the Shadow Banking
System
11.1 Investment Banking
1) Investment banks
A) lease machinery and equipment to business firms.
B) acquire deposits from savers and lend them to borrowers.
C) assist business firms in raising new capital in primary markets.
D) aid the government to raise funds to cover the budget deficit.
2) Underwriting involves
A) insuring the life or health of individuals.
B) guaranteeing a price for new capital to the issuing firm.
C) selling stock more cheaply than conventional stockbrokers.
D) issuing stock and using the proceeds to buy bonds.
3) In investment banking the “spread” is the difference between
A) the value of a firm’s assets and the value of its liabilities.
B) the bid and asked prices on a bond.
C) the price of new capital guaranteed to the issuing firm and the price that can be obtained in
the market.
D) the price of a new stock issue and the price of an equivalent new bond issue.
4) A syndicate is
A) a group of brokers illegally making use of insider information.
B) a group of commercial banks that agrees to accept the checks of each other’s depositors.
C) a group of investment banks underwriting a large security issue.
D) a group of dealers that markets a government bond issue.
5) The due diligence process is
A) the process by which a firm chooses an investment bank.
B) when an investment bank researches a firm’s value.
C) how an investment bank underwrites large issues.
D) the review of a prospectus by the SEC.
6) What does it mean for an investment bank conducts a “road show”?
A) It involves an investment bank marketing its services to firms considering new issues.
B) It is when an investment bank goes to the SEC to seek approval for a new issue.
C) It is when firms seeking an underwriter consider alternative investment banks.
D) It involves visits to institutional investors who might want to buy the security issue.
7) The most important service provided by underwriters is
A) lowering of information costs.
B) dealing with problems of moral hazard.
C) insuring firms against loss from fire.
D) insuring firms against loss from employee theft.
8) What is the book value of a firm?
A) the market value of its existing shares of stocks
B) the current value of its retained earnings
C) the difference between the value of a firm’s assets and the value of its liabilities
D) its accumulated earnings over time
9) Which of the following activities is NOT a primary concern of investment banks?
A) taking in deposits and making loans
B) providing advice and financing for mergers and acquisitions
C) underwriting new security issues
D) providing advice on new security issues
10) The development of new financial securities or investment strategies using sophisticated
models is known as
A) underwriting.
B) factoring.
C) financial engineering.
D) hedging.
11) When investment banks buy or sell securities on their own account, it’s called
A) financial engineering.
B) proprietary trading.
C) underwriting.
D) factoring.
12) During the financial crisis, which type of risk was the biggest problem faced by investment
banks?
A) interest-rate risk
B) currency risk
C) hedging risk
D) credit risk
13) The risk that increased market interest rates will cause a decline in the value of an investment
bank’s holdings of long-term securities is known as
A) credit risk.
B) interest-rate risk.
C) currency risk.
D) security risk.
14) Suppose an investment bank has a leverage ratio of 10 and the value of its securities decline
by 10%. What happens to its return on equity investment?
A) declines by 1%
B) increases by 1%
C) declines by 100%
D) increases by 100%
15) The risk that the party on the other side of a financial transaction fails to meet its obligation
is called
A) credit risk.
B) currency risk.
C) counterparty risk.
D) leverage.
16) The Glass-Steagall Act was designed to
A) legally separate investment banking from commercial banking.
B) promote mergers in the banking industry.
C) impose high capital ratios on investment banks.
D) promote the interests of community banks.
17) Investment banks are vulnerable because
A) the maturity of their liabilities is less than the maturity of their assets.
B) the maturity of their assets is less than the maturity of their liabilities.
C) they tend to be underleveraged.
D) they tend to primarily hold short-term assets.
18) Which of the following was NOT a result of the passage of the Gramm-Leach-Bliley Act?
A) It repealed the Glass-Steagall Act.
B) It allowed commercial banks to participate in securities, insurance, and real estate activities.
C) It authorized new financial holding companies which permitted securities and investment
firms to own commercial banks.
D) It increased the capital requirements for commercial banks.
19) What are the risks and reward for investment banks involved in underwriting a new security
issue?
20) What information is typically included in a prospectus?
21) What makes advising on mergers and acquisitions particularly profitable for investment
banks relative to other services that they provide?
22) How do investment banks use the results of their research?
23) What type of economic research do analysts at investment banks conduct?
24) How does proprietary trading expose investment banks to interest-rate and credit risk?
25) How is the use of leverage a “double-edged sword”?
26) Suppose an investment bank buys $100 million worth of mortgage-backed securities. It
finances the purchase by borrowing $90 million and using $10 million from its equity. If the
value of holdings of mortgage-backed securities declines by 5%, what is its return on equity
investment?
27) Why did Goldman Sachs and Morgan Stanley seek to become financial holding companies in
October 2008?
1) Mutual funds
A) take in deposits from savers and make loans to borrowers.
B) sell shares to savers and purchase assets with the funds.
C) take in deposits from savers and purchase assets with the funds.
D) bring together small savers and small borrowers.
2) Which of the following is an investment institution?
A) The New York Stock Exchange
B) Greater Illinois Savings and Loan
C) Prudential Insurance Company
D) Fidelity Magellan Mutual Fund
3) The portfolios that mutual funds offer to savers are
A) usually made up of bonds.
B) usually made up of common stocks.
C) tax free in most states.
D) usually more liquid than the underlying assets.
4) In what year did the mutual fund industry in the United States begin?
A) 1812
B) 1924
C) 1974
D) 1990
5) A load fund
A) charges a commission for purchases or sales.
B) is not obligated to redeem shares issued.
C) earns income only from management fees.
D) issues shares that may sell at a discount to the market value of the underlying assets.
6) Money market mutual funds
A) hold portfolios of stocks.
B) hold portfolios of short-term assets.
C) are always load funds.
D) hold only U.S. Treasury securities.
7) Finance companies
A) issue stock and use the proceeds to purchase bonds.
B) raise funds in financial markets to lend to households and firms.
C) raise funds from banks to lend to households and firms.
D) issue bonds and use the proceeds to purchase stock.
8) Finance companies
A) take in deposits from savers and make loans to borrowers.
B) sell commercial paper and securities and make loans to borrowers with the funds.
C) take in deposits from savers and purchase assets with the funds.
D) bring together small savers and large borrowers.
9) Which of the following statements is NOT true of consumer finance companies?
A) Their borrowers have higher default risk than bank customers.
B) They charge higher interest rates than banks do on similar loans.
C) They lend primarily to consumers.
D) They are strictly regulated by state governments.
10) Business finance companies
A) purchase accounts receivable of small firms at a discount.
B) sell commercial paper and buy long-term corporate bonds.
C) take in deposits from savers and buy corporate commercial paper.
D) are strictly regulated by state governments.
11) All of the following are types of finance companies EXCEPT
A) government finance.
B) consumer finance.
C) sales finance.
D) business finance.
12) Factoring
A) involves selling stocks and using the proceeds to buy bonds.
B) is purchasing accounts receivable at a discount.
C) is calculating the optimal par values of stocks and bonds.
D) has been declared illegal under the Factoring Reform Act of 1994.
13) Sales finance companies
A) purchase accounts receivable of small firms at a discount.
B) sell commercial paper and buy long-term corporate bonds.
C) take in deposits from savers and buy corporate commercial paper.
D) are affiliated with companies which manufacture or sell goods.
14) What do many economists see finance companies as having an advantage in?
A) in purchasing commercial paper
B) in selling long-term securities
C) in monitoring the value of collateral
D) in charging consumers particularly low interest rates
15) All of the following are differences between hedge funds and mutual funds EXCEPT
A) hedge funds are largely unregulated.
B) hedge funds consist of a relatively number of wealthy investors.
C) hedge funds make risky investments that mutual funds cannot make.
D) hedge funds use money collected from savers to make investments.
16) Modern hedge funds typically make investments that involve
A) hedging.
B) speculating.
C) acquiring safe, short-term assets.
D) focus on stocks instead of bonds.
17) Hedge funds have been criticized for
A) their heavy use of short selling.
B) their inability to mobilize a large amount of funds.
C) forcing quick price changes that reduce market inefficiencies.
D) excessive use of hedging strategies.
18) What services are finance companies able to offer consumers and businesses that banks do
not offer?
19) How did the financial crisis of 2007-2009 reveal that market participants underestimated two
sources of risk from using commercial paper?
20) What are some reasons that hedge funds have become controversial?
11.3 Contractual Savings Institutions: Pensions Funds and Insurance Companies
1) An insurance premium is a
A) payment made by an insurance company to a policyholder after the occurrence of an
insurable event.
B) payment made by an insurance company to a policyholder following a period in which the
policyholder has filed no claims against the company.
C) fee paid by policyholders to insurance companies as payment for coverage.
D) fee paid by policyholders to insurance companies in exchange for special considerations, such
as a particularly large policy.
2) Which of the following is a contractual saving institution?
A) The New York Stock Exchange
B) Greater Illinois Savings and Loan
C) Prudential Insurance Company
D) Fidelity Magellan Mutual Fund
3) When an insurance company makes a direct loan to a firm, the loan is known as
A) a private placement.
B) a commercial paper.
C) an account receivable.
D) an account payable.
4) The law of large numbers allows insurance companies to
A) hold capital market instruments as assets without fearing overly large numbers of defaults.
B) hold money market instruments as assets without fearing overly large numbers of defaults.
C) predict the average number of occurrences of insurable events in a large population of
policyholders.
D) charge higher premiums than necessary, knowing that large numbers of individuals will pay
them.
5) Blood tests administered to applicants for medical insurance are an example of an attempt by
insurance companies to deal with the problem of
A) moral hazard.
B) the drug abuse problems currently plaguing the country.
C) adverse selection.
D) failure of policyholders to keep paying their premiums.
6) Charging drivers with good records lower premiums than drivers with bad records is an
example of an attempt by insurance companies to deal with the problem of
A) moral hazard.
B) adverse selection.
C) drunk driving.
D) failure of policyholders to keep paying their premiums.
7) The use of deductibles and coinsurance are examples of attempts by insurance companies to
deal with the problem of
A) moral hazard.
B) adverse selection.
C) failure of policyholders to keep paying their premiums.
D) excessive government regulation.
8) Property and casualty insurers hold
A) more short-term assets than do life insurance companies.
B) fewer short-term assets than do life insurance companies.
C) roughly the same amount of short-term assets as do life insurance companies.
D) only long-term assets.
9) The largest institutional participants in capital markets are
A) pension funds.
B) insurance companies.
C) consumer finance companies.
D) business finance companies.
10) In which of the following have pension funds invested the most?
A) corporate equities and mutual fund shares
B) government securities
C) corporate bonds
D) mortgages
11) Vesting refers to
A) the right of the holder of an insurance policy to collect for an insurable event.
B) the shielding of returns on whole life policies from taxation.
C) the length of service required of an employee before he or she is eligible for a pension.
D) the payments made by an employee into a pension plan.
12) In a defined contribution pension plan,
A) pension income varies depending on how well the plan’s investments have done.
B) the employee is promised an assigned benefit based on earnings and years of service.
C) if the funds in the pension plan exceed the amount promised, the excess accrues to the issuing
firm or institution.
D) all earnings are taxable as regular income.
13) A defined benefits plan
A) is always fully funded.
B) may be underfunded but cannot be overfunded.
C) may be overfunded but cannot be underfunded.
D) may be either underfunded or overfunded.
14) To deal with difficulties in administering pension funds, Congress in 1974 passed the
A) Corrupt Pension Fund Reform Act.
B) Securities and Exchange Act.
C) Employee Retirement Income Security Act.
D) Social Security Act.
15) What is the name of the pension plan under which employees can make tax-deductible
contributions through regular payroll deductions?
A) 401(k) plans
B) Social Security plans
C) Early retirement plans
D) 486(b) plans
16) What are three reasons that employees may prefer to save through pensions provided by
employers rather than through savings accounts?
17) How do defined-contribution plans differ from defined-benefit plans?
1) The shadow banking system refers to
A) commercial banks.
B) community banks.
C) pawn shops and institutions that offer payday loans.
D) nonbank financial institutions such as investment banks, hedge funds, and money market
mutual funds.
2) Which agency did Congress create in the 1930s to reduce information costs in financial
markets?
A) FDIC
B) SEC
C) Federal Reserve
D) Consumer Financial Protection Agency
3) What was the primary reason that Congress initiated deposit insurance in the 1930s?
A) protect the deposits of individual savers
B) provide more of an incentive for depositors to monitor bank activities
C) reduce systemic risk to the financial system
D) reduce information problems in the banking system
4) Which of the following is NOT a form of a short-term loan in the shadow banking system?
A) repurchase agreements
B) commercial paper
C) money market mutual fund shares
D) bank deposits
5) Which government agency regulates futures markets?
A) SEC
B) Commodity Futures Trading Commission
C) Board of Trade
D) the Federal Futures Agency
6) What regulatory change did Congress approve in 2010 to reduce counterparty risk in the
shadow banking system?
A) push more trading of derivatives onto exchanges
B) required investment banks to follow the same rules on leverage as commercial banks
C) require increased collateral for those trading derivatives
D) banned trading of mortgage-backed securities
7) Which of the following is NOT a reason that firms in the shadow banking system were more
vulnerable than commercial banks during the financial crisis of 2007-2009?
A) They could invest in riskier assets.
B) Investors had no insurance against loss of principal.
C) They made investments that would lose value if housing prices decline.
D) They were more heavily regulated than commercial banks, making them less able to adjust to
changing market conditions.
8) Which of the following is likely to be more of a problem after the introduction of deposit
insurance?
A) moral hazard
B) adverse selection
C) contagion
D) bank runs
9) Which of the following was the main reason for increased counterparty risk in the shadow
banking system prior to the financial crisis of 2007-2009?
A) increased leverage
B) government insuring money market deposits
C) many firms borrowing long term for short-term investments
D) trading of derivatives on exchanges
10) what were the two main rationale for exempting nonbanks from restrictions on assets and
degrees of leverage?