Money, Banking, and the Financial System (Hubbard/O’Brien)
Chapter 4 Determining Interest Rates
4.1 How to Build an Investment Portfolio
1) Investors value liquidity in an asset because
A) liquid assets tend to have high rates of return.
B) liquid assets incur lower selling costs.
C) liquid assets incur lower tax liabilities.
D) whereas liquid assets have high information costs, their low risk offsets this.
2) A portfolio is a
A) brokerage house specializing in the trading of common stock.
B) brokerage house specializing in the trading of corporate bonds.
C) measure of the risk involved with a holding a particular asset.
D) collection of assets.
3) Economists believe that as a saver’s wealth increases, the saver will generally
A) increase his or her holdings of all assets proportionately.
B) increase the fraction of wealth held as cash.
C) increase the fraction of wealth held as common stock.
D) decrease the fraction held as corporate bonds.
4) As wealth increases, which of the following is likely to account for a smaller fraction of a
saver’s portfolio?
A) corporate stock
B) corporate bonds
C) cash
D) U.S. government securities
5) As wealth decreases, which of the following is likely to account for a larger fraction of a
saver’s portfolio?
A) corporate stock
B) corporate bonds
C) U.S. government securities
D) checking account balance
6) The average investor must weigh the benefits of liquidity against
A) the high taxes generally levied on liquid assets.
B) the lower returns on liquid assets.
C) the high transactions costs involved in disposing of liquid assets.
D) the greater variability in the nominal returns on liquid assets.
7) Why do CDs have lower rates of return than stocks?
A) CDs are much riskier investments than stocks.
B) CDs are less risky than stocks.
C) CDs are not taxed while stock s returns are taxable.
D) CDs are not as liquid as stocks.
8) Which of the following can best be characterized as a “Black Swan” event?
A) decline in stock prices due to a recession
B) rising market interest rates as the Fed tightens monetary policy
C) a financial crisis causing credit to dry up
D) an individual firm unexpectedly filing for bankruptcy
9) In an article, “Preparing for the Next Black Swan” (Wall Street Journal, Aug 21, 2010), the
point is made that diversification may be insufficient in protecting one’s portfolio during a
“Black Swan” event. Why may this be true?
A) virtually all asset classes may decline at the same time
B) investors may be unable to buy different assets during a “Black Swan” event
C) some assets may rise while others decline during a “Black Swan” event
D) Black Swan events are surprises and thus one cannot prepare for such an event.
10) Suppose there’s a 50% chance of a stock rising by 20% and a 50% chance of it falling by
20%. What is the expected rate of return on the stock?
A) -20%
B) 0%
C) 10%
D) 20%
11) Suppose there’s an 80% chance of a stock rising by 20% and a 20% chance of it falling by
40%. What is the expected rate of return on the stock?
A) -40%
B) -20%
C) 8%
D) 16%
12) As a person’s wealth increases, which of the following portfolio holdings is likely to increase
the least?
A) checking account
B) stocks
C) money market fund
D) bonds
13) Suppose there’s an 80% chance of a stock rising by 20% and a 20% chance of it falling by
40%. Which type of investor would prefer an investment with a guaranteed return of 5%?
A) risk loving investor
B) risk neutral investor
C) risk averse investor
D) risk is not relevant in this example
14) Given that most investors tend to be risk averse,
A) no one buys risky assets.
B) there’s a trade-off between risk and return.
C) low risk assets provide the best return.
D) it must be a superior strategy compared to one that is risk loving.
15) Which of the following financial assets has both the highest risk and highest return for the
period of 1926-2009?
A) small company stocks
B) large company stocks
C) corporate bonds
D) Treasury bills
16) Which best describes the relationship between the cost of acquiring information and return?
A) a high return must compensate for a high cost of acquiring information
B) a higher cost of information corresponds with a low return
C) a low cost of acquiring information corresponds with a high return
D) a higher return results in a lower cost of acquiring information
17) Since all assets typically do not move together, how can investors typically reduce risk?
A) purchase only the best performing assets
B) diversify one’s portfolio across different asset classes
C) avoid poor performing assets
D) actively manage one’s portfolio
18) Risk that is common to all assets of a certain type is referred to as
A) systematic risk.
B) unsystematic risk.
C) idiosyncratic risk.
D) structural risk.
19) Suppose that you own $10,000 worth of stock in General Motors. Adding stock in which of
the following companies would be least likely to reduce the risk in your portfolio?
A) Google
B) Wal-Mart
C) Ford
D) General Electric
20) Which combination of assets represents the most diversification?
A) holding corporate and Treasury bonds
B) holding shares of Google and Yahoo
C) holding shares of Google and Microsoft
D) holding shares of Google along with Treasury bonds
21) Which is the best example of idiosyncratic risk?
A) a financial crisis
B) a lawsuit because the corporation produced a faulty product
C) a recession
D) rising interest rates
22) If you think that there is a 75% chance of a stock increasing by 8% and a 25% change of it
falling by 20%, what is the expected return on the stock? Report using percentages with two
decimal places.
23) Suppose you are risk averse and you are deciding between two investments. One has a
guaranteed return of 5% while the second has a 50% chance of a 10% return and a 50% change
of a 0% return. Which investment would you choose? Why?
24) Suppose you are risk loving and you are deciding between two investments. One has a
guaranteed return of 5% while the second has a 50% chance of a 10% return and a 50% change
of a 0% return. Which investment would you choose? Why?
25) What is a black swan event?
26) How can diversification reduce idiosyncratic risk but not systematic risk?
27) How should a financial plan of an older saver differ from that of a younger saver?
4.2 Market Interest Rates and the Demand and Supply for Bonds
1) The bond demand curve slopes down because
A) interest rates decline as bond prices decline.
B) when bond prices are low, inflation is low.
C) the lender is willing and able to purchase more bonds when the price of the bond is low.
D) the borrower is willing and able to purchase more bonds when the price of the bond is low.
2) The formula for the yield to maturity, i, on a discount bond is
A) i = (Face value – Discount price)/Discount price.
B) i = (Discount price – Face value)/Discount price.
C) i = (Face value – Discount price)/Face value.
D) i = (Discount price – Face value)/Face value.
3) A one-year discount bond with a face value of $1000 that is currently selling for $900 has an
interest rate of
A) 5.26%.
B) 10%.
C) 11.1%.
D) 100%.
4) A one-year discount bond with a face value of $10,000 that is currently selling for $9400 has
an interest rate of
A) 3.10%.
B) 6%.
C) 6.38%.
D) 60%.
5) A one-year discount bond with a face value of $1000 has an interest rate of 4%. What is its
price?
A) $960
B) $961.54
C) $996
D) $1,040
6) As wealth increases in the economy, savers are willing to
A) hold more cash relative to their holdings of bonds.
B) buy fewer bonds at any given price.
C) buy more bonds at any given price.
D) lend less at any given interest rate.
7) If there is an excess demand for bonds at a given price of bonds, then
A) the interest rate will fall.
B) the interest rate will rise.
C) the price of bonds will fall.
D) the interest rate may rise or the interest rate may fall depending upon the reasons for the
excess demand for bonds.
8) If there is an excess supply of bonds at a given price of bonds, then
A) the interest rate will fall.
B) the interest rate will rise.
C) the price of bonds will fall.
D) the interest rate may rise or the interest rate may fall depending upon the reasons for the
excess demand for bonds.
9) Which of the following would NOT cause the demand curve for bonds to shift?
A) a change in wealth
B) a change in the price of bonds
C) a change in the liquidity of bonds
D) a change in expected inflation
10) As wealth increases in the economy, savers are willing to
A) hold more cash relative to their holdings of bonds.
B) buy fewer bonds at any given price.
C) lend more at any given interest rate.
D) lend less at any given interest rate.
11) As wealth increases in the economy, we would expect to observe
A) bond prices and interest rates both rise.
B) bond prices and interest rates both fall.
C) bond prices rise and interest rates fall.
D) bond prices fall and interest rates rise.
12) If the expected gains on stocks rise, while the expected returns on bonds do not change, then
A) the demand curve for bonds will shift to the right.
B) the supply curve for loanable funds will shift to the right.
C) the equilibrium interest rate will fall.
D) the equilibrium interest rate will rise.
13) If the expected gains on stocks rise, while the expected returns on bonds do not change, then
A) the demand curve for bonds will shift to the left.
B) the supply curve for loanable funds will shift to the right.
C) the demand curve for loanable funds will shift to the left.
D) the equilibrium interest rate will fall.
14) The bond supply curve
A) shows the quantity of bonds lenders are willing to supply as bond prices change.
B) shows the quantity of bonds lenders are willing to supply as interest rates change.
C) shows the quantity of bonds borrowers are willing to supply as bond prices change.
D) is represented by a downward-sloping line when the price of bonds is on the vertical axis and
the quantity of bonds supplied is on the vertical axis.
15) The bond supply curve slopes up because
A) interest rates rise as bond prices rise.
B) when bond prices are high, inflation is high.
C) the lender is willing and able to offer more bonds when the price of the bond is low.
D) the borrower is willing and able to offer more bonds when the price of the bond is high.
16) How is the interest rate that prevails in the bond market determined?
A) by the interaction of stock prices and bond prices
B) by the decision of the president, in consultation with Congress
C) by the demand for and supply of bonds
D) by the Board of Governors of the New York Stock Exchange
17) In the bond market, the buyer is considered to be
A) the lender.
B) the borrower.
C) the lender or the borrower, depending upon the use to which the funds are put.
D) the lender or the borrower, depending upon whether interest rates are rising or falling.
18) In the bond market, the seller is considered to be
A) the lender.
B) the borrower.
C) the lender or the borrower depending upon the use to which the funds are put.
D) the lender or the borrower depending upon whether interest rates are rising or falling.
19) Suppose that a new bond rating service is established that specializes in rating municipal
bonds that had not previously been rated. The likely result would be
A) a shift to the left in the demand curve for municipal bonds.
B) a shift to the left in the supply curve for municipal bonds.
C) an increase in the equilibrium interest rate.
D) a decrease in the equilibrium interest rate.
20) The demand curve for bonds would be shifted to the left by an
A) increase in wealth.
B) increase in expected returns on bonds.
C) increase in expected inflation.
D) increase in the liquidity of bonds relative to other assets.
21) The demand curve for bonds would be reduced by
A) a decrease in expected returns on other assets.
B) an increase in the information costs of bonds relative to other assets.
C) an increase in wealth.
D) an increase in the liquidity of bonds relative to other assets.
22) The demand curve for bonds would be shifted to the left by
A) an increase in expected returns on other assets.
B) a decrease in the information costs of bonds relative to other assets.
C) a decrease in expected inflation.
D) an increase in the liquidity of bonds relative to other assets.
23) The supply curve for loanable funds would decline due to
A) an increase in wealth.
B) an increase in the expected return on bonds.
C) an increase in expected inflation.
D) a decrease in the riskiness of bonds relative to other assets.
24) Businesses typically issue bonds to finance
A) their inventories.
B) payments to their workers.
C) spending on new plant and equipment.
D) dividend payments to their stockholders.
25) In an effort to increase government revenue, Congress and the president decide to increase
the corporate profits tax. The likely result will be
A) the supply curve for bonds shifts to the left.
B) the demand curve for bonds shifts to the left.
C) the equilibrium interest rate rises.
D) the equilibrium price of bonds falls.
26) An increase in the corporate profits tax is likely to cause
A) the equilibrium interest rate to rise and the equilibrium price of bonds to fall.
B) the equilibrium interest rate to fall and the equilibrium price of bonds to rise.
C) the equilibrium interest rate and the equilibrium price of bonds both rise.
D) the equilibrium interest rate and the equilibrium price of bonds both fall.
27) Suppose that Congress passes an investment tax credit. The likely result will be
A) the supply curve for bonds will shift to the right.
B) the demand curve for bonds will shift to the left.
C) the demand curve for bonds will shift to the right.
D) the equilibrium interest rate will fall.
28) If a government’s income tax receipts exceed its expenditures, the government is running a
A) surplus and is a net borrower of funds.
B) surplus and is a net saver of funds.
C) deficit and is a net borrower of funds.
D) deficit and is a net saver of funds.
29) During most of the time in recent decades, the government sector
A) has not spent more than it collected in taxes.
B) has run large deficits.
C) has run large surpluses.
D) has balanced its budget every year.
30) During most of the time in recent decades, the domestic government sector was
A) a net borrower.
B) a net lender.
C) neither a borrower nor a lender.
D) a major factor in keeping real interest rates low.
31) If the federal government decreases its spending and doesn’t decrease taxes, the bond supply
shifts to the
A) left and the equilibrium interest rate rises.
B) left and the equilibrium interest rate falls.
C) right and the equilibrium interest rate rises.
D) right and the equilibrium interest rate falls.
32) If the government were to simultaneously cut the personal income tax and the corporate
profits tax, the equilibrium interest rate
A) would fall.
B) would rise.
C) would be unaffected.
D) might either rise or fall.