Midterm 1

Correct answers are in italics

I. Multiple Choice (60 points). Choose the single best answer for the following 20 questions.

1. The market for new securities is classified as a:
a. secondary market.
b. primary market.
c. equity market.
d. stock market.
e. None of the above.

2. Which of the following can be described as involving indirect finance?
a. A corporation issues new shares of stock.
b. A pension fund manager buys commercial paper in the secondary market.
c. People buy shares in a mutual fund.
d. Both (a) and (b) of the above.
e. Both (b) and (c) of the above.

3. Assume the Federal government goes from a state of budgetary balance to a budget deficit. Which of the following statements is (are) false?
a. The budget deficit, according to the Ricardian Equivalence theory, will have no effect on the interest rate.
b. The size of the budget deficit can be measured as the vertical distance between the old and new bond supply curves.
c. The effect of the budget deficit on the interest rate will be smaller the more elastic is the bond demand curve.
d. b and c.
e. none of the above.

4. Which of the following statements regarding the current yield is (are) false?
a. The formula for calculating the current yield is the same as the formula for calculating the yield to maturity on a consol bond.
b. The current yield is a closer approximation of the yield to maturity the longer is the time to maturity.
c. The current yield is a closer approximation of the yield to maturity the closer is the price of the bond to its face value.
d. all of the above.
e. none of the above.

5. Federal funds are
a. funds raised by the federal government in the bond market.
b. loans made by the Federal Reserve System to banks.
c. loans made by banks to the Federal Reserve System.
d. loans made by banks to each other.
e. none of the above.

6. Factors that cause the demand curve for bonds to shift to the right include
a. a decrease in the inflation rate.
b. an increase in the volatility of stock prices.
c. an increase in the liquidity of stocks.
d. all of the above.
e. only (a) and (b) of the above.

7. Which of the following markets is sometimes organized as an over-the-counter market?
a. The stock market
b. The federal funds market
c. The foreign exchange market
d. The bond market
e. Each of the above

8. Bonds that are denominated in a currency other than that of the country in which they are sold are known as
a. foreign bonds.
b. Eurobonds.
c. equity bonds.
d. country bonds.
e. none of the above.

9. An examination of revised monthly money supply statistics, when compared to the initial statistics, suggests that:
a. the initial statistics are pretty good.
b. the initial statistics do not provide a good guide to short-run movements in the money supply.
c. the initial statistics provide a good guide for monetary policy, though they are usually overestimates of the revised statistics.
d. the initial statistics provide a good guide for monetary policy, though they are usually underestimates of the revised statistics.

10. If an individual moves money from a consumer money market mutual fund to a money market deposit account,
a. M2 decreases and M3 stays the same.
b. M2 increases and M3 decreases.
c. M2 stays the same and M3 stays the same.
d. M2 stays the same and M3 increases.

11. Which of the following assets could not be included in an empirical definition of the money supply?
a. currency.
b. demand deposits.
c. NOW account deposits.
d. term Eurodollars.
e. none of the above (i.e, all could be included).

12. The difference between money and income is that
a. money is a flow and income is a stock.
b. there is no difference--money and income are both stocks.
c. there is no difference--money and income are both flows.
d. money is a stock and income is a flow.

13. An asset with a beta of _____ has more systematic risk than an asset with a beta of _____.
a. 1.0; 2.0
b. 0.4; 0.5
c. 0.5; 0.4
d. 2.0; 3.0

14. In which of the following situations would you prefer to be making a loan?
a. The interest rate is 9% and the expected inflation rate is 7%.
b. The interest rate is 4% and the expected inflation rate is 1%.
c. The interest rate is 7% and the expected inflation rate is 9%.
d. The interest rate is 13% and the expected inflation rate is 15%.
e. The interest rate is 25% and the expected inflation rate is 24%.

15. If the interest rates on all bonds fall from 6% to 5% over the course of the year, which bond would you prefer to have been holding?
a. A bond with one year to maturity.
b. A bond with five years to maturity.
c. A bond with ten years to maturity.
d. A bond with twenty years to maturity.

16. If the expected return on NBC stock rises from 5% to 8% and the expected return on CBS stock rises from 12% to 17%, then:
a. the opportunity cost of holding CBS stock rises and the quantity demanded of CBS stock rises.
b. the opportunity cost of holding CBS stock falls and the quantity demanded of CBS stock rises.
c. the opportunity cost of holding CBS stock falls and the quantity demanded of CBS stock falls.
d. the opportunity cost of holding CBS stock rises and the quantity demanded of CBS stock falls.
e. none of the above.

17. When the expected inflation rate decreases, the demand for bonds_____, the supply of bonds_____, and the interest rate_____.
a. increases; decreases; rises.
b. decreases; decreases; falls.
c. increases; increases; falls.
d. decreases; increases; rises.
e. none of the above are correct.

18. When brokerage commissions on bonds rise and the volatility of stock prices is expected to rise at the same time,
a. the demand curve for bonds shifts to the left and the interest rate rises.
b. the demand curve for bonds shifts to the left and the interest rate falls.
c. the demand curve for bonds shifts to the right and the interest rate rises.
d. the demand curve for bonds shifts to the right and the interest rate falls.
e. the demand curve for bonds may shift left or right and the effect on the interest rate is uncertain.

19. When people revise downward their expectations of future stock prices,
a. the demand curve for bonds shifts to the left and the interest rate rises.
b. the demand curve for bonds shifts to the left and the interest rate falls.
c. the demand curve for bonds shifts to the right and the interest rate rises.
d. the supply curve for bonds shifts to the right and the interest rate falls.
e. none of the above occurs.

20. Whatever a society uses as money, the distinguishing characteristic is that
a. it must be produced by the government.
b. it must be generally acceptable as payment for goods and services or in the repayment of debt.
c. it must be completely inflation proof.
d. it must contain gold.

Part II. Problems (10 points) SHOW ALL WORK.

1. The current yield on a $5,000 12% coupon bond selling for $4,000 is:

i = 600/4000 = 15%

2. What is the return on a 14% $1,000 coupon bond that initially sells for $1,000 and sells for $800 next year?

RET = (140 + 800 - 1000 )/1000 = -6%

3. What is the present value of a security that pays $155 next year and $533 three years from now when the interest rate is 10%?

Part III. Essays (30 points). Answer 2 of the following 3 questions.

1. Answer the following questions regarding the empirical and theoretical approaches to defining money.

(a) Explain the theoretical approach to defining money and discuss any problems with this approach. (6 points)

The theoretical definition of money includes those assets that are a generally accepted means of payment (medium of exchange). The problem with this approach is that some assets are partly "money." (i.e., money market mutual funds allow checks over $500 to written against the account balance).

(b) Explain the empirical approach to defining money and discuss any problems with this approach. (6 points)

The empirical approach defines money as those assets that best predict economic variables such as the GNP, inflation, and etc. One problem with this approach is that other assets could be well correlated with these economic variables, not just money. Another is that thhe assets that are best correlated with economic variables change over time.

(c) Specifically, what assets would be included in a theoretical definition of money. (3 points)

Currency, demand deposits, other checkable deposits, and traveler's checks.

2. In terms of the theory of asset demand, explain why you would be more or less willing to buy AT&T bonds under the following circumstances:

(a) gold again becomes acceptable as a medium of exchange (3 points).

Less willing. The relative liquidity of ATT bonds has fallen.

(b) prices on the gold market become more volatile (3 points).

More willing. The relative risk of ATT bonds has risen.

(c) you expect stock prices to decline in the future (3 points).

More willing. The relative expected return of ATT bonds has risen.

(d) you expect interest rates to fall in the future (3 points).

More willing. The relative expected return of ATT bonds has risen (the price of bonds will rise).

(e) brokerage commissions on stocks fall (3 points).

Less willing. The relative liquidity of ATT bonds has fallen.

3. a) Assume the following two events occur at the same time. First, expected future interest rates rise. Second, the federal budget deficit rises. Discuss the effect of these two events on the interest rate in the loanable funds framework. Be sure your answer includes the appropriate diagram.

In the loanable funds framework an increase in the expected future interest rates will shift bond demand to the left due to the decreased expected return of bonds. The increased federal budget deficit will bond supply to the right. The result will be a higher interest rate.

b) Assume that you know the events in part (a) will happen tomorrow. Should you buy more bonds or sell your holdings of bonds today? Further assume that you are confident these change the short- and long-term bond rates equally. Explain your answer using a numerical example to support your argument.

As an investor, you should decrease your holdings of bonds now. The rationale for this decision is based on the inverse relationship exists between bond prices and interest rates. This relationship can be most readily seen with consol bonds. For example, assume the following facts about a current consol bond: Price=$1,000, interest rate=.10, and Coupon payment=$100. If the interest rate on new consol bonds rises to .20, then the price of old consol bonds will fall to $500 (P=100/.20=$500). Thus, you have made a loss of $500.

c) To maximize your profits, should you do this action for long or short-term bonds? Explain.

You should maximize your profits by selling long-term bonds since the price change will be the largest on these bonds for a given interest rate change.