Questions and Answers of Economics Of Money Banking And Financial Markets

Explain what financial instruments are, how they are used, and how they are valued.
Discuss the role and structure of financial markets and identify the characteristics of a well-run financial market.
Describe the role of financial institutions and structure of the financial industry.
Jane and Mike purchase identical houses for $400,000. Jane makes a down payment of $80,000, while Mike puts down only $20,000; for each individual, the down payment is the total of his or her net
Secondary-market trading in stocks has become increasingly decentralized. Identify some reasons why you might expect this trend to continue.
Financial instruments are crucial to the operation of the economy.a. Financial arrangements can be either formal or informal. Industrial economies are dominated by formal arrangements.b. A financial
Financial markets are essential to the operation of our economic system.a. Financial markets i. Offer savers and borrowers liquidity so that they can buy and sell financial instruments easily.ii.
Financial institutions perform brokerage and asset transformation functions.a. In their role as brokers or dealers, they provide access to financial markets.b. In transforming assets, they provide
Compare the value of monetary payments using present value and future value.
Apply present value to a stream of payments using internal rate of return and bond valuation.
Explain the difference between real and nominal interest rates and how each is calculated.
Compute the present value of a $100 investment to be made 6 months, 5 years, and 10 years from now at 4 percent interest. Explain why the present value is lower the further into the future the
Assuming that the current interest rate is 3 percent, compute the present value of a five-year, 5 percent coupon bond with a face value of $1,000. What happens when the interest rate goes to 4
A friend has received an unexpected windfall of $10,000 and is considering whether to use the money to pay down their existing debt, on which they pay 6 percent interest, or invest it in a mutual
If a climate change analyst applies a discount rate of 2 percent to losses expected in 300 years’ time, how much, per $1 of expected loss, might she be willing to spend today to avoid those losses?
The value of a payment depends on when it is made.a. Future value is the present value of an initial investment times one plus the interest rate for each year you hold it. The higher the interest
Present value can be used to value any stream of future payments.a. The internal rate of return is the interest rate that equates the present value of the future payments or profits from an
The real interest rate is the nominal interest rate minus expected inflation. It expresses the interest rate in terms of purchasing power rather than current dollars.
Interpret risk as a measure of uncertainty about payoffs.
Explain how to quantify risk.
Define risk aversion and explain the role the risk premium plays in the risk-return tradeoff.
Explain the difference between idiosyncratic and systematic risks.
Demonstrate how to reduce risk through hedging and diversification.
Assume that the economy can experience four possible states: high growth, normal growth, recession, or depression. For each of those states, you expect the following stock market returns for the
Suppose an investment pays off $800 or $1,600 with equal probability per $1,000 invested. What is the maximum leverage ratio you could have and still have enough to repay the loan in the event the
Suppose you identify 10 possible investments whose payoffs are completely independent of one another. All the investments have the same expected value and standard deviation. You have $1,000 to
The imposition of new trade tariffs has resulted in tensions between the United States and some of its major trading partners. Suppose you are a small business owner in the United States.a. How would
The rise in wealth inequality in the United States has reduced the capacity of much of the population to cope with transitory income shocks. How might you expect that to impact workers’ preferences
Risk is a measure of uncertainty about the possible future payoffs of an investment.It is measured over some time horizon, relative to a benchmark.
Measuring risk is crucial to understanding the financial system.a. To study random future events, start by listing all the possibilities and assign a probability to each. Be sure the probabilities
A risk-averse investor:a. Always prefers a certain return to an uncertain one with the same expected return.b. Requires compensation in the form of a risk premium in order to take risk.c. Trades off
Risk can be divided into idiosyncratic risk, which is specific to a particular business or circumstance, and systematic risk, which is common to everyone.
There are two types of diversification:a. Hedging, in which investors reduce idiosyncratic risk by making investments with offsetting payoff patterns.b. Spreading, in which investors reduce
Explain the relationship between bond pricing and present value.
Define the relationship among a bond’s price and its coupon rate, current yield, yield to maturity, and holding period return.
Explain how bond prices are determined and why they change.
Identify the three major types of bond risk: default, inflation, and interest rate changes.
Valuing bonds is an application of present value.a. Pure discount or zero-coupon bonds promise to make a single payment on a predetermined future date.b. Fixed-payment loans promise to make a fixed
Yields are measures of the return on holding a bond.a. The yield to maturity is a measure of the interest rate on a bond. To compute it, set the price of the bond equal to the present value of the
Bond prices (and bond yields) are determined by supply and demand in the bond market.a. The higher the price, the larger the quantity of bonds supplied.b. The higher the price, the smaller the
Bonds are risky because of:a. Default risk: the risk that the issuer may fail to pay.b. Inflation risk: the risk that the inflation rate may be more or less than expected, affecting the real value of
Explain the links between credit risk, bond ratings, and bond yields.
Distinguish taxable and tax-free bonds.
Define the yield curve and interpret it using the expectations hypothesis and liquidity premium theory.
Discuss how yields anticipate future economic activity.
Suppose that the interest rate on one-year bonds is 4 percent and is expected to be 5 percent in one year and 6 percent in two years. Using the expectations hypothesis, compute the yields in two- and
Suppose the yields on tax-exempt local government bonds in Problem 9 initially were below the Treasury yields of the same maturity. If the tax-exempt status were then removed from the local
Select the circumstance in which the impact on government bond yields of a new source of revenue (such as a natural resource discovery) would be largest.Explain your choice.a. Before the discovery,
Bond ratings summarize the likelihood that a bond issuer will meet its payment obligations.a. Highly rated investment-grade bonds are those with the lowest risk of default.b. If a firm encounters
Municipal bonds are usually exempt from income taxes. Because investors care about the after-tax returns on their investments, these bonds have lower yields than bonds whose interest payments are
The term structure of interest rates is the relationship between yield to maturity and time to maturity. A graph with the yield to maturity on the vertical axis and the time to maturity on the
The risk structure and the term structure of interest rates both signal financial markets’ expectations of future economic activity. Specifically, the likelihood of a recession will be higher
Identify the characteristics of common stock.
Distinguish leading stock market indices and their types.
Explain how stocks are valued.
Assess the risk in holding stocks for the long run.
Describe the stock market’s role in the economy.
Suppose you use the dividend-discount model to calculate the price you are willing to pay for a stock and find that this differs from the market price. What might account for the difference in the
The growth of private equity markets in the United States expands the options available to firms to raise funds, as well as the investment choices available to some investors. Why do you think
Stockholders own the firms in which they hold shares.a. They are residual claimants, which means they are last in line after all other creditors.b. They have limited liability, so their losses cannot
There are two basic types of stock market index.a. The Dow Jones Industrial Average is a price-weighted index.b. The S&P 500 is a value-weighted index.c. For every stock market in the world, there is
There are several ways to value stocks.a. Some analysts examine patterns of past performance; others follow investor psychology.b. The fundamental value of a stock depends on expectations for a
Stock investments are much less risky when they are held for long periods than when they are held for short periods.
Stock prices are a central element in a market economy, because they ensure that investment resources flow to their most profitable uses. When occasional bubbles and crashes distort stock prices,
Explain what derivatives are and how they transfer risk.
Distinguish between forward and futures contracts.
Define put and call options and describe how to use them.
Show how swaps can be used to manage risk or to conceal it.
The E-mini S&P 500 futures contract is one-fifth the size of the standard futures contract and can be traded on the 24-hour CME Globex electronic trading system.What might be some of the advantages
Explain why trading derivatives on centralized exchanges rather than in over-the counter markets helps reduce systemic risk. Can you think of a way in which more trading on centralized exchanges
The following table shows the interest rates on the fixed and floating borrowing choices available to three firms. Firms A and B want to be exposed to a floating interest rate while Firm C would
Derivatives transfer risk from one person or firm to another. They can be used in any combination to unbundle risks and resell them.
Futures contracts are standardized contracts for the delivery of a specified quantity of a commodity or financial instrument on a prearranged future date, at an agreed-upon price. They are a bet on
Options give the buyer (option holder) a right and the seller (option writer) an obligation to buy or sell an underlying asset at a predetermined price on or before a fixed future date.a. A call
Interest rate swaps are agreements between two parties to exchange a fixed for a variable interest rate payment over a future period.a. The fixed rate payer in a swap typically pays the U.S. Treasury
Credit default swaps (CDS) are a form of insurance in which the buyer of the insurance makes payments (like insurance premiums) to the seller, who in turn agrees to pay the buyer if an underlying
Derivatives allow firms to arbitrarily divide up and rename risks and future payments, rendering their actual names irrelevant.
Distinguish real and nominal exchange rates.
Explain how prices and inflation affect exchange rates in the long run.
Analyze the supply of and demand for currencies to explain exchange rates in the short run.
Discuss government intervention in foreign exchange markets.
If the U.S. dollar–British pound exchange rate is $1.30 per pound, and the U.S.dollar–euro rate is $1.12 per euro:a. What is the pound-per-euro rate?b. How could you profit if the pound-per-euro
If a video game costs $30 in the United States and £27 in the United Kingdom, what is the real “video game” exchange rate? Look up the current dollar–pound exchange rate and compare the two
The same television set costs $600 in the United States, €450 in France, £300 in the United Kingdom, and ¥100,000 in Japan. If the law of one price holds, what are the euro–dollar,
You need to purchase Japanese yen and have called two brokers to get quotes.The first broker offered you a rate of 125 yen per dollar. The second broker, ignoring market convention, quoted a price of
If the Chinese renminbi appreciated against the U.S. dollar, what would you expect to happen to:a. U.S. exports to China?b. U.S. imports from China?c. the U.S. trade deficit with China?Explain your
Suppose events elsewhere in the world lead to an increase in demand for Japanese yen, as investors seek a “safe haven” for their funds. How would this development affect Japanese exporters and
Different areas and countries of the world use different currencies in their transactions.a. The nominal exchange rate is the rate at which the currency of one country can be exchanged for the
In the long run, the value of a country’s currency is tied to the price of goods and services in that country.a. The law of one price states that two identical goods should sell for the same price,
In the short run, the value of a country’s currency depends on the supply of and demand for the currency in foreign exchange markets.a. When people in the United States wish to purchase foreign
Some governments buy and sell their own currency in an effort to affect the exchange rate. Such foreign exchange interventions are usually ineffective.
Discuss the role of financial intermediaries and how they promote efficiency.
Explain asymmetric information, the problems it causes, and solutions to these problems.
Describe how moral hazard and adverse selection are managed by intermediaries and how they influence business finance.
In some cities, media outlets publish a weekly list of restaurants that have been cited for health code violations by local health inspectors. What information problem is this feature designed to
In 2009, Bernard Madoff was sentenced to 150 years in prison for executing what was likely the largest Ponzi scheme in history. What problem associated with asymmetric information was central to
Your parents give you $3,000 as a graduation gift and you decide to invest the money in the stock market. If you are risk averse, should you purchase some stock in a few different companies through a
Suppose you are the financial advisor to a firm that is in good financial health.What suggestions would you make to the firm’s management about obtaining borrowed funds if both financially healthy
Use a core principle from Chapter 1 to explain why, everything else being equal, a software company might find it more expensive to issue debt than a furniture store?
Financial intermediaries specialize in reducing costs by:a. Pooling the resources of small savers and lending them to large borrowers.b. Providing safekeeping, accounting services, and access to the

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