Questions and Answers of Financial System Of The Economy

In each of the following fictitious examples, tell whether the money multiplier will increase, decrease, or stay the same: a. Depositors become concerned about the safety of depository institutions,
Assume that a depository institution has excess reserves of $100 and the required reserve ratio is 10 percent. What is the amount of checkable deposits at the depository institution resulting from
Suppose that you withdraw $1,000 in cash from your Bank of America checking account for a weekend trip to Las Vegas. Use a T-account to show the impact on the bank’s assets and liabilities. Given a
By definition, narrow banking requires 100 percent reserve backing for checkable deposits. What is the money multiplier in this case?
List two services that FIs provide to the public. Why do intermediaries provide these services? What is a contingent financial claim? Give two examples.
With financial intermediation, net lenders can earn a higher return on their surplus funds, and net borrowers can acquire funds at a lower cost.” Explain how this seemingly contradictory statement
How are FIs like other firms? How are FIs similar to each other? How are they different?
If an FI has mainly long-term liabilities with few payment uncertainties, in what type of assets is it most likely to invest? Why?
What is a depository institution? What are the main types of depository institutions? What distinguishes them from other intermediaries?
Define default risk, asymmetric information, adverse selection, moral hazard, interest rate risk, liquidity risk, and exchange rate risk.
Identify the major contractual- type FIs. What are their main sources of funds (liabilities) and their main uses of funds (assets)?
What are the main sources of funds (liabilities) and uses of funds (assets) for finance company type FIs?
Why does A-1 Student Auto Insurance Company need to hold more liquid assets than Senior Life Insurance Company? How do depository institutions manage liquidity risk?
John, a recent college graduate, is buying his first house. From which FIs could he obtain a mortgage loan?
How do money market mutual funds differ from mutual funds? How are money market mutual funds similar to depository institutions? As an investor, Sam holds both mutual funds and money market mutual
Would a property and casualty company hold municipal securities in its portfolio of assets? What about a credit union and a life insurance company? Why or why not?
How can diversification reduce credit or default risk? In the event of widespread economic collapse, will diversification always reduce this risk?
What are the major determinants of an FI’s liability structure? Give examples of each.
What was the purpose of the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989? Why was the act needed?
Which FIs have deposit insurance?
What is a mutual savings bank?
Explain whether each of the following situations involves asymmetric information, adverse selection, or moral hazard: a. I am financing a new car. In applying for a loan, I withhold information
If a bank has assets of $100 million and liabilities of $95 million, what is its net worth? If 60 percent of its assets were loans, what percentage of the loans could go sour before the bank would
What type of risk does each of the following situations portray? a. After the attack on the World Trade Center, several major insurance companies did not have sufficient cash assets available to
Explain why stock and bond prices adjust until investors are indifferent between stocks and bonds, given varying degrees of risk and liquidity.
What is diversification? What is the expected return to a portfolio that is composed of a variety of financial assets?
If the returns to two different fi nancial instruments are perfectly positively correlated, can holding a combination of the two reduce risk for any given return? Explain. If the returns to two
When full adjustment has occurred, what do differences in returns on various financial instruments reflect?
If current and expected earnings rise, what happens to stock prices?
Interest rates are going up. What happens to the prices of previously issued bonds?
How do adaptive expectations differ from rational expectations?
Why is the actual value of a financial variable different from the optimal forecast of that variable? Assuming that expectations are rational, what, on average, will be the difference between the
What is the efficient markets hypothesis? How does it differ from the stronger version of the hypothesis?
What is the fundamental value of a financial instrument?
What is the rationale behind the efficient markets hypothesis?
Explain why the expected return on newly issued and previously issued bonds is the prevailing interest rate plus any expected capital gain or loss.
Must all market participants know the optimal forecast of a financial instrument for the price of the financial instrument to be driven to the optimal forecast?
What is a “bubble” in a financial market? Can financial prices ever overshoot or undershoot optimal values?
News comes out that leads investors to believe that there is more risk involved with owning financial instrument A. What will happen to its equilibrium return?
If the house hold, business, and government sectors are all deficit sectors, what does this imply about the rest- of- the- world sector?
Assume that in 2009, the U.S. government wants to significantly increase the government deficit. What does this imply about the other sectors?
If the current price of a share of stock that pays a $1 dividend is $20, and if the expected capital gain is $2, what is the expected return? What is the return if there is an expected capital loss
Assume the equilibrium return on a financial instrument is 10 percent, and the instrument pays no dividends or interest. If the current price is $100 and the expected future price one year from now
Assume that the equilibrium return on a financial instrument is 10 percent. If the current price is $100 and the instrument does not pay interest or dividend, what is the price expected one year from
Assume that HappyDays, Inc., pays an 8 percent return during expansions and a zero percent return during recessions with certainty. SadDays, Inc., pays a zero percent return in expansions and an 8
Given the yield curve in question 15, what is the expected direction of future one- year rates? Under what circumstances would one- year rates be expected to decline?Question 15Assume that current
What would happen to the risk premium if the economy went into a strong expansion? A deep recession?
If yield curves became flatter (steeper), what does this say about expectations of future interest rates?
Use the liquidity premium to give an explanation for why yield curves have most often been upward sloping over the past 50 years. Could a yield curve be upward sloping even if short- term rates were
Use graphical analysis to show that if Y and M both increase, the interest rate may increase, decrease, or stay the same. In each case, what happens to the equilibrium quantity demanded and supplied?
Under what conditions will a bond sell at a premium above par? At a discount from par?
Explain why it would be incorrect to view the various sectors of the financial markets as totally separate entities.
Show on a graph how the interest rate and the quantity demanded of money are related. Do the same for the quantity supplied of money. When is the market for money in equilibrium?
List the major responsibilities of each of the following: a. The Board of Governors.b. The 12 Reserve Banks.c. The Federal Open Market Committee.
What is the difference between the demand for money and the quantity demanded of money?
Discuss the similarities between how the price of cell phones is determined in the market for cell phones and how the interest rate is determined in the market for money.
Briefly define the interest rate, reserves, and the required reserve ratio.
Your friend took a class in money and banking two years ago and recalls that currency in the hands of the public is in M1. Explain to your friend why currency in the hands of the public is also
Zoto is a remote island that has experienced rapid development. In contrast, Zaha is an island where growth has been sluggish and the level of economic activity remains low. How could the existence
Discuss the factors that determine the shape and level of a yield curve. How do term to maturity, credit risk, and tax treatment affect the interest rate on a particular asset?
Explain why a yield curve can be negatively sloped. Would interest rates be abnormally high or low? What would be the overall expectation of the direction of future short-term interest rates?
According to the expectations theory, how is the long-term interest rate determined? Why is the geometric average used instead of the simpler arithmetic average?
BBB- rated corporate bonds are riskier than AAArated bonds. Explain where the two yield curves will lie relative to each other. What could cause the spread to widen?
What determines expectations? Are expectations about future prices in de pen dent of expectations about future money supply growth rates? Why or why not?
Could the yield curve for municipals ever lie above the yield curve for government securities? What effect would an increase in marginal tax rates have on the position of the yield curve for
Define preferred habitats. Explain how this modification affects the expectations theory. What could cause market segmentation based on preferred habitats to break down? How is the market
Discuss the following statements: Over a typical cycle, the movement of the yield curve is like the wagging of a dog’s tail. The entire tail wags, but short-term rates wag more often than long-term
Assume that current interest rates on government securities are as follows: one-year rate, 5 percent; two- year rate, 6 percent; three- year rate, 6.5 percent; four- year rate, 7 percent. Graph the
If a taxpayer’s marginal tax rate is 33 percent, what is the after- tax yield on a corporate bond that pays 5 percent interest? If the average marginal tax rate of all taxpayers is 50 percent, will
What would happen to interest rates on municipal securities, given each of the following scenarios?a. The government increases marginal tax rates. b. The tax exemption on municipals is
Draw the yield curve assuming that future short-term rates are expected to remain constant and the liquidity premium is positive. Now assume that net lenders increase their preference for short-term
Define the concepts of compounding and discounting. Use future values and present values to explain how these concepts are related.
Use the concept of present value to explain why a trip to Hawaii next year would be valued more to most people than the same trip in the year 2015.
During the Great Depression of the 1930s, nominal interest rates were close to zero. Explain how real interest rates could be very high even though nominal interest rates were very low.
Assume that after you graduate, you get a job as the chief financial officer of a small company. Explain why being able to forecast the direction of interest rate changes may be critical for your
What factors affect the demand for loanable funds? The supply of loanable funds?
In general, discuss the movement of interest rates, the money supply, and prices over the business cycle.
A young couple is borrowing $100,000 to buy their first home. An older couple is living off the interest income from the $100,000 in financial assets they own. How does the interest rate affect each
What is the present value of each of the following income streams? a. $100 to be received at the end of each of the next three years. b. $100 to be received at the end of each of the next three
Assume that a bond with five years to maturity, a par value of $1,000, and a $60 annual coupon payment costs $1,100 today. What is the coupon rate? What is the current yield?
The nominal interest rate is 12 percent, and anticipated inflation is 8 percent. What is the real interest rate?
Graph the demand and supply for loanable funds. If there is an increase in income, ceteris paribus, show what happens to the interest rate, the demand for loanable funds, and the quantity supplied of
As an enrolling freshman, would you have been willing to pay $18,000 for four years’ tuition rather than $5,000 per year for four years? (Assume you would be able to do so and that you have no fear
You win a million- dollar lottery to be paid out in 20 annual installments of $50,000 over the next 20 years. Assuming an interest rate of 6 percent, how large a payment would you accept today for
Jake is given $10,000 in a CD that matures in 10 years. Assuming that interest payments are reinvested during the life of the CD, how much will the CD be worth at maturity if the interest rate is 5
Henry and Sheree just had a baby. How much will they have to invest today for the baby to have $100,000 for college in 18 years if the interest rate is 5 percent? If the interest rate is 10 percent?
Assume that the price of a market basket of goods and services is $2,000 in the base period, $2,060 one year later, and $2,100 two years later. What is the price index in the base period? After the
In June 2010, John pays $9,800 for a one- year T-bill that can be redeemed for $10,000. What is the amount of interest earned? What is the yield?
Rank the following financial instruments in terms of their safety and liquidity: a. U.S. T-bills b. Large negotiable CDs c. Mortgagesd. Government bonds e. Government agency securities f.
Can the bid price ever be greater than the asked price?
Why are municipals attractive to individuals and corporations with high incomes or profits?
Would you rather own the stocks or bonds of a particular corporation if you believed that the corporation was going to earn exceptional profits next year?
What is the difference between a government security and a government agency security? Which asset would you prefer to own if safety and liquidity were important to you?
Define and contrast stocks and bonds. What are the advantages of owning preferred stock? What are the advantages of owning common stock?
What are mortgages?
Define commercial paper, negotiable certificates of deposit, repurchase agreements, bankers’ acceptances, federal funds, and Eurodollars. In what ways are they similar, and in what ways are they
If you call a local brokerage firm, you will find that the commission or brokerage fee charged for purchasing $10,000 of T-bills is less than the fee associated with purchasing $10,000 of, say,
Discuss the major function of market makers in securities markets. What is the difference between a broker and a dealer?
What is the difference between financial futures and financial forward markets? What are derivative markets? What are the ways derivatives can be used?
The secondary market for T-bills is active, and the secondary market for federal agency securities is limited. How does this affect the primary market for each security? Why are well- developed

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