Economics 230
Sample Midterm Examination
Part A: Multiple Choice. Choose the one alternative that best completes the statement or
answers the question.
1. If fluctuations in interest rates become larger, then, other things equal, the demand for stocks _____ and
the demand for long-term bonds _____.
a. increases; increases
c. decreases; decreases
b. increases; decreases
d. decreases; increases
2. When an asset has a _____ beta, it has a _____ amount of systematic risk; thus, one would predict that
the asset's expected return would be _____.
a. high; low; low
d. high; high; high
b. high; low; high
e. low; low; high
c. high; high; low
3. Diversification cannot eliminate risk entirely because securities
a. have nonsystematic risk.
c. have systemic risk.
b. have systematic risk.
d. coincident risk.
4. Large-denomination CDs are _____, so that like a bond they can be resold in a _____ market before they
mature.
a. nonnegotiable; secondary
c. negotiable; secondary
b. nonnegotiable; primary
d. negotiable; primary
5. The presence of _____ in financial markets leads to adverse selection and moral hazard problems that
interfere with the efficient functioning of financial markets.
a. noncollateralized risk
b. free-riding
c. asymmetric information d. costly state verification
6. Financial intermediaries
a.
b.
c.
d.
e.
7.
exist because there are substantial information and transactions costs in the economy.
improve the access to the financial market of the small saver.
are involved in the process of indirect finance.
do each of the above.
do only (a) and (b) of the above.
An $8,000 coupon bond with a $400 coupon payment every year has a coupon rate of
a. 5 percent
b. 8 percent
c. 10 percent
d. 40 percent
8. A coupon bond pays the owner of the bond
a.
b.
c.
d.
e.
the same amount every month until maturity date.
the face value of the bond plus an interest payment once the maturity date has been reached.
a fixed-interest payment every period and repays the face value at the maturity date.
the face value at the maturity date.
none of the above.
9. With an interest rate of 8 percent, the present value of $100 next year is approximately
a. $108.
b. $100.
c. $96.
d. $93.
10. The formula for the measure of the interest rate called the yield on a discount basis has two
peculiarities:
a. it uses the percentage gain on the face value of the bill, rather than the percentage gain on the purchase
price of the bill.
b. it ignores the time to maturity.
c. it puts the yield on the annual basis of a 360 day year.
d. both (a) and (b) of the above.
e. both (a) and (c) of the above.
11. In the Keynesian liquidity preference framework, a rise in the price level causes the demand for money
to _____ and the demand curve to shift to the _____.
a. increase, left
b. increase, right
c. decrease, left
d. decrease, right
12. The economist Irving Fisher, after whom the Fisher effect is named, explained why interest rates _____
as the expected rate of inflation _____.
a. rise; increases
d. fall; increases
b. rise; stabilizes
e. fall; stabilizes
c. rise; decreases
13. Holding other factors constant, when the price level _____, the demand curve for money shifts to the
_____ and the interest rate _____.
a. falls; left; falls
d. rises; left; rises
b. falls; right; falls
e. rises; right; falls
c. falls; left; rises
14. When the growth rate of the money supply increases, interest rates end up being permanently higher if
a.
b.
c.
d.
the liquidity effect is larger than the other effects.
there is fast adjustment of expected inflation.
there is slow adjustment of expected inflation.
the expected inflation effect is larger than the liquidity effect.
15. Factors that cause the demand curve for bonds to shift to the right include
a. an increase in the inflation rate.
b. an decrease in the liquidity of common stocks.
c. a decrease in the volatility of stock prices. d. all of the above.
16. Factors that can cause the supply curve for bonds to shift to the right include
a. an expansion in overall economic activity.
b. an increase in expected inflation.
c. a decrease in government deficits.
d. all of the above.
e. only (a) and (b) of the above.
17. The theory of asset demand provides a framework for deciding what factors cause the demand curve for
bonds to shift. These factors include changes in the
a. wealth of investors.
b. liquidity of bonds relative to alternative assets.
c. expected returns on bonds relative to alternative assets.
d. risk of bonds relative to alternative assets.
e. all of the above.
18. Which of the following can be described as involving indirect finance?
a.
b.
c.
d.
You make a loan to your neighbor.
A corporation buys a share of common stock issued by another corporation.
You buy a U.S. Treasury bill from the U.S. Treasury.
You make a deposit at a bank.
19. Which of the following $1,000 face-value securities has the highest yield to maturity?
a.
b.
c.
d.
A 5 percent coupon bond selling for $1,000
A 10 percent coupon bond selling for $1,000
A 12 percent coupon bond selling for $1,000
A 12 percent coupon bond selling for $1,100
20. Federal funds are
a.
b.
c.
d.
e.
funds raised by the federal government in the bond market.
loans made by the Federal Reserve System to banks.
loans made by banks to the Federal Reserve System.
loans made by banks to each other.
none of the above.
21. An examination of revised 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 poor guide of monetary policy because they are usually underestimates of
the revised statistics.
d. the initial statistics provide a good guide of monetary policy, though they are usually underestimates of
the revised statistics.
22. If an individual moves money from a small-denomination time deposit to a demand deposit account,
a. M1 increases and M2 stays the same.
c. M1 stays the same and M2 stays the same.
b. M1 stays the same and M2 increases.
d. M1 increases and M2 decreases.
23. The risk structure of interest rates is
a.
b.
c.
d.
the structure of how interest rates move over time.
the relationship among interest rates of different bonds with the same maturity.
the relationship among the term to maturity of different bonds.
the relationship among interest rates on bonds with different maturities.
24. Which of the following long-term bonds has the highest interest rate?
a. Corporate Baa bonds
c. Corporate Aaa bonds
b. U.S. Treasury bonds
d. Municipal bonds
25. When the default risk in corporate bonds increases, other things equal, the demand curve for corporate
bonds shifts to the _____ and the demand curve for Treasury bonds shifts to the _____.
a. right; right
b. right; left
c. left; left
d. left; right
26. The risk premium on corporate bonds becomes smaller if
a. the riskiness of corporate bonds increases.
c. the liquidity of corporate bonds decreases.
e. both (b) and (d) occur.
b. the liquidity of corporate bonds increases.
d. the riskiness of corporate bonds decreases.
27. If the expected path of one-year interest rates over the next five years is 2 percent, 4 percent, 1 percent,
4 percent, and 3 percent, the expectations hypothesis predicts that the bond with the lowest interest rate
today is the one with a maturity of
a. one year.
b. two years.
c. three years.
d. four years.
28. A plot of the interest rates on default-free government bonds with different terms to maturity is called
a. a risk-structure curve.
c. a yield curve.
b. a term-structure curve.
d. an interest-rate curve.
29. According to the segmented markets theory of the term structure
a. the interest rate for each maturity bond is determined by supply and demand for that maturity bond.
b. bonds of one maturity are not substitutes for bonds of other maturities, therefore, interest rates on bonds
of different maturities do not move together over time.
c. investors' strong preferences for short-term relative to long-term bonds explains why yield curves
typically slope upward.
d. all of the above.
e. none of the above.
30. Which of the following theories of the term structure are able to explain the fact that yield curves
usually slope upward?
a.
b.
c.
d.
e.
The expectations hypothesis
The segmented markets theory
The preferred habitat theory
Both (b) and (c) of the above
Both (a) and (c) of the above
Part B: Fill-in-blank. Note that it may take more than one word to complete a
blank.
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
The process of channeling funds by way of a financial intermediary is known as __________.
Financial markets can be classified as debt or __________ markets, __________ or secondary
markets, organized exchanges or __________ markets, money or __________ markets.
Money has three primary functions. It is a __________, a __________, and a __________.
A loan requiring the borrower to make the same payment every period until maturity is called a
__________.
For the coupon bond, the coupon payment expressed as a percentage of the face value of the bond
is the __________.
An asset is a luxury when it has a wealth elasticity __________.
The supply curve for bonds is upward sloping because a rising bond price means a __________
interest rate, thereby reducing the cost of borrowing funds.
The liquidity preference and loanable funds framework indicates that there are four possible effects
of an increase in the rate of money supply growth on interest rates: (a) the negative __________
effect; (b) the positive ___________ effect; (c) the positive __________ effect; and (d) the
positive __________ effect.
The risk that a change in interest rate has greater effect on bonds with longer term to maturity than
on bonds with shorter term to maturity is called __________.
The key assumption in the segmented market theory of the term structure of interest rates is that
bonds of different maturities are __________.
Part C: Short answer. Do (1) or (2) but not both.
(1)
Answer the following question with a clearly drawn and labeled diagram of the bond market.
a.
b.
c.
d.
(2)
Identify the initial equilibrium.
Suppose there is an increase in expected inflation, carefully explain how this may affect
the supply and demand for bond. Show the changes in your diagram, and identify the new
equilibrium.
At the new equilibrium, is the market interest higher, lower, or the same as the initial
equilibrium?
At the new equilibrium, is the equilibrium quantity of bond higher, lower, or the same as
the initial equilibrium?
The following question concerns the Expectations Hypothesis of the term structure of interest
rates.
a.
b.
c.
d.
What is the key assumption of the Expectations Hypothesis?
Carefully, explain (i.e., do not simply state the result but explain how you arrive at the
result) the key implication of the Expectations Hypothesis.
How does the Expectations Hypothesis explain the three possible shapes of the yield
curves? Explain.
How does the Expectations Hypothesis explain the three observed facts of the yield
curves? Explain.
Part A: Multiple Choice.
1. B
11. B
21. B
2. D
12. A
22. A
3. B
13. A
23. B
4. C
14. D
24. A
5. C
15. B
25. D
Part B: Complete sentences by fill-in-blanks.
6. D
16. E
26. E
7. A
17. E
27. A
8. C
18. D
28. C
9. D
19. C
29. D
10. E
20. D
30. D
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
indirect finance
equity; primary; over-the-counter; capital
medium of exchange; unit of account; store of value
fixed payment
coupon interest rate
greater than one
lower
liquidity; income; price level; inflation expectations
the interest rate risk (not the risk structure of interest rates)
not substitutable
Part C: Short Answer. 10 points (20%).
1.a
b.
c.
d.
Point A in the diagram
There will be an increase in bond supply, i.e., bond supply curve will shift to the right. The reason
is that, holding everything constant, an increase in expected inflation means a lower real interest
rate, thus a lower real cost of borrowing.
Bond demand will decrease, i.e., bond demand curve will shift to the left. There are three reasons.
The first reason is that the lower real interest rate means a lower real return. Second, a higher
expected inflation will cause a higher nominal interest rate (the Fisher effect) which will cause a
capital loss on long-term bond, thus making bond less attractive. Third, other assets, particularly
real assets (as opposed to financial assets), will increase in value with inflation, thus making them
more attractive.
The new equilibrium is at point B.
Nominal interest rate is higher at the new equilibrium.
This depends on the relative shifts in supply and demand. It could be more, less, or the same as the
initial equilibrium.
2.a
The key assumption is that bonds of different maturities are perfect substitutes for each other.
b.
The chief implication is that the expected return will be the same regardless of the maturity of the
bond that you are holding, provided that the holding periods are the same. For example, if the
holding period is three years. Your expected returns will be the same if you hold a 3-year bond to
maturity or hold a series of one-year bond and reinvesting both principles and interest for three
years. As a result, the interest rate on long term bond can be shown to be an average of the
current and expected future short-term interest rates on one year bond.
The explanation of the shape of the three yield curves is dependent on the fact that, under the
expectations hypothesis, the long term interest rate is an average of the current and expected future
short-term interest rates on one year bond. Thus, an upward sloping yield curve means that future
short-term interest rates are expected to increase. A flat yield curve means that future short-term
interest rates are expected to be the same as the current short-term interest rate. A downward
sloping yield curve means that future short term interest rates are expected to fall.
If short-term interest rises today, according to the expectations hypothesis, we also expect future
short-term interest rates to rise also. This is why we observe that both short-term and long-term
interest rates tend to move together. This explains fact 1. For fact 2, expectations hypothesis
makes an additional assumption that there is a normal level of interest rate. Thus, when short-term
interest rate is higher than the normal rare, it is expected to fall in the future. When the short-term
interest rate is lower than the normal rate, it is expected to rise in the future. This explains fact 2
that when short-term interest rate is high, the yield curve is generally downward sloping, when
short-term interest rate is low, the yield curve is generally upward sloping. The expectations
hypothesis cannot explain fact 3 that yield curves generally slope upward.
c.
d.