Financial Markets Sample Midterm
Multiple Choice (3 Points each)
Suppose, two years ago, you purchased a 10-year a coupon bond paying 7% interest
annually with a face value of $1000. It is now two years later and you just received an
interest payment yesterday (the bond matures in exactly eight years).
1) You look in the paper and the yield on comparable debt is 6%, what is the bond
currently worth?
a) 1062$
b) 1073$
c) 1000$
d) 1063$
e) None of the above
2) If you bought it a Par value, did you have a capital gain or loss? Also, if the yield
increased to 8%, would you have a Capital Gain or Loss, or could you tell?
a) Capital Gain, Capital Gain
b) Capital Gain, Capital Loss
c) Capital Loss, Capital Gain
d) Capital Loss, Capital Loss
e) No Gain or Loss
3) What is the Current Yield?
a) Less than 6%
b) 6% to < 6.5%
c) 6.5% to < 6.8%
d) 6.8% to < 7%
e) 7% or more
C=7%=$70
FV=$1,000
Purchased at par value $1,000 2 years ago.
There are 8 years to maturity and the yield is 6%, this
bond pays coupon annually.
1  1.068 
70
1,000
8
Pr ice  

 70 * 
  1,000 *1.06  $1,062.10
i
8
1.06
i 1 1.06
 0.06 
8
Under this assumption we have a capital gain, because our
selling price higher than our purchase price, additionally
we have received 2 coupons for $70 each. The current yield
is 70
 6.59%
1,062.10
Financial Markets Sample Midterm
Suppose that instead of buying the coupon bond, you invested in a ten-year zero-coupon
bond with a face value of $2000.
4) If the bond was originally cost $1100, what was the yield on the bond when you
originally purchased it?
a) Less than 6%
b) 6% to < 6.5%
c) 6.5% to < 7%
d) 7% to < 7.5%
e) 7.5% or more
5) Suppose that today (two years later) comparable bonds are yielding 9%, if you sold
the bond today, would you have a capital gain or loss?
a) Capital Gain > $100
b) Capital Gain < $100
c) Capital Loss > $100
d) Capital Loss < $100
FV=$2,000
Price=$1,100
10 years to maturity.
1
2,000
 2,000  10
1,100 
 (1  ytm)  
  ytm  6.16%
10
(1  ytm)
 1,100 
After 2 years the yield (ytm) rise to 9%. We have just 8
years to maturity.
2,000
 1,003.73
1.09 8
We get a capital loss because our selling price is $94.27
lower than our purchase price.
Pr ice 
Financial Markets Sample Midterm
Compare the two bonds (the par versus the zero):
6) Assuming that the yields on the bonds are perfectly correlated (the yields move up
and down together), which is more sensitive to a change in interest rates, and why?
a) The par bond, because the coupon is smaller
b) The par bond, because it makes a single payment
c) The discount bond, because it has a higher yield
d) The discount bond, because it makes several payments
e) None of the above
The lower the coupon, the more sensitive a bond is to
changes in yield. The zero-coupon bond (assuming equal
maturity) is the most sensitive because the entire weight
of the bond is subject to the highest discount factor.
7) Which portfolio would be most sensitive to a change in interest rates A) five $1000,
5-year annual coupon bonds with a 10% coupon, B) a $5000, 5-year semi-annual
coupon bond, with 10% coupons, or C) a $5000, 3-year annual coupon bond with a
10% coupon?
a) A
b) B
c) C
d) Can’t Tell
8) Indicate which Portfolio has the highest duration.
a) A
b) B
c) C
d) Can’t tell
A
10% coupon annual
5
years
maturity
B
10%
coupon
annual
to 5
years
maturity
C
semi 10% coupon
to 3
years
maturity
to
Portfolio A is the most sensitive (and likewise has the
highest duration).
Portfolio B has the same coupon and
maturity, but pays semiannually, thus it is less sensitive
than Portfolio A (some of the coupon payments are subject
to lower discounting exponents). Portfolio C has the same
coupon,
but
a
shorter
maturity,
therefore
is
less
sensitive.
Financial Markets Sample Midterm
Suppose that you wish to buy a new Mitsubishi Eclipse that will cost you $22,000. If you
must put $5000 down, and will finance the rest at 6% APR for the next 60 months, paid
at the beginning of each month.
9) What will your monthly payments be?
a) 328.66
b) 283.33
c) 283.75
d) 327.02
e) None of the above
10) Suppose that you find out that given your credit, you should have only been charged
an EAR of 5%, how much did you overpay because of dealer financing?
a) Less than $350
b) 350 to 400
c) 400 to 450
d) 450 to 500
e) More than $500
Price of the car: $22,000, Down payment: $5,000
Period: 60 monthly payments at the beginning of each month.
Rate: 6% APR (nominal, this means that the monthly rate is
6/12=0.5% per month)
Therefore, the loan principal will be $17,000.
1  (1.005) 60 
17,000  PMT  
  (1.005)
0
.
005


The monthly payment will be $327.02
For a 5% EAR, the corresponding monthly rate is:
1
rmonthly  1.0512  1  .00407
The present value of your annuity payments at a 5% EAR is:
1  (1.00407) 60 
PV  327.02  
  (1.00407)  17,448.64
0.00407


You Paid $22,448.64.
through financing.
The dealer made an extra $448.64
Financial Markets Sample Midterm
11) (I) Most corporate bonds have a face value of $1000, pay interest semi-annually, and
can be redeemed anytime the issuer wishes. (II) Registered bonds have now been
largely replaced by bearer bonds, which do not have coupons.
a) (I) is true, (II) false.
b) (I) is false, (II) true.
c) Both are true.
d) Both are false.
12) (I) Debt markets are often referred to generically as the bond market. (II) A bond is a
security that is a claim on the earnings and assets of a corporation.
a) (I) is true, (II) false.
b) (I) is false, (II) true.
c) Both are true.
d) Both are false.
13) Which of the following are primary markets?
a) The New York Stock Exchange
b) The U.S. government bond market
c) The over-the-counter stock market
d) The options markets
e) None of the above
14) The current yield is a less accurate measure of the yield to maturity the ______ the
time to maturity of the bond and the ______ the price is from/to the par value.
a) shorter; closer
b) shorter; farther
c) longer; closer
d) longer; farther
15) A decrease in the expected rate of inflation causes the demand curve for bonds to
_____ and the supply curve of bonds to _____
a) fall; fall.
b) fall; rise.
c) rise; fall.
d) rise; rise.
Financial Markets Sample Midterm
16) If a corporation begins to suffer large losses, then the default risk on corporate bonds
a) will increase, and the equilibrium interest rate on these bonds will increase.
b) will decrease, and the equilibrium interest rate on these bonds will increase.
c) will increase, and the equilibrium interest rate on these bonds will decrease.
d) will decrease, and the equilibrium interest rate on these bonds will decrease.
17) According to the pure expectations theory of the term structure,
a) the interest rate on long-term bonds will exceed the average of expected future
short-term interest rates.
b) interest rates on bonds of different maturities move together over time.
c) buyers of bonds prefer short-term to long-term bonds.
d) all of the above.
e) only (A) and (B) of the above.
18) In situations where the asymmetric information problem is not severe,
a) the money markets have a distinct cost advantage over banks in providing shortterm funds.
b) banks have a distinct cost advantage over the money markets in providing shortterm funds.
c) banks have a comparative advantage over the money markets in providing shortterm funds.
d) banks have an absolute advantage over the money markets in providing shortterm funds.
19) Federal government bonds are subject to _____ risk but are free of _____ risk.
a) default; interest rate
b) default; underwriting
c) interest rate; default
d) interest rate; underwriting
20) If the duration of a bond being discounted a 5% is 3.3 years, and interest rates on
comparable debt increase by .25%, how much will the price rise or fall?
a) Rise approximately .8%
d) Rise approximately 8%
b) Fall approximately .8%
e) Fall approximately 3.4%
c) Fall approximately 8%
Financial Markets Sample Midterm
21) The efficient market hypothesis suggests that
a) investors should not try to outguess the market by constantly buying and selling
securities.
b) investors do better on average if they adopt a "buy and hold" strategy.
c) buying into a mutual fund is a sensible strategy for a small investor.
d) all of the above are sensible strategies.
e) only (A) and (B) of the above are sensible strategies.
22) That most used cars are sold by intermediaries (i.e., used car dealers) provides
evidence that these intermediaries
a) have been afforded special government treatment, since used car dealers do not
provide information that is valued by consumers of used cars.
b) are able to prevent competitors from free-riding off the information they provide.
c) have failed to solve adverse selection, because “lemons” continue to be traded.
d) do all of the above.
23) Factors that cause the demand curve for bonds to shift to the left include
a) an increase in the inflation rate.
b) an increase in the liquidity of stocks.
c) a decrease in the volatility of stock prices.
d) all of the above.
e) none of the above.
24) The yield on a discount basis of a 90-day $1,000 Treasury bill selling for $900 is
a) 10 percent.
b) 20 percent.
c) 25 percent.
d) 40 percent.
25) When the borrower engages in activities that make it less likely that the loan will be
repaid, _____________ is said to exist.
a) asymmetric information
b) adverse selection
c) moral hazard
d) fraud
Financial Markets Sample Midterm
26) The Fisher equation states that:
a) the nominal interest rate equals the real interest rate plus expected inflation.
b) the real interest rate equals the nominal interest rate less expected rate inflation.
c) the nominal interest rate equals the real interest rate less expected inflation.
d) both (A) and (B) of the above are true.
e) both (A) and (C) of the above are true.
27) If inflation is expected to increase, what qualitative statements can we make?
a) Bond yields will increase.
b) Bond prices will increase.
c) The quantity of bonds sold will fall.
d) both (A) and (B) of the above are true.
e) both (A) and (C) of the above are true.
28) If the federal government increases spending, according to expected inflation effect:
a) Bond prices will increase as the price level falls
b) Bond prices will decrease because of the increased supply of bonds
c) Bond prices will decrease as the price level rises
d) Bond prices will increase as the real money supply increases
e) None of the above
29) What would be the result of an increase in private consumption?
a) The demand curve shift out, and bond prices rise
b) The demand curve shifts out, and bond yields fall
c) The demand curve shifts back, and bond yields fall
d) The demand curve would shift back, and the real money supply falls
e) None of the above
30) Which of the following are not Capital Market Instruments?
a) Preferred Stock
b) Treasury Strips
c) Commercial Paper
d) T-bonds
e) All of the above are Capital Market Instruments
Financial Markets Sample Midterm
Essay Question: Explain how “adverse selection” can cause the financial markets to
fail and the concomitant economic effects. Also discuss the key types of firms that
have arisen to correct the problem, and their role. (10 Points)
-
-
-
-
Adverse selection is where the issuer cannot discern
between good and bad credit among borrowers
The effect on the financial markets is the rationing
of credit—lenders refuse to lend, or lend much less
than they would if they could identify good and bad
risks
The result is that fewer low risk borrowers are able
to raise capital, this slows or eliminates economic
growth
Commercial Banks are one of the chief financial firms
that have arisen to correct the problem. By
specializing in particular (lending) markets, they are
able to reduce adverse selection through information
gathering.
Financial research firms (e.g. Bloomberg), rating
agencies, and investment banks (through market
analysts and disclosure for new issues) also reduce
this problem by providing investors information about
firms seeking to raise funds.