Economics of Financial Markets
Exam Preparation Guide
Course Introduction
Economics of Financial Markets examines the fundamental principles that govern financial markets, including the behavior of asset prices, market efficiency, and the role of information. The course explores topics such as risk and return, portfolio theory, the functioning of stock, bond, and derivatives markets, and the impact of macroeconomic factors on financial systems. Students gain insights into how market participants make decisions, the regulatory environment, and issues related to financial crises and market stability. Through analytical and empirical tools, the course equips students with a comprehensive understanding of how financial markets operate and their significance in the broader economy.
Recommended Textbook
Financial Markets and Institutions 8th Edition by Frederic Mishkin
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Chapter 1: Why Study Financial Markets and Institutions?
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Sample Questions
Q1) Financial market activities affect
A) personal wealth.
B) spending decisions by individuals and business firms.
C) the economy's location in the business cycle.
D) all of the above.
Answer: D
Q2) The bond markets are important because
A) they are easily the most widely followed financial markets in the United States.
B) they are the markets where interest rates are determined.
C) they are the markets where foreign exchange rates are determined.
D) all of the above.
Answer: B
Q3) Although the internet has changed many aspects of our lives,it hasn't proven very useful for collecting and/or analyzing financial and economic data.
A)True
B)False
Answer: False
Q4) What is money?
Answer: NOT Answerd
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Chapter 2: Overview of the Financial System
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Q1) Distinguish between primary markets and secondary markets.
Answer: 11ec663f_db52_ebd0_bd63_d36f7881685f_TB2777_00
Q2) Banks providing depositors with checking accounts that enable them to pay their bills easily is known as
A) liquidity services.
B) asset transformation.
C) risk sharing.
D) transaction costs.
Answer: A
Q3) Financial intermediaries
A) exist because there are substantial information and transaction costs in the economy.
B) improve the lot of the small saver.
C) are involved in the process of indirect finance.
D) do all of the above.
E) do only A and B of the above.
Answer: D
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Chapter 3: What Do Interest Rates Mean and What Is Their
Role in Valuation?
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Sample Questions
Q1) All else being equal,the greater the interest rate the greater the duration is. A)True
B)False
Answer: False
Q2) If a $10,000 face value discount bond maturing in one year is selling for $9,000,then its yield to maturity is approximately A) 9 percent.
B) 10 percent.
C) 11 percent.
D) 12 percent.
Answer: C
Q3) An indexed bond is a bonds whose interest and/or principal payments are adjusted for changes in the price level.
A)True
B)False
Answer: True
Q4) Unless a bond defaults,an investor cannot lose money investing in bonds. A)True
B)False
Answer: False
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Chapter 4: Why Do Interest Rates Change?
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Sample Questions
Q1) A decline in the expected inflation rate causes the demand for money to ________ and the demand curve to shift to the ________.
A) decrease; right
B) decrease; left
C) increase; right
D) increase; left
Q2) Explain the differences between the loanable funds framework and the liquidity preference framework.
Q3) When the interest rate on a bond is below the equilibrium interest rate,there is excess ________ in the bond market and the interest rate will ________.
A) demand; rise
B) demand; fall
C) supply; fall
D) supply; rise
Q4) Diversification benefits an investor by
A) increasing wealth.
B) increasing expected return.
C) reducing risk.
D) increasing liquidity.
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Chapter 5: How Do Risk and Term Structure Affect Interest
Rates?
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Q1) ________ bonds are the most liquid of all long-term bonds.
A) Callable
B) Municipal
C) Corporate Aaa
D) U.S. Treasury
Q2) The spread between interest rates on low-quality corporate bonds and U.S.government bonds ________ during the Great Depression.
A) was reversed
B) narrowed significantly
C) widened significantly
D) did not change
Q3) If a bond has a favorable tax treatment,its required interest rate (all else equal)
A) will be higher.
B) will not be affected.
C) will be lower.
D) all of the above could happen.
Q4) Bonds with the lowest risk of default are often referred to as junk bonds.
A)True
B)False
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Chapter 6: Are Financial Markets Efficient?
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Sample Questions
Q1) Which of the following types of information will most likely enable the exploitation of a profit opportunity?
A) Financial analysts' published recommendations
B) Technical analysis
C) Hot tips from a stockbroker
D) None of the above
Q2) Explain what the market reaction will be in an efficient market if a firm announces a fully anticipated filing for bankruptcy.
Q3) The efficient market hypothesis applies to
A) both the stock market and the foreign exchange market.
B) the stock market but not the foreign exchange market.
C) the foreign exchange market but not the stock market.
D) neither the stock market nor the foreign exchange market.
Q4) In an efficient market,abnormal returns are not possible,even using inside information.
A)True
B)False
Q5) What is the optimal investment strategy according to the efficient market hypothesis? Why?
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Chapter 7: Why Do Financial Institutions Exist?
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Sample Questions
Q1) Issuing marketable securities is the primary way businesses finance their operations.
A)True
B)False
Q2) American businesses use stock to finance about 10 percent of their external financing.
A)True
B)False
Q3) Distinguish between adverse selection and moral hazard.
Q4) The principal-agent problem is an example of the adverse selection problem that can result from asymmetric information.
A)True
B)False
Q5) Net worth
A) is the difference between current assets and current liabilities.
B) is the difference between assets and liabilities.
C) is total assets divided by total liabilities.
D) is total assets plus total liabilities.
Q6) What is the free-rider problem? Describe some situations that this problem creates.
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Chapter 8: Why Do Financial Crises Occur and
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Sample Questions
Q1) Which of the following factors led up to the Greece debt crisis in 2009-2010?
A) Speculative attacks on the euro and a rise in actual and expected inflation
B) A decline in tax revenues resulting from a contraction in economic activity
C) A double-digit budget deficit
D) All of the above
E) only B and C of the above
Q2) Approximately how large was the U.S.subprime mortgage market in 2007?
A) $100 million
B) $100 billion
C) $500 billion
D) $1 trillion
Q3) Describe a special purpose vehicle. How are they related to the creation of collateralized debt obligations?
Q4) Explain the relationship between agency theory and a financial crisis.
Q5) Factors that lead to worsening conditions in financial markets include
A) increases in interest rates.
B) declining stock prices.
C) increasing uncertainty in financial markets.
D) all of the above.
E) only A and B of the above.
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Chapter 9: Central Banks and the Federal Reserve System
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Sample Questions
Q1) The Federal Advisory Council has ________ member(s)from each district.
A) one
B) two
C) three
D) can have any number of
Q2) The Federal Open Market Committee consists of
A) the five senior members of the seven-member Board of Governors.
B) the seven members of the Board of Governors and seven presidents of the regional Fed banks.
C) the seven members of the Board of Governors and five presidents of the regional Fed banks.
D) the twelve regional Fed bank presidents and the chairman of the Board of Governors.
Q3) What are the arguments for and against an independent Fed?
Q4) Describe the structure and responsibility for policy tools in The Federal Reserve System.
Q5) What are the factors that promote the independence of the Federal Reserve?
Q6) Are central banks in other nations moving toward more or less independence? Why?
Q7) Describe similarities and differences between the ECB and the US Fed.
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Q8) In recent years,has Fed policymaking become more or less transparent? Why?
Chapter 10: Conduct of Monetary Policy: Tools, Goals, Strategy, and Tactics
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Q1) What are the arguments for and against central bank intervention during asset-price bubbles?
Q2) The federal funds rate is an operating target.
A)True
B)False
Q3) Which of the following statements is true?
A) Credit-driven asset bubbles are particularly dangerous. When asset prices fall, the deleveraging of credit markets reduces economic activity.
B) Bubbles driven soley by irrational exuberance lead to a failure of financial institutions.
C) Both A and B are correct.
D) Neither A nor B is correct.
Q4) Which of the following is not an operating target?
A) Nonborrowed reserves
B) Monetary base
C) Federal funds interest rate
D) Discount rate
E) All are operating targets
Q5) Describe what criteria is applied when choosing a policy instrument.
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Chapter 11: The Money Markets
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Sample Questions
Q1) Explain why banks,which would seem to have a comparative advantage in gathering information,have not eliminated the need for the money markets.
Q2) Explain how and why repurchase agreements would be used.
Q3) Which of the following are true statements about participants in the money markets?
A) Large banks participate in the money markets by selling large negotiable CDs.
B) The U.S. government and corporations borrow in the money markets because cash inflows and outflows are rarely synchronized.
C) The Federal Reserve is the single most influential participant in the U.S. money market.
D) All of the above are true.
E) Only A and B of the above are true.
Q4) Which of the following is the largest borrower in the money markets?
A) Commercial banks
B) Large corporations
C) The U.S. Treasury
D) U.S. firms engaged in foreign trade
Q5) What are the major types of securities and who are the major participants in the money markets?
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Chapter 12: The Bond Market
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Sample Questions
Q1) Which of the following are true for the current yield?
A) The current yield is defined as the yearly coupon payment divided by the price of the security.
B) The formula for the current yield is identical to the formula describing the yield to maturity for a discount bond.
C) The current yield is always a poor approximation for the yield to maturity.
D) All of the above are true.
E) Only A and B of the above are true.
Q2) What role do restrictive covenants play in bond markets?
Q3) The current yield is a less accurate approximation 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
Q4) Governments never issue stock because they cannot sell ownership claims.
A)True
B)False
Q5) Explain the different types of corporate bonds.
Page 14
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Chapter 13: The Stock Market
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Sample Questions
Q1) To list on the NYSE,a firm must
A) have earnings of at least $10 million per year.
B) have at least $500 million in outstanding debt.
C) have a total of $100 million in market value.
D) meet all of the above requirements.
E) meet A and C of the above requirements.
Q2) In 2013,the NYSE traded ________ shares on an average trading day.
A) 4 billion
B) 7 billion
C) 10 billion
D) 12 billion
Q3) In over-the-counter markets,dealers increase the liquidity of thinly traded securities.
A)True
B)False
Q4) The Securities and Exchange Commission requires firms to submit various documents to increase the flow of information to investors but does not verify the accuracy of that information.
A)True
B)False
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Chapter 14: The Mortgage Markets
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Sample Questions
Q1) Mortgage-backed securities
A) have been growing in popularity in recent years as institutional investors look for attractive investment opportunities.
B) are securities collateralized by a pool of mortgages.
C) are securities collateralized by both insured and uninsured mortgages.
D) are all of the above.
E) are only A and B of the above.
Q2) How does an amortizing mortgage loan differ from a balloon mortgage loan?
Q3) Closing for a mortgage loan refers to the moment the loan is paid off.
A)True
B)False
Q4) Which of the following are useful for home buyers who expect their income to fall in the future?
A) GPMs
B) RAMs
C) GEMs
D) Only A and B are useful.
E) Only A and C are useful.
Q5) Discuss the pros and cons of a subprime market for residential mortgages in the U.S.
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Chapter 15: The Foreign Exchange Market
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Sample Questions
Q1) Discuss the relationship between changes in domestic real and nominal interest rates and exchange rates.
Q2) A decrease in the foreign interest rate shifts the expected return schedule for ________ deposits to the ________ and causes the domestic currency to appreciate.
A) domestic; right
B) domestic; left
C) foreign; right
D) foreign; left
Q3) The ________ states that exchange rates between any two currencies will adjust to reflect changes in the price levels of the two countries.
A) theory of purchasing power parity
B) law of one price
C) theory of money neutrality
D) quantity theory of money
Q4) What are some of the long-run determinants of the exchange rate?
Q5) Explain the logic underlying the law of one price and the theory of purchasing power parity.
Q6) Explain the theory of purchasing power parity.
Page 17
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Chapter 16: The International Financial System
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Q1) A central bank sale of ________ to purchase ________ in the foreign exchange market results in an equal rise in its international reserves and the monetary base.
A) foreign assets; domestic currency
B) foreign assets; foreign currency
C) domestic currency; foreign assets
D) domestic currency; domestic currency
Q2) A dirty float is
A) when the value of a currency is pegged relative to the value of one other currency.
B) when the value of a currency is allowed to fluctuate against all other currencies.
C) when countries intervene in foreign exchange markets in an attempt to influence their exchange rates by buying and selling foreign assets.
D) when the value of a currency is pegged relative to an anchor currency.
Q3) If a country's central bank eventually runs out of international reserves,it cannot keep its currency from depreciating and a devaluation must occur.
A)True
B)False
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Chapter 17: Banking and the Management of Financial Institutions
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Q1) Bankers' concern regarding the optimal mix of excess reserves,secondary reserves,borrowings from the Fed,and borrowings from other banks to deal with deposit outflows is an example of
A) liability management.
B) liquidity management.
C) managing interest-rate risk.
D) none of the above.
Q2) When $1 million is deposited at a bank,the required reserve ratio is 20 percent,and the bank chooses not to hold any excess reserves but instead makes loans,then in the bank's final balance sheet,
A) the assets at the bank increase by $800,000.
B) the liabilities of the bank increase by $1,000,000.
C) the liabilities of the bank increase by $800,000.
D) reserves increase by $160,000.
Q3) Which of the following statements is false?
A) Checkable deposits are usually the lowest-cost source of bank funds.
B) Checkable deposits are the primary source of bank funds.
C) Checkable deposits are payable on demand.
D) Checkable deposits include NOW accounts.
Q4) Explain how a capital crunch can lead to a credit crunch in our economy.
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Chapter 18: Financial Regulation
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Sample Questions
Q1) Which of the following solutions have been proposed to solve the too-big-to-fail problem?
A) Break up large, systemically important financial institutions.
B) Impose higher capital requirements on large, systemically important financial institutions.
C) Do nothing, since Dodd-Frank effectively eliminated the problem.
D) All of the above have been proposed.
Q2) Moral hazard and adverse selection problems increased in prominence in the 1980s
A) as deregulation opened up more avenues for savings and loans and mutual savings banks to take on more risk.
B) following a burst of financial innovation in the 1970s and early 1980s that produced new financial instruments and markets, thereby widening the scope for risk taking.
C) following an increase in federal deposit insurance from $40,000 to $100,000.
D) because of all of the above.
E) because of only A and B of the above.
Q3) Why does the safety net created by deposit insurance increase the adverse selection and moral hazard problems in banking? How do bank regulations attempt to overcome these problems?
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Chapter 19: Banking Industry: Structure and Competition
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Q1) Are bank consolidations and nationwide banking good things? Why?
Q2) An alternative corporate structure for U.S.banks that operate overseas is the Edge Act corporation,a special subsidiary engaged primarily in international banking.
A)True B)False
Q3) Discuss some of the major milestones in the development of the U.S.banking system.
Q4) So-called fallen angels differ from junk bonds in that
A) junk bonds refer to newly issued bonds with low credit ratings, whereas fallen angels refer to previously issued bonds which have had their credit ratings fall below Baa. B) junk bonds refer to previously issued bonds which have had their credit ratings fall below Baa, whereas fallen angels refer to newly issued bonds with low credit ratings. C) junk bonds have ratings below Baa, whereas fallen angels have ratings below C. D) fallen angels have ratings below Baa, whereas junk bonds have ratings below C.
Q5) Explain the innovations that have been created to lower interest-rate risk.
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Chapter 20: The Mutual Fund Industry
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Sample Questions
Q1) Hedge funds are
A) low risk because they are market-neutral.
B) low risk if they buy Treasury bonds.
C) low risk because they hedge their investments.
D) high risk because they are market-neutral.
E) high risk, even though they may be market-neutral.
Q2) Late trading and market timing
A) allow large, favored investors in a mutual fund to profit at the expense of other investors in the fund.
B) hurt ordinary investors by increasing the number of fund shares and diluting the fund's net asset value.
C) are both A and B of the above.
D) are none of the above.
Q3) What are the five benefits of mutual funds?
Q4) How does the governance structure of mutual funds lead to asymmetric information and conflicts of interest?
Q5) What are two key differences between a traditional mutual fund and a hedge fund?
Q6) How is a mutual fund's net asset value calculated?
Q7) What benefits do mutual funds offer investors?
Page 22
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Chapter 21: Insurance Companies and Pension Funds
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Sample Questions
Q1) A basic product of life insurance companies is ________.
A) disability insurance
B) annuities
C) health insurance
D) all of the above
Q2) Which of the following is not what can we expect in the future regarding pension funds?
A) Pension funds will help create more stable financial markets.
B) Pension funds will continue their growth and popularity.
C) Pension fund variety will continue to expand.
D) Pension funds will gain increased control over corporations as they invest in the equity of these companies.
Q3) In the case of an insurance policy,________ occurs when the existence of insurance encourages the insured party to take risks that increase the likelihood of an insurance payoff.
A) moral hazard
B) opportunism
C) adverse selection
D) shirking
Q4) Distinguish between different types of life insurance.
Page 23
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Chapter 22: Investment Banks, Security Brokers and
Dealers, and Venture Capital Firms
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Q1) To help raise the money to finance railroad expansions,J.P.Morgan's father resided in London and sold Morgan railroad securities to European investors.
A)True
B)False
Q2) The Securities Acts Amendment of 1975 abolished fixed commissions.
A)True
B)False
Q3) In a ________,new issues of a security are sold to buyers by the corporation or government agency ultimately using the funds.
A) primary market
B) secondary market
C) capital market
D) money market
Q4) How do venture capital firms overcome the problem of information asymmetries that accompany start-up firms?
Q5) Private placements are more common for the sale of stocks than for bonds. A)True
B)False
Q6) Discuss the advantages of a private equity buyout.
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Chapter 23: Risk Management in Financial Institutions
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Q1) One problem with duration gap analysis is that it
A) is calculated assuming that the yield curve is flat.
B) is calculated assuming that the yield curve does not change. C) does not measure the sensitivity of net worth to interest rate changes.
D) does not measure the sensitivity of income to interest rate changes. E) applies only to financial institutions.
Q2) If a bank has a negative gap,then a decrease in interest rates will increase income.
A)True
B)False
Q3) If interest rates rise by 5 percentage points,then bank profits (measured using gap analysis)will increase regardless of the income gap.
A)True
B)False
Q4) What is the difference between credit risk and interest-rate risk?
Q5) Effective screening and information collection together form an important principle of credit risk management.
A)True
B)False
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Chapter 24: Hedging with Financial Derivatives
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Q1) Future options are particularly useful for offsetting risk created when a bank
A) extends option-like commitments to bank customers
B) has the right to borrow at a fixed-rate in the future
C) has a loan portfolio of primarily fixed-rate loan products
D) is involved in gold and other inflation-hedging instruments
Q2) If Second National Bank has more rate-sensitive liabilities than rate-sensitive assets,it can reduce interest-rate risk with a swap which requires Second National to A) pay a fixed rate while receiving a floating rate.
B) receive a fixed rate while paying a floating rate.
C) both receive and pay a fixed rate.
D) both receive and pay a floating rate.
Q3) A call option gives the owner the ________ to ________ the underlying security. A) right; sell
B) obligation; sell
C) right; buy
D) obligation; buy
Q4) Distinguish between forward and futures contracts.
Q5) Define and distinguish between call options and put options.
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Chapter 25: Financial Crises In Emerging Market Economies
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Q1) A speculative attack on the currency of a country is the focus of Stage Two of a financial crisis in an emerging market economy.
A)True
B)False
Q2) Discuss the difference in Stage Two of a financial crisis between an advanced economy and an emerging market economy.
Q3) Describe the differences in the evolution of the financial crises in South Korea (1997-1998)and Argentina (2001-2002).
Q4) The experience with financial crises in emerging market economies suggests a number of government policies that can help make financial crises in emerging market countries less likely,including
A) beefing up prudential regulation and supervision of banks.
B) better bank risk disclosure.
C) limiting the currency mismatch.
D) all of the above.
E) only B and C of the above.
Q5) Why did the financial crisis in Iceland (2008)resemble a crisis in an emerging market economy as opposed to an advanced market economy?
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Chapter 26: Savings Associations and Credit Unions
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Q1) Regulatory forbearance reduces moral hazard because an operating but insolvent S&L will take fewer risks than healthy S&Ls that can take risks and still remain solvent.
A)True
B)False
Q2) Since 1980,the number of credit unions has ________. A) declined substantially B) remained steady C) increased substantially D) increased slightly
Q3) Explain how the Lincoln Savings and Loan scandal is an application of the principal-agent problem.
Q4) The Federal Home Loan Bank Board and the FSLIC,both of which failed in their regulatory tasks,were abolished by the
A) Competitive Equality in Banking Act of 1987.
B) Financial Institutions Reform, Recovery, and Enforcement Act of 1989.
C) Office of Thrift Supervision.
D) Office of the Comptroller of the Currency.
Q5) Explain why thrift regulators engaged in regulatory forbearance in the 1980s.
Q6) What factors contributed to creating the thrift crisis?
Page 28
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Chapter 27: Finance Companies
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Q1) A balloon loan requires periodic payments of principle and interest.
A)True
B)False
Q2) Although finance companies are largely unregulated,they do face some regulations aimed primarily at
A) protecting unsophisticated customers.
B) the government deposit insurance.
C) large corporate customers.
D) protecting the finance companies from failure.
Q3) In factoring,a finance company makes a loan and
A) purchases the firm's accounts receivables at a premium.
B) purchases the firm's accounts payables at a premium.
C) purchases the firm's accounts receivables at a discount.
D) purchases the firm's accounts payables at a discount.
Q4) Many retailers established finance companies to provide financing for their customers.Although these finance subsidiaries did increase sales,the subsidiary was typically unprofitable.
A)True
B)False
Q5) Describe the process of factoring? When and why is it used?
Page 29
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