Economics of Financial Markets
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Course Introduction
Economics of Financial Markets explores the fundamental principles that govern financial markets, examining how they operate, the role of financial institutions, and the behavior of various market participants. The course covers topics such as asset pricing, risk and return, market efficiency, the functions of stock, bond, and derivative markets, and the impact of government policies and regulations. Through theoretical frameworks and real-world case studies, students develop an understanding of how information, incentives, and risk management shape financial decision-making, and gain insight into the mechanisms and dynamics that influence market outcomes in the global economy.
Recommended Textbook
Financial Markets and Institutions 12th Edition by Jeff Madura
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Chapter 1: Role of Financial Markets and Institutions
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Sample Questions
Q1) The foreign exchange market facilitates the exchange of:
A) information between investors in different countries.
B) debt securities.
C) equity securities.
D) currencies.
Answer: D
Q2) Which of the following financial intermediaries commonly invests in stocks and bonds?
A) pension funds
B) insurance companies
C) mutual funds
D) all of the above
Answer: D
Q3) The total asset value of savings institutions is larger than that of commercial banks.
A)True
B)False
Answer: False
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Page 3
Chapter 2: Determination of Interest Rates
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Q1) At any given point in time, households would demand a ____ quantity of loanable funds at ____ rates of interest.
A) greater; higher
B) greater; lower
C) smaller; lower
D) none of the above
Answer: B
Q2) Businesses demand loanable funds to
A) finance installment debt.
B) subsidize other companies.
C) invest in fixed and short-term assets.
D) none of the above
Answer: C
Q3) According to the Fisher effect, if the real interest rate is zero, the nominal interest rate must be equal to the expected inflation rate.
A)True
B)False
Answer: True
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Chapter 3: Structure of Interest Rates
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Sample Questions
Q1) If a yield curve is upward sloping, the investment strategy of buying long-term securities, then selling them after a short period (say, one year) is called
A) riding the yield curve.
B) liquidating the yield curve.
C) segmenting the yield curve.
D) a forward roll.
E) none of the above
Answer: A
Q2) Assume an investor's tax rate is 25 percent. The before-tax yield on a security is 12 percent. What is the after-tax yield?
A) 16.00 percent
B) 9.25 percent
C) 9.00 percent
D) 3.00 percent
E) none of the above
Answer: C
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5
Chapter 4: Functions of the Fed
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Q1) Assume that the reserve requirement ratio is 12 percent and that the Fed uses open market operations to buy $200 million worth of Treasury securities. Assuming that banks use all funds exceptrequired reserves to make loans and that the public does not store any cash, the money supply should ____ by about ____.
A) increase; $200 million
B) increase; $1.67 billion
C) decrease; $200 million
D) decrease; $1.67 billion
Q2) Adjustment of the primary credit lending rate is the most common means by which the Fed controls the money supply.
A)True
B)False
Q3) When open market operations are used to ____ bank funds, the yield on debt instruments ____.
A) reduce; decreases
B) reduce; increases
C) increase; increases
D) none of the above
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6
Chapter 5: Monetary Policy
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Q1) Which of the following is not a disadvantage of inflation targeting?
A) If the U.S. inflation rate deviates substantially from the Fed's target inflation rate, the Fed could lose credibility.
B) The Fed's focus on inflation could result in a much higher unemployment level.
C) The Fed's focus on inflation could result in much higher interest rates, which would discourage economic growth.
D) All of the above are disadvantages of inflation targeting.
Q2) The Fed can affect the interaction between the demand for money and the supply of money to influence interest rates, the aggregate level of spending, and therefore economic growth.
A)True
B)False
Q3) A credit crunch occurs when:
A) interest rates decline.
B) interest rates rise.
C) creditors restrict the amount of loans they are willing to provide.
D) the economy is strong.
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Chapter 6: Money Markets
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Questions
Q1) The yield on commercial paper is ____ the yield of Treasury bills of the same maturity. The difference between their yields would be especially large during a ____ period.
A) higher than; recessionary
B) higher than; boom economy
C) less than; boom economy
D) less than; recessionary
Q2) The minimum denomination of commercial paper is
A) $25,000.
B) $100,000.
C) $150,000.
D) $200,000.
Q3) The effective yield of a foreign money market security is ____ when the foreign currency strengthens against the dollar.
A) increased
B) reduced
C) always negative
D) unaffected
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8
Chapter 7: Bond Markets
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Q1) Many bonds are listed on the New York Stock Exchange (NYSE).
A)True
B)False
Q2) Which of the following is not an advantage of online bond brokerage services?
A) Pricing is more transparent because investors can easily compare bid and ask spreads.
B) Some services charge commissions, which may be more easily understood than bid and ask spreads.
C) Some brokers have narrowed their spreads so that they do not lose business to competitors.
D) All of the above are advantages of online bond brokerage services.
Q3) Assume that you purchased corporate bonds one year ago that have no protective covenants. Today, it is announced that the firm that issued the bonds plans a leveraged buyout. The market valueofyour bonds will likely ____ as a result.
A) rise
B) decline
C) be zero
D) be unaffected
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9
Chapter 8: Bond Valuation and Risk
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Q1) If the coupon rate of a bond is above the investor's required rate of return, the price of the bond should be below its par value.
A)True
B)False
Q2) Using a(n) ____ strategy, investors allocate funds evenly to bonds in each of several different maturity classes.
A) matching
B) laddered
C) barbell
D) interest rate
E) none of the above
Q3) For a bond of a given par value, the higher the investor's required rate of return is above the coupon rate, the
A) greater is the premium on the price.
B) greater is the discount on the price.
C) smaller is the premium on the price.
D) smaller is the discount on the price.
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10
Chapter 9: Mortgage Markets
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Sample Questions
Q1) Mortgage lenders normally charge a higher initial interest rate on adjustable-rate mortgages than on fixed-rate mortgages.
A)True
B)False
Q2) Which of the following is not true with respect to a growing-equity mortgage?
A) It is similar to a graduated-payment mortgage
B) It allows borrowers to initially make small payments on the mortgage.
C) It involves increased payments, on a graduated basis, over the first five to ten years of the mortgage.
D) It involves payments that level off after the first five to ten years of the mortgage.
Q3) Mortgage-backed securities are assigned ratings by:
A) rating agencies.
B) the Treasury.
C) the Fed.
D) the mortgage originator.
Q4) Mortgages are rarely sold in the secondary market.
A)True
B)False
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Chapter 10: Stock Offerings and Investor Monitoring
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Q1) Analysts periodically communicate with high-level managers of the firms whose stock they rate.
A)True
B)False
Q2) International exchange-traded funds (ETFs) represent international indexes that reflect the stock markets of particular countries; shares of an index can be purchased or sold, thereby allowinginvestors to invest directly in a stock index representing any one of several countries.
A)True
B)False
Q3) ____ sell shares to investors and use the proceeds to invest in portfolios of international stocks created and managed by portfolio managers.
A) International mutual funds
B) American depository receipts
C) World equity depository receipts
D) Initial public depository receipts
Q4) Index-traded funds are passive funds that track a specific index.
A)True
B)False
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Chapter 11: Stock Valuation and Risk
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Sample Questions
Q1) The PE method to stock valuation may result in an inaccurate valuation for a firm if errors are made in forecasting the firm's future earnings or in choosing the industry composite used to derivethe PE ratio.
A)True
B)False
Q2) The Sharpe index measures the
A) average return on a stock.
B) variability of stock returns per unit of return
C) stock's beta adjusted for risk.
D) excess return above the risk-free rate per unit of risk.
Q3) The price-earnings valuation method applies the ____ price-earnings ratio to the ____ earnings per share in order to value the firm's stock.
A) firm's; industry
B) firm's; firm's
C) average industry; industry
D) average industry; firm's
Q4) A beta of 1.8 implies that the stock has a risk premium of 1.8 percent.
A)True
B)False
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Chapter 12: Market Microstructure and Strategies
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Sample Questions
Q1) The ____ the trading volume of a stock, the ____ the spread.
A) higher; wider
B) higher; narrower
C) lower; narrower
D) none of the above
Q2) A short interest ratio of 20 or higher indicates that many investors
A) believe that the stock price is currently overvalued.
B) believe that the stock price is currently undervalued.
C) are selling the stock short.
D) both A and C
Q3) Until recently, international trading of stocks was limited by
A) transaction costs
B) information costs.
C) exchange rate risk.
D) all of the above
Q4) The short interest ratio is commonly measured as the number of shares sold short divided by the number of shares that the firm has repurchased in the last quarter.
A)True
B)False
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Chapter 13: Financial Futures Markets
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Sample Questions
Q1) The futures price is mainly a function of the prevailing price of the underlying security plus an expected adjustment in that price by the settlement date.
A)True
B)False
Q2) ____ risk is the risk that the position being hedged by a futures contract is not affected in the same manner as the instrument underlying the futures contract.
A) Market
B) Liquidity
C) Credit
D) Basis
E) None of the above
Q3) Currency futures may be purchased to hedge ____ or to capitalize on the expected ____ of that currency against the dollar.
A) receivables; appreciation
B) receivables; depreciation
C) payables; depreciation
D) payables; appreciation
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Chapter 14: Options Markets
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Sample Questions
Q1) A speculator purchases a put option for a premium of $4, with an exercise price of $30. The stock is presently priced at $29 and rises to $32 before the expiration date. What is the maximum profit per unit to the speculator who owned the put option assuming he or she exercises the option at the ideal time?
A) -$4
B) -$3
C) -$2
D) $2
E) $3
Q2) When the market price of the underlying security exceeds the exercise price, a
A) call option is in the money.
B) put option is in the money.
C) call option is at the money.
D) call option is out of the money.
Q3) The ____ is not a factor affecting the call option premium.
A) market price of the underlying instrument (relative to the option's exercise price)
B) volatility of the underlying instrument
C) current price of futures contracts on the underlying instrument
D) time to maturity of the call option
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Page 16
Chapter 15: Swap Markets
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Sample Questions
Q1) An interest rate collar involves the ____ of an interest rate cap and the simultaneous ____ of an interest rate floor.
A) sale; sale
B) sale; purchase
C) purchase; purchase
D) purchase; sale
Q2) A putable swap gives the party making the fixed-rate payments the right to terminate the swap.
A)True
B)False
Q3) Interest rate floors are commonly used to hedge against lower interest rates.
A)True
B)False
Q4) Interest rate swaps are rarely used by companies that issue bonds.
A)True
B)False
Q5) The primary purpose of interest rate swaps is to reduce exchange rate risk.
A)True
B)False
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Chapter 16: Foreign Exchange Derivative Markets
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Sample Questions
Q1) Financial institutions rarely use the forward market.
A)True
B)False
Q2) S. interest rates suddenly become much higher than European interest rates (and if this does not cause concern about higher inflation in the United States), the U.S. demand for euros would____, and the supply of euros to be exchanged for dollars would ____, other factors held constant.
A) increase; increase
B) increase; decrease
C) decrease; increase
D) decrease; decrease
Q3) The Smithsonian Agreement allowed for a devaluation of the dollar and for a widening of the boundaries within which currencies were allowed to fluctuate.
A)True
B)False
Q4) Exchange rates usually change precisely as suggested by the purchasing power parity (PPP) theory.
A)True
B)False
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Chapter 17: Commercial Bank Operations
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Sample Questions
Q1) Which of the following statements is incorrect with respect to the federal funds market?
A) It allows depository institutions to accommodate the short-term liquidity needs of other financial institutions.
B) Federal funds purchased represent an asset to the borrowing bank and a liability to the lending bank that sells them.
C) The federal funds market is typically most active on Wednesday, because that is the final day of each particular settlement period for which each bank must maintain a specified volume of reserves required by the Fed.
D) All of the above are true with respect to the federal funds market.
Q2) Protective covenants impose conditions that require the bank to provide additional loans to a borrower to protect the borrower from going bankrupt.
A)True
B)False
Q3) Bank rates on credit card balances are usually similar to the rate charged on business loans.
A)True
B)False
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19
Chapter 18: Bank Regulation
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Sample Questions
Q1) Which banking act allowed for the creation of NOW accounts?
A) McFadden Act
B) Glass-Steagall Act
C) DIDMCA
D) Garn-St Germain Act
Q2) The opening of a commercial bank in the United States
A) does not require a charter.
B) always requires a charter from a state government.
C) always requires a charter from the federal government.
D) requires a charter from a state or the federal government.
E) requires a charter from both the state and federal government.
Q3) The Financial Reform Act (Wall Street Reform and Consumer Protection Act or Dodd-Frank Act) of 2010:
A) ended the system of risk-based insurance premiums.
B) set requirements for the Deposit Insurance Fund's reserves.
C) raised the limit for insured deposits to $750,000 per depositor.
D) allowed large insurance companies such as American International Group to compete with the FDIC to insure bank deposits.
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Chapter 19: Bank Management
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Q1) Durango Bank has $2 million in rate-sensitive liabilities and $3 million in rate-sensitive assets. Durango's gap is ____, and Durango is probably more concerned about a(n) ____ in interest rates.
A) -$1 million; increase
B) -$1 million; decrease
C) $1 million; increase
D) $1 million; decrease
E) none of the above
Q2) Banks are more liquid as a result of securitization because it allows them to request repayment of the loan principal from the borrower upon demand.
A)True
B)False
Q3) ____ is not a method used to assess interest rate risk.
A) Efficiency analysis
B) Gap analysis
C) Duration analysis
D) Regression analysis
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Chapter 20: Bank Performance
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Q1) Banks with relatively ____ ROAs often incur ____ noninterest expenses.
A) low; very low
B) low; very high
C) high; very high
D) none of the above
Q2) If banks continue to offer new services (such as insurance or securities services), their noninterest income will decrease over time.
A)True
B)False
Q3) Fees charged by a bank on various services allow the bank to generate:
A) noninterest income
B) components of net interest margin
C) components of net interest income
D) components of gross interest income
Q4) The level of competition is an industry characteristic that will favorably affect cash flows, because a high level of competition may increase a bank's volume of business or increase the pricesit can charge for its services.
A)True
B)False
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Chapter 21: Thrift Operations
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Sample Questions
Q1) Money market deposit accounts (MMDAs) are
A) trust accounts managed by savings institutions.
B) checking accounts that do not pay interest.
C) accounts offered primarily by money market funds.
D) deposit accounts offering limited checking and close-to-market interest rates.
Q2) The ____ acts as a temporary lender to credit unions
A) World Bank
B) Central Liquidity Facility
C) Federal Home Loan Bank
D) National Credit Union Administration
Q3) The maximum insurance per depositor provided by the National Credit Union Share Insurance Fund is
A) $250,000.
B) $50,000.
C) $40,000.
D) $25,000.
Q4) Credit unions use the majority of their funds to invest in the stock market.
A)True
B)False
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Chapter 22: Finance Company Operations
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Sample Questions
Q1) Although commercial paper is available only for short-term financing, finance companies can continually roll over their issues to create a permanent source of funds.
A)True
B)False
Q2) Some finance companies offer credit card loans through a particular retailer.
A)True
B)False
Q3) Unlike loans made by commercial banks, loans made by finance companies cannot be securitized (bundled together and sold as securities to investors).
A)True
B)False
Q4) When interest rates increase, finance companies tend to use more long-term debt to lock in their cost of funds over an extended period of time.
A)True
B)False
Q5) Business finance companies focus on loans to very large businesses. A)True B)False
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Chapter 23: Mutual Fund Operations
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Sample Questions
Q1) Mutual funds that include both non-U.S. stocks and U.S. stocks are called ____ funds.
A) global
B) foreign
C) combined
D) mixed
Q2) Which of the following statements is incorrect?
A) Investors can purchase shares directly from an open-end fund at any time.
B) The number of shares of an open-end fund is always changing.
C) Open-end funds typically maintain some cash on hand in case investments exceed redemptions.
D) There are many different categories of open-end mutual funds.
Q3) _______ are promoted strictly by the mutual fund of concern and do not involve a sales charge.
A) Closed-end funds
B) Load mutual funds
C) No-load mutual funds
D) Open-end mutual funds.
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25
Chapter 24: Securities Operations
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Q1) Which of the following is not an example of a securities firm that experienced financial problems as a result of taking on excessive risk when engaging in proprietary trading?
A) Washington Mutual
B) Société Générale
C) Bear Stearns
D) Barings Bank
Q2) Securities firms commonly engage in all of the following functions except
A) proprietary trading.
B) underwriting stock.
C) operating mutual funds.
D) providing brokerage services.
E) operating credit unions.
Q3) Securities firms that converted to bank holding companies during the credit crisis:
A) gained more flexibility to obtain financing from the Federal Reserve.
B) had to give up their traditional securities function of underwriting.
C) came under greater regulatory oversight by the Securities Investor Protection Corporation.
D) were prohibited from investing in or selling mortgage-backed securities.
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Page 26
Chapter 25: Insurance Operations
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Q1) Which of the following is a difference in characteristics between life insurance companies and property and casualty insurance companies?
A) Property and casualty policies are longer term.
B) The type of policies offered by life insurance companies are less focused.
C) Future compensation amounts paid on property and casualty policies are more difficult to forecast.
D) Life insurance companies need to maintain a more liquid asset portfolio.
Q2) ____ is(are) not a typical source of funds for life insurance companies.
A) Deposit insurance premiums
B) Annuity plans
C) Investment income
D) Life and health insurance premiums
Q3) A ____ life insurance company is owned by its policyholders; most life insurance companies are ____.
A) stock-owned; mutual
B) mutual; mutual
C) stock-owned; stock-owned
D) mutual; stock-owned
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27
Chapter 26: Pension Fund Operations
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Q1) The government agency that guarantees that participants in defined-benefit plans will receive their benefits upon retirement is the:
A) Federal Pension Insurance Corporation.
B) Pension Benefit Guaranty Corporation.
C) Office of Pension Insurance.
D) Employee Pension Protection Bureau.
Q2) The asset composition of private pension portfolios is most heavily concentrated in A) corporate bonds.
B) mortgages.
C) common stock.
D) money market securities.
Q3) In recent years, defined-contribution plans have commonly been replaced by defined-benefit plans.
A)True
B)False
Q4) Underfunded pensions are primarily a problem with defined-contribution pension plans.
A)True
B)False
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