Financial Economics
Exam Preparation Guide
Course Introduction
Financial Economics is a course that explores the application of economic principles to financial markets and instruments. It examines how individuals, firms, and institutions make financial decisions under conditions of risk and uncertainty, analyzing topics such as asset pricing, portfolio theory, market efficiency, financial intermediation, and the functioning of stock, bond, and derivatives markets. Students will also study the impact of macroeconomic policies and global events on financial systems, gaining insights into the relationship between real economic activity and financial markets. The course combines theoretical frameworks with practical examples, preparing students to understand and analyze complex financial environments.
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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Q1) If investors speculate in the underlying asset rather than in derivative contracts on the underlying asset, they will probably achieve ____ returns, and they are exposed to relatively ____ risk.
A) lower; lower
B) lower; higher
C) higher; lower
D) higher; higher
Answer: A
Q2) If markets are ____, investors could use available information ignored by the market to earn abnormally high returns.
A) perfect
B) active
C) inefficient
D) in equilibrium
Answer: C
Q3) Savings institutions are a type of nondepository institution.
A)True
B)False
Answer: False
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Page 3
Chapter 2: Determination of Interest Rates
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Q1) If the economy weakens, there is ____ pressure on interest rates. If the Federal Reserve increases the money supply there is ____ pressure on interest rates (assume that inflationary expectationsare not affected).
A) upward; upward
B) upward; downward
C) downward; upward
D) downward; downward
Answer: D
Q2) If the real interest rate is expected to become negative, then the purchasing power of savings would be ____, as the inflation rate is expected to be ____ the existing nominal interest rate.
A) decreasing; less than B) decreasing; greater than C) increasing; greater than D) increasing; less than
Answer: B
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4
Chapter 3: Structure of Interest Rates
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Q1) Assume that the Treasury bond yield today is 2 percentage points higher than it was one year ago. Also assume that the credit (default) risk premium of an A-rated bond declined by 0.4 percentagepoint since one year ago. A newly issued A-rated bond will likely offer a yield today that is ____ the yield that was offered on an A-rated bond issued one year ago.
A) greater than B) equal to
C) less than
D) A or B are both common
Answer: A
Q2) Which of the following is not a characteristic affecting the yields on debt securities?
A) credit (default) risk
B) liquidity
C) tax status
D) term to maturity
E) All of the above affect yields on debt securities.
Answer: A
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Page 5
Chapter 4: Functions of the Fed
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Sample Questions
Q1) Credit may be used for any purpose and is available only to depository institutions that meet specific requirements for financial soundness.
A) Primary
B) Secondary
C) Tertiary
D) None of the above
Q2) The ____ is made up of seven individual members, and each member is appointed by the president of the United States.
A) Board of Governors
B) Federal Reserve district bank
C) Federal Open Market Committee (FOMC)
D) Securities and Exchange Commission
Q3) The purchase of government securities by someone other than the Fed results in
A) an overall increase in funds among commercial banks.
B) an overall decrease in funds among commercial banks.
C) offsetting changes in funds at commercial banks.
D) an increase in securities maintained by the Fed.
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Chapter 5: Monetary Policy
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Sample Questions
Q1) A weak dollar would stimulate ____, discourage ____, and ____ the U.S. economy.
A) U.S. exports; U.S. imports; weaken
B) U.S. exports; U.S. imports; stimulate
C) U.S. imports; U.S. exports; stimulate
D) none of the above
Q2) The Fed faces a trade-off in monetary policy between reducing unemployment and reducing the federal government's budget deficit.
A)True
B)False
Q3) Global crowding out is described in the text to mean the impact of
A) excessive U.S. population growth on interest rates.
B) excessive global population growth on interest rates.
C) an excessive budget deficit in one country on interest rates of another country.
D) an excessive budget deficit in one country on exchange rates.
Q4) Which of the following might be monitored as an indicator of inflation?
A) consumer price index
B) gold prices
C) oil prices
D) All of the above may be indicators of inflation.
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Chapter 6: Money Markets
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Q1) The rate at which depository institutions effectively lend or borrow funds from each other is the ____.
A) federal funds rate
B) discount rate
C) prime rate
D) repo rate
Q2) Because money market securities have a short-term maturity and typically cannot be sold easily, they provide investors with a low degree of liquidity.
A)True
B)False
Q3) The price that competitive and noncompetitive bidders will pay at a Treasury bill auction is the
A) highest price entered by a competitive bidder.
B) highest price entered by a noncompetitive bidder.
C) lowest price entered by a competitive bidder
D) equally weighted average price paid by all competitive bidders whose bids were accepted.
E) none of the above
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8
Chapter 7: Bond Markets
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Sample Questions
Q1) Bonds issued by large well-known corporations in large volume are illiquid because most buyers hold these bonds until maturity.
A)True
B)False
Q2) Corporate bonds usually pay interest on an annual basis.
A)True
B)False
Q3) Which of the following would not be a likely example of a protective covenant provision?
A) a limit on the amount of dividends a firm can pay
B) a limit on the corporate officers' salaries a firm can pay
C) the amount of additional debt a firm can issue
D) a call feature
Q4) The coupon rate of most variable-rate bonds is tied to
A) the prime rate.
B) the discount rate.
C) LIBOR.
D) the federal funds rate.
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Chapter 8: Bond Valuation and Risk
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Sample Questions
Q1) Hurricane Corp. recently purchased corporate bonds in the secondary market with a par value of $11 million, a coupon rate of 12 percent (with annual coupon payments), and four years until maturity. If Hurricane intends to sell the bonds in two years and expects investors' required rate of return on similar investments to be 14 percent at that time, what is the expected market value of the bonds in two years?
A) $9.33 million
B) $11.00 million
C) $10.64 million
D) $9.82 million
E) none of the above
Q2) When holding other factors constant, increased borrowing by the Treasury can result in a _______ required return and therefore _______ prices on existing bonds.
A) higher; lower
B) higher; higher
C) lower; higher
D) lower; lower
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10
Chapter 9: Mortgage Markets
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Sample Questions
Q1) Lehman Brothers commonly used _________ as collateral when borrowing short-term funds, but its funding was cut off because prospective creditors questioned the quality of the collateral.
A) commercial paper
B) Treasury securities
C) its stock
D) mortgages
Q2) Which of the following is not a correct description of qualified mortgages?
A) They must comply with regulations issued by the Consumer Financial Protection Bureau.
B) Their term cannot exceed 30 years.
C) They cannot be interest-only mortgages or result in negative amortization.
D) They must be retained by the lending institution that originated the mortgages and cannot be sold.
E) They place limits on the borrower's debt-to-income ratio.
Q3) Borrowers who have a lower level of income relative to the periodic loan payments are more likely to default on their mortgages.
A)True
B)False
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Page 11
Chapter 10: Stock Offerings and Investor Monitoring
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Sample Questions
Q1) Sudden favorable news about the performance of a firm will make investors believe that the firm's stock is ____ at its prevailing price.
A) overvalued
B) fixed
C) appropriate
D) undervalued
Q2) American depository receipts (ADRs) are similar to A) stock options.
B) bank deposits.
C) stocks.
D) bonds.
Q3) Common law countries such as the United States, Canada, and the United Kingdom allow for more legal protections for shareholders than civil law countries such as France or Italy.
A)True
B)False
Q4) If the secondary market for a stock is inactive, then the shares are illiquid.
A)True
B)False
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Chapter 11: Stock Valuation and Risk
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Sample Questions
Q1) Value at risk estimates the ____ a particular investment for a specified confidence level.
A) beta of
B) risk-free rate of C) largest expected loss to
D) standard deviation of
Q2) A higher beta for an asset reflects
A) lower risk.
B) lower covariance between the asset's returns and market returns.
C) higher covariance between the asset's returns and the market returns.
D) none of the above
Q3) The expected acquisition of a firm typically results in ____ in the target's stock price.
A) an increase
B) a decrease
C) no change
D) none of the above
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) Which of the following statements is incorrect?
A) In a short sale, investors place an order to sell a stock that they do not own.
B) Investors sell a stock short when they anticipate that its price will rise.
C) When investors sell short, they will ultimately have to provide the stock back to the investor from whom they borrowed it.
D) Short-sellers must make payments to the investor from whom the stock was borrowed to cover the dividend payments that the investor would have received of the stock had not been borrowed.
Q2) You purchase a stock with cash, and you earn a negative return on the stock. If you had purchased the stock with 60 percent cash and 40 percent borrowed funds, your return on your investment wouldhave been
A) positive
B) more negative than if you had covered the entire investment with cash.
C) negative, but more favorable than if you had covered the entire investment with cash.
D) zero
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Chapter 13: Financial Futures Markets
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Sample Questions
Q1) Assume that a futures contract on Treasury bonds with a face value of $100,000 is purchased at 93-00. If the same contract is later sold at 94-18, what is the gain, ignoring transaction costs?
A) $1,180,000
B) $118
C) $11,800
D) $15,625
E) $1,562.50
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) Stock index futures cannot be closed out before the settlement date
A)True
B)False
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15
Chapter 14: Options Markets
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Sample Questions
Q1) An option with a higher exercise price has a higher call option premium and a lower put option premium.
A)True
B)False
Q2) Which of the following statements is incorrect?
A) Some firms allowed their CEOs to backdate options that they were granted to an earlier period when the stock price was lower.
B) Backdating is completely inconsistent with the idea of granting options to encourage managers to focus on maximizing the stock price.
C) Firms readily promote their option compensation programs and are more than willing to acknowledge that the options are an expense.
D) All of the above are correct.
Q3) A call option is said to be at the money when the market price of the underlying security exceeds the exercise price.
A)True
B)False
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Chapter 15: Swap Markets
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Sample Questions
Q1) Interest rate ____ are interest rate derivative instruments that are normally classified separately from interest rate swaps.
A) caps
B) floors
C) collars
D) all of the above
Q2) Sovereign risk differs from credit risk because it is dependent on the financial status of the government rather than the counterparty itself.
A)True
B)False
Q3) In a swap arrangement, the most common index used for floating-rate payments is the
A) coupon rate on existing bonds.
B) stock dividend rate based on a U.S. stock index.
C) London Interbank Offer Rate (LIBOR).
D) Treasury bond yield.
Q4) Interest rate swaps are rarely used by companies that issue bonds.
A)True
B)False
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Chapter 16: Foreign Exchange Derivative Markets
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Sample Questions
Q1) If the spot rate ____ the exercise price, a currency ____ option will not be exercised. A) remains below; call B) remains below; put C) remains above; call D) A and B
Q2) Central bank intervention can be overwhelmed by market forces and may not always succeed in reversing exchange rate movements.
A)True
B)False
Q3) The European Central Bank is responsible for setting fiscal policy for all countries in the eurozone.
A)True
B)False
Q4) The euro is presently pegged to the British pound in order to stabilize international payments between European countries.
A)True
B)False
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Chapter 17: Commercial Bank Operations
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Sample Questions
Q1) With a _________, a bank agrees to purchase a firm's __________ if the firm cannot place the issue in the market at an acceptable interest rate.
A) note issuance facility; commercial paper
B) note issuance facility; bonds
C) paper placement commitment; commercial paper
D) bond placement commitment; bonds
Q2) The primary credit lending rate is determined by
A) the Federal Reserve.
B) Congress.
C) the Treasury.
D) the President of the United States.
Q3) When banks need funding for just a few days, they would most likely
A) issue bonds and then call them.
B) issue stock and then repurchase it.
C) borrow in the federal funds market.
D) issue NCDs.
Q4) A bank's uses of funds represent liabilities of a bank.
A)True
B)False
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Chapter 18: Bank Regulation
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Sample Questions
Q1) ____ is not a rating criterion used by bank regulators.
A) Capital adequacy
B) Savings deposit volume
C) Asset quality
D) Management
E) Liquidity
Q2) The Reigle-Neal Interstate Banking and Branching Efficiency Act allowed banks to achieve economies of scale through nationwide interstate banking.
A)True
B)False
Q3) Which of the following was not achieved by the Depository Institutions Deregulation and Monetary Control Act of 1980?
A) removed interest rate ceilings on deposits
B) allowed banks to offer NOW accounts
C) increased competition among depository institutions
D) allowed interstate banking for depository institutions in most states
Q4) Commercial banks are allowed to invest in junk bonds.
A)True
B)False
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Chapter 19: Bank Management
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Sample Questions
Q1) Banks can resolve cash deficiencies by
A) creating additional liabilities
B) selling assets
C) buying back common stock
D) increasing dividend payouts
E) A or B
Q2) If the duration of all banks assets with a maturity of greater than one year is similar to that of its liabilities with a maturity greater than one year, , interest rate risk is nonexistent.
A)True
B)False
Q3) 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
Q4) Floating-rate loans completely eliminate interest rate risk.
A)True
B)False
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Page 21
Chapter 20: Bank Performance
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Q1) Banks A and B have the same net income. Bank A has a higher capital ratio and more assets than B. Bank A's return on assets is ____ than Bank B's. Bank A's return on equity is ____ than BankB's.
A) higher; higher
B) higher; lower
C) lower; higher
D) lower; lower
Q2) Small banks tend to make more loans to small local businesses, and the rates on these loans are typically lower than the rates that larger banks charge on the loans they provide to large businesses.
A)True
B)False
Q3) Interest income generated from all a bank's assets is called A) net interest margin.
B) the spread.
C) gross interest income.
D) net interest income.
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Chapter 21: Thrift Operations
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Sample Questions
Q1) Savings institutions commonly ____ to reduce their risk.
A) purchase futures contracts on stock indexes
B) purchase futures contracts on Treasury bonds
C) sell futures contracts on stock indexes
D) sell futures contracts on Treasury bonds
Q2) The majority of maturities on consumer loans offered by credit unions are ____ term, causing income generated on their asset portfolio to be ____ to interest rate movements.
A) long; insensitive
B) short or medium; sensitive
C) long; sensitive
D) short or medium; insensitive
Q3) The National Credit Union Administration (NCUA) is responsible for regulating savings institutions.
A)True
B)False
Q4) Credit unions obtain most of their funds by borrowing from the U.S. government.
A)True
B)False
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Chapter 22: Finance Company Operations
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Sample Questions
Q1) The value of a finance company can be modeled as the present value of its future cash flows.
A)True
B)False
Q2) 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
Q3) The main competition for finance companies in the consumer loan market comes from pension funds and insurance companies.
A)True
B)False
Q4) Which of the following is not a main source of funds for finance companies?
A) bank loans
B) commercial paper issues
C) bonds
D) borrowing from the Federal Reserve
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Chapter 23: Mutual Fund Operations
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Sample Questions
Q1) Compared to open-end mutual funds, exchange-traded funds generate much more capital gain income that must be distributed to their shareholders, who must pay tax on the gains.
A)True
B)False
Q2) Mutual funds with ____ expense ratios tend to ____ others that have a similar investment objective.
A) lower; underperform
B) higher; outperform
C) lower; outperform
D) A and B
Q3) Large mutual funds can exert some control over the management of firms because they commonly are the largest shareholders.
A)True
B)False
Q4) Which of the following are most likely to invest in mortgages?
A) stock mutual funds
B) real estate investment trusts
C) load funds
D) money market funds
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Chapter 24: Securities Operations
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Sample Questions
Q1) 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.
Q2) ____ is not a service that a securities firm provides in placing bonds.
A) Origination
B) Underwriting
C) Distribution
D) Advising
E) All of the above are services that securities firms provide in placing bonds
Q3) The Securities and Exchange Commission's approval of a registration statement guarantees the quality and safety of the securities to be issued.
A)True
B)False
Q4) During the credit crisis, many commercial banks were forced to convert to securities firms.
A)True
B)False
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Chapter 25: Insurance Operations
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Sample Questions
Q1) With a(n) ____ insurance policy, the benefits awarded by the life insurance company to the beneficiary differ, depending on the assets backing the policy.
A) universal life
B) whole life
C) variable life
D) group life
E) none of the above
Q2) Under ____, the benefits awarded by the life insurance company to a beneficiary vary with the assets backing the policy.
A) whole life insurance
B) term insurance
C) variable life insurance
D) universal life insurance
Q3) Bond insurance is available only for corporate bonds and not for municipal securities.
A)True
B)False
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Chapter 26: Pension Fund Operations
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Sample Questions
Q1) To reduce interest rate risk, pension fund managers can
A) shift from variable-rate to fixed-rate bonds.
B) increase the average maturity on fixed-rate bonds.
C) sell bond futures contracts.
D) reduce the investment in money market securities.
Q2) Most pension fund contributions are contributed by the A) employer.
B) employee.
C) state government.
D) federal government.
E) none of the above
Q3) A pension fund manager might hedge against interest rate movements by selling bond futures contracts.
A)True
B)False
Q4) Projective funding limits the manager's discretion, allowing only investments that match future payouts.
A)True
B)False
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