Financial Markets and Institutions
Practice Questions
Course Introduction
Financial Markets and Institutions explores the structure, function, and role of financial markets and institutions within the broader economy. The course examines various types of financial markets, including money, capital, and derivative markets, and delves into the operations of key financial institutions such as commercial banks, investment banks, insurance companies, and mutual funds. Students will learn how these entities facilitate the flow of funds, manage risks, and contribute to economic growth. Topics also include interest rate determination, financial regulation, monetary policy, recent trends in global financial systems, and the impact of technological innovation on the financial sector.
Recommended Textbook
Financial Markets and Institutions 7th Edition by Frederic S. Mishkin
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Chapter 1: Why Study Financial Markets and Institutions
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Sample Questions
Q1) The largest one-day drop in the history of the American stock markets occurred in A)1929.
B)1987.
C)2000.
D)2001.
Answer: B
Q2) If you are planning a vacation to Europe, do you prefer a strong dollar or weak dollar relative to the euro? Why?
Answer: not answered
Q3) A security
A)is a claim or price of property that is subject to ownership.
B)promises that payments will be made periodically for a specified period of time.
C)is the price paid for the usage of funds.
D)is a claim on the issuer's future income.
Answer: D
Q4) What is the central bank and what does it do?
Answer: not answered
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Chapter 2: Overview of the Financial System
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Sample Questions
Q1) When the lender and the borrower have different amounts of information regarding a transaction, ________ is said to exist.
A)asymmetric information
B)adverse selection
C)moral hazard
D)fraud
Answer: A
Q2) Many common stocks are traded over the counter, although a majority of the largest corporations have their shares traded at organized stock exchanges.
A)True
B)False
Answer: True
Q3) The country whose banks are the most restricted in the range of assets they may hold is
A)Japan.
B)Canada.
C)Germany.
D)the United States.
Answer: D
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Page 4
Chapter 3: What Do Interest Rates Mean and What Is Their
Role in Valuation
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Sample Questions
Q1) How does reinvestment risk differ from interest-rate risk?
Answer: not answered
Q2) The current yield goes up as the price of a bond falls.
A)True
B)False
Answer: True
Q3) Which of the following are true of coupon bonds?
A)The owner of a coupon bond receives a fixed interest payment every year until the maturity date, when the face or par value is repaid.
B)U)S. Treasury bonds and notes are examples of coupon bonds.
C)Corporate bonds are examples of coupon bonds.
D)All of the above.
E)Only A and B of the above.
Answer: D
Q4) In which of the following situations would you prefer to be borrowing?
A)The interest rate is 9 percent and the expected inflation rate is 7 percent.
B)The interest rate is 4 percent and the expected inflation rate is 1 percent.
C)The interest rate is 13 percent and the expected inflation rate is 15 percent.
D)The interest rate is 25 percent and the expected inflation rate is 50 percent.
Answer: D
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Chapter 4: Why Do Interest Rates Change
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Sample Questions
Q1) Determining asset prices using stocks of assets rather than flow is called
A)asset transformation.
B)expected return.
C)asset market approach.
D)market equilibrium.
Q2) An increase in expected inflation causes the supply of bonds to ________ and the supply curve to shift to the ________.
A)increase, left
B)increase, right
C)decrease, left
D)decrease, right
Q3) In Figure 4.3, an increase in the interest rate from i<sub>2</sub> to i<sub>1</sub> can be explained by
A)a decrease in money growth.
B)an increase in money growth.
C)a decline in the price level.
D)an increase in the expected price level.
Q4) When interest rates decrease, the demand curve for bonds shifts to the left.
A)True
B)False
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Chapter 5: How Do Risk and Term Structure Affect Interest
Rates
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Sample Questions
Q1) The market segmentation theory is able to explain why interest rates on bonds of different maturities move together over time.
A)True
B)False
Q2) According to the market segmentation theory of the term structure,
A)the interest rate for bonds of one maturity is determined by the supply and demand for bonds of that maturity.
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 preference for short-term relative to long-term bonds explains why yield curves typically slope downward.
D)only A and B of the above.
Q3) Explain why a flight to quality occurred following the subprime collapse and how this affected the interest rates on lower-quality corporate bonds and Treasury bonds.
Q4) What is meant by the risk structure of interest rates?
Q5) Explain why the liquidity premium theory is so widely accepted.
Q6) What do credit-rating agencies do and why is this work important?
Page 7
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Chapter 6: Are Financial Markets Efficient
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Q1) The efficient market hypothesis suggests that
A)investors should purchase no-load mutual funds, which have low management fees.
B)investors can use the advice of technical analysts to outperform the market.
C)investors let too many unexploited profit opportunities go by if they adopt a "buy and hold" strategy.
D)only A and B of the above are sensible strategies.
Q2) 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.
Q3) Rules used to predict movements in stock prices based on past patterns are, according to the efficient markets theory, A)a waste of time.
B)profitably employed by all financial analysts.
C)the most efficient rules to employ.
D)consistent with the random walk hypothesis.
Q4) What is a rational bubble?
Q5) Give evidence both for and against market efficiency.
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Chapter 7: Why Do Financial Institutions Exist
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Sample Questions
Q1) One financial intermediary in our financial structure that helps to reduce the moral hazard arising from the principal-agent problem is the
A)venture capital firm.
B)money market mutual fund.
C)pawn broker.
D)savings and loan association.
Q2) The free-rider problem
A)occurs when people who do not pay for information take advantage of the information other people have to pay for.
B)suggests that the private sale of information will only be a partial solution to the lemons problem.
C)prevents the private market from producing enough information to eliminate all the asymmetric information that leads to adverse selection.
D)all of the above.
Q3) The financial system is one of the most heavily regulated sectors of the economy.
A)True
B)False
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Chapter 8: Why Do Financial Crises Occur and Why Are
They so Damaging to the Economy
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Sample Questions
Q1) Describe the sequence of events in a financial crisis in an emerging market economy and explain why they can cause economic activity to decline.
Q2) In an emerging market economy, a country typically faces a ________ fiscal policy before a crisis initiates.
A)solid
B)poor
C)weakening
D)uncertain
Q3) Prior to the financial crisis in Mexico in 1994, Mexico ran a budget deficit of around ________ of GDP.
A)120%
B)40%
C)15%
D)1%
Q4) In an advanced economy, a financial crisis can begin in several ways, including: A)mismanagement of financial liberalization or innovation.
B)asset pricing booms and busts.
C)an increase in uncertainty caused by failure of financial institutions.
D)all of the above.
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Chapter 9: Central Banks and the Federal Reserve System
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Sample Questions
Q1) Supporters of the current system of Fed independence believe that a less autonomous Fed would
A)adopt a long-run bias toward policymaking.
B)pursue overly expansionary monetary policies.
C)be more likely to create a political business cycle.
D)do only B and C of the above.
Q2) Which Federal Reserve Bank president always has a vote in the Federal Open Market Committee?
A)Philadelphia
B)New York
C)Boston
D)San Francisco
Q3) The Federal Reserve banks act as liaisons between the business community and the Federal Reserve System.
A)True
B)False
Q4) What are the factors that promote the independence of the Federal Reserve?
Q5) What are the arguments for and against an independent Fed?
Q6) What is the theory of bureaucratic behavior? What types of behavior does it predict the Fed might undertake?
Page 11
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Chapter 10: Conduct of Monetary Policy: Tools, Goals, Strategy, and Tactics
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Q1) If the Fed uses nonborrowed reserves, a reserve aggregate, as a target, an increase in the demand for reserves will result in a(n)________ in ________.
A)increase; nonborrowed reserves
B)decrease; nonborrowed reserves
C)increase; the federal funds interest rate
D)decrease; the federal funds interest rate
Q2) If the Federal Reserve wants to expand reserves in the banking system, it will
A)purchase government securities.
B)raise the discount rate.
C)sell government securities.
D)raise reserve requirements.
Q3) "The interest rate targeting strategy employed by the Fed in the 1960s and 1970s led to procyclical money growth. Why?
A)True
B)False
Q4) Describe the goals of the Federal Reserve. What happens when these goals come into conflict? How would one decide if lower inflation is more important than lower unemployment? Explain.
Q5) Describe an asset-price bubble.
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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) In situations where asymmetric information problems are not severe,
A)the money markets have a distinct cost advantage over banks in providing short-term funds.
B)the money markets have a distinct cost advantage over banks in providing long-term funds.
C)banks have a distinct cost advantage over the money markets in providing short-term funds.
D)the money markets cannot allocate short-term funds as efficiently as banks can.
Q3) Commercial paper has been used in various forms since the 1930s.
A)True
B)False
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
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Chapter 12: The Bond Market
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Sample Questions
Q1) A secured bond is backed by
A)the general creditworthiness of the borrower.
B)an insurance company's financial guarantee.
C)the expected future earnings of the borrower.
D)specific collateral.
Q2) Municipal bonds that are issued to pay for essential public projects are exempt from federal taxation.
A)True
B)False
Q3) Treasury 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
Q4) The security with the longest maturity is a Treasury A)note.
B)bond.
C)acceptance. D)bill.
Q5) Distinguish between general obligation and revenue municipal bonds.
Page 14
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Chapter 13: The Stock Market
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Sample Questions
Q1) In the one-period valuation model, a stock's value will be higher
A)the higher its expected future price is.
B)the lower its dividend is.
C)the higher the required return on investments in equity is.
D)all of the above.
Q2) The PE ratio approach to valuing stock is especially useful for valuing
A)publicly held corporations.
B)firms that regularly pay dividends.
C)both A and B of the above.
D)neither A nor B of the above.
Q3) Which of the following is true regarding the Gordon growth model?
A)Dividends are assumed to grow at a constant rate forever.
B)The dividend growth rate is assumed to be greater than the required return on equity.
C)Both A and B of the above.
D)Neither A nor B of the above.
Q4) More stock trading in the U.S. occurs in over-the-counter markets rather than on organized exchanges.
A)True
B)False
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Chapter 14: The Mortgage Markets
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Sample Questions
Q1) What factors are used in determining a person's FICO score?
A)past payment history
B)outstanding debt
C)length of credit history
D)all of the above
Q2) Private mortgage insurance is a policy that guarantees to make up any discrepancy between the value of the property and the loan amount, should a default occur.
A)True
B)False
Q3) Discount points (or simply points)are interest payments made at the beginning of a loan.
A)True
B)False
Q4) Subprime loans are those made to borrowers who do not qualify for loans at the usual market rate of interest because of a poor credit rating or because the loan is larger than justified by their income.
A)True
B)False
Q5) What are points? What is their purpose?
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Chapter 15: The Foreign Exchange Market
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Sample Questions
Q1) When the value of the dollar changes from £0.50 to £0.75, the pound has ________ and the dollar has ________.
A)appreciated; appreciated
B)depreciated; appreciated
C)appreciated; depreciated
D)depreciated; depreciated
Q2) Quotas
A)are restrictions placed on the quality of foreign goods that can be imported.
B)are fees placed on imported goods.
C)are restrictions placed on the quantity of foreign goods that can be exported.
D)are none of the above.
Q3) According to the interest parity condition, if the domestic interest rate is ________ the foreign interest rate, then ________.
A)above; there is expected appreciation of the foreign currency
B)above; there is expected depreciation of the foreign currency
C)below; there is expected appreciation of the foreign currency
D)below; the interest parity condition is violated
Q4) Explain graphically how a change in the domestic price level will affect exchange rates, holding everything else constant.
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Chapter 16: The International Financial System
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Sample Questions
Q1) The Bretton Woods system was one in which central banks
A)agreed to limit domestic money growth to the average of the seven largest industrial nations.
B)agreed not to intervene in the foreign exchange market to maintain a fixed exchange rate regime that had existed prior to World War I.
C)agreed to limit domestic money growth to the average of the five largest industrial nations.
D)bought and sold their own currencies to keep their exchange rates fixed.
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) What are the arguments for and against the IMF acting as an international lender of last resort?
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Chapter 17: Banking and the Management of Financial Institutions
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Q1) Which of the following are primary concerns of a bank manager?
A)maintaining sufficient reserves to minimize the cost to the bank of deposit outflows
B)extending loans to borrowers who will pay high interest rates, but who are also good credit risks
C)acquiring funds at a relatively low cost, so that profitable lending opportunities can be realized
D)all of the above
Q2) Since their introduction in 1961, negotiable CDs have become an important source of bank funds.
A)True
B)False
Q3) Banks earn profits by selling ________ with attractive combinations of liquidity, risk, and return, and using the proceeds to buy ________ with a different set of characteristics.
A)loans; deposits
B)securities; deposits
C)liabilities; assets
D)assets; liabilities
Q4) What costs do banks hope to avoid by holding excess reserves?
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Chapter 18: Financial Regulation
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Sample Questions
Q1) Probably the most important feature of FDICIA is its prompt corrective action provisions which require the FDIC to intervene earlier and more vigorously when a bank gets into trouble.
A)True
B)False
Q2) Why is international financial regulation becoming more important in recent years?
Q3) The chartering process is especially designed to deal with the ________ problem, and restrictions on asset holdings help to reduce the ________ problem.
A)adverse selection; adverse selection
B)adverse selection; moral hazard
C)moral hazard; adverse selection
D)moral hazard; moral hazard
Q4) Prior to the 2007-2009 financial crisis, inaccurate ratings provided by credit rating agencies helped promote risk taking throughout the financial system.
A)True
B)False
Q5) Describe the CAMELS rating system used by bank examiners.
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Page 20
Chapter 19: Banking Industry: Structure and Competition
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Q1) Describe Edge Act corporations, international banking facilities, and the structure of foreign banks in the United States.
Q2) The most important developments that have reduced banks' cost advantages in the past twenty years include
A)the elimination of Regulation Q ceilings.
B)the competition from money market mutual funds.
C)the growth of securitization.
D)all of the above.
E)only A and B of the above.
Q3) Financial innovation has widened the cost advantages that banks have in acquiring funds, helping to explain why bank profitability has soared in recent years.
A)True
B)False
Q4) The existence of large numbers of banks in the United States indicates the presence of vigorous competition.
A)True
B)False
Q5) What are the reasons for the decline of traditional banking?
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Chapter 20: The Mutual Fund Industry
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Sample Questions
Q1) Capital appreciation funds select stocks of ________ and tend to be ________ risky than total return funds.
A)large, established companies that pay dividends regularly; more B)large, established companies that pay dividends regularly; less C)companies expected to grow rapidly; more
D)companies expected to grow rapidly; less
Q2) The increase in the number of defined contribution pension funds has slowed the growth of mutual funds.
A)True
B)False
Q3) Late trading is the practice of allowing orders received ________ to trade at the ________ net asset value.
A)before 4:00 pm; 4:00 pm
B)after 4:00 pm; 4:00 pm
C)after 4:00 pm; next day's
D)before 4:00 pm; previous day's
Q4) Describe the practices of late trading and market timing and explain how these practices harm a mutual fund's shareholders.
Q5) What benefits do mutual funds offer investors?
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Chapter 21: Insurance Companies and Pension Funds
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Q1) Insurance management tools that give policyholders incentives to avoid accidents insured against include ________.
A)deductibles
B)risk-based premiums
C)coinsurance
D)all of the above
Q2) Between 1995 and 2009, the amount of credit default swaps (CDSs)exploded, along with the marketing of securitized mortgages. By their peak in 2008, there were about ________ of CDSs outstanding.
A)$62 million
B)$62 billion
C)$6.2 trillion
D)$62 trillion
Q3) The federal regulatory agency responsible for regulating the activities of life insurance companies is
A)the Federal Deposit Insurance Corporation.
B)the Federal Reserve.
C)the Federal Life Insurance Board.
D)none of the above; there is no such federal regulatory agency.
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Chapter 22: Investment Banks, Security Brokers and Dealers,
and Venture
Capital Firms
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Q1) Which of the following is a characteristic feature of venture capital firms?
A)developing a portfolio of companies
B)holding debt in the firms that are funded
C)allowing firms to use the funds as they see fit
D)having a short-term investment horizon
Q2) The process of underwriting a stock or bond issue requires that the investment bank
A)assure investors that the issue will provide them a high return.
B)purchase the entire issue at a predetermined price if the quantity demanded by consumers is insufficient at the predetermined price.
C)purchase the entire issue at a predetermined price and then resell it in the market.
D)do both A and B of the above.
Q3) How do best efforts agreements and private placements differ from the usual process of underwriting new securities issues?
Q4) Junk bonds are high-risk, high-return equity securities that were used primarily to finance takeover attempts.
A)True
B)False
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Chapter 23: Risk Management in Financial Institutions
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Sample Questions
Q1) Banks face the problem of adverse selection in loan markets because bad credit risks are the ones most likely to seek bank loans.
A)True
B)False
Q2) If a bank has more rate-sensitive liabilities than assets, then an increase in interest rates will reduce bank profits.
A)True
B)False
Q3) Duration gap analysis
A)is a refinement of basic gap analysis that accounts for interest-rate changes over a multiyear period.
B)is a refinement of basic gap analysis that accounts for how long a gap will last.
C)is a complement to basic gap analysis that accounts for the effect of interest rate changes on market value.
D)is a complement to basic gap analysis that accounts for the influence of partially rate-sensitive assets.
Q4) What is the difference between credit risk and interest-rate risk?
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Chapter 24: Hedging With Financial Derivatives
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Q1) If you buy a futures contract on the S&P 500 Index at a price of 450 and the index rises to 500, you will ________.
A)lose $12,500
B)gain $12,500
C)lose $50
D)gain $50
Q2) An option that gives the holder the right to buy an asset in the future is a put.
A)True
B)False
Q3) A short contract obligates the holder to sell securities in the future.
A)True
B)False
Q4) As compared to a default on the notional principle, a default on a swap
A)is more costly.
B)is about as costly.
C)is less costly.
D)may cost more or less than default on the notional principle.
Q5) Explain the advantages of protecting against interest-rate risk using options rather than futures contracts.
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Chapter 25: Savings Associations and Credit Unions
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Q1) In the 1980s, regulators engaged in bureaucratic gambling when they allowed insolvent S&Ls to continue operating.
A)True
B)False
Q2) Mutual savings banks are concentrated in the ________ United States.
A)northeastern
B)southeastern
C)western
D)all of the above
Q3) Mutual savings banks
A)are heavily concentrated in mortgages.
B)have more flexibility in their investing practices.
C)are both A and B of the above.
D)are neither A nor B of the above.
Q4) What factors contributed to creating the thrift crisis?
Q5) The mutual form of ownership accentuates the principal-agent problem that exists in corporations.
A)True
B)False
Q6) Explain why thrift regulators engaged in regulatory forbearance in the 1980s.
Page 27
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Chapter 26: Finance Companies
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Q1) In which industry is factoring a common practice?
A)automobile
B)tech services
C)entertainment
D)apparel
Q2) Like the consumer finance market, finance companies face many regulations in the business loan market.
A)True
B)False
Q3) Finance companies essentially sell commercial paper and use the proceeds to make loans.
A)True
B)False
Q4) A balloon loan requires periodic payments of principle and interest.
A)True
B)False
Q5) Describe the process of factoring? When and why is it used?
Q6) Discuss the regulatory environment for finance companies relative to commercial banks.
Q7) What are the various types of finance companies?
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