Revision questions:

Chapter 1
True/ false questions:
1. Primary and secondary markets are markets for short-term and long-term securities,
respectively.
2. Financial markets are intermediaries that channel the savings of individuals,
businesses, and government into loans or investments.
3. The money market involves trading of securities with maturities of one year or less
while the capital market involves the buying and selling of securities with maturities of
more than one year.
4. A bond issued by a U.S. firm that is denominated in Swiss Francs and sold in
Switzerland would be an example of a foreign bond.
5. Holders of equity have claims on both income and assets that are secondary to the
claims of creditors.
6. Preferred stock is a special form of stock having a fixed periodic dividend that must be
paid prior to payment of any interest to outstanding bonds.
7. Unlike the organized exchanges, the OTC handles both outstanding securities and new
public issues, making it both a secondary and a primary market.
8. Commercial banks obtain most of their funds from borrowing in the capital markets. 9.
Credit unions are the largest type of financial intermediary handling individual savings.
10. A mutual fund is a type of financial intermediary that obtains funds through the sale
of shares and uses the proceeds to acquire bonds and stocks issued by various business
and governmental units.
11. IPO stands for Interest and Principal Obligation.
12. The two primary types of municipal bonds are general obligation and revenue bonds.
13. The forward exchange rate is the rate of exchange between two currencies at some
specified future date.
14. The spot exchange rate is the prevailing rate of exchange between two currencies.
15. Derivative securities derive their values from underlying assets.
Multiple choices questions:
1. A ______ is the largest financial intermediary handling individual savings. It
receivespremium payments that are placed in loans or investments to accumulate
funds to cover future benefits.
a. life insurance company
b. commercial bank
c. savings bank
d. credit union
2. The key participants in financial transactions are individuals, businesses, and
governments. Individuals are net ______ of funds, and businesses are net ______
of funds.
a. suppliers; demanders
b. purchasers; sellers
c. demanders; suppliers
d. users; providers
3. Which of the following is not a financial institution?
a. a. A pension fund
b. b. A newspaper publisher
c. c. A commercial bank
d. d. An insurance company
4. A ______ is set up so that employees of corporations or governments can receive
income after retirement.
a. life insurance company
b. pension fund
c. savings bank
d. credit union
5. A ______ is a type of financial intermediary that pools savings of individuals and
makes them available to business and government demanders. Funds are obtained
through the sale of shares.
a. mutual fund
b. savings and loans
c. savings bank
d. credit union
6. Most businesses raise money by selling their securities in
a. a direct placement.
b. a stock exchange.
c. a public offering.
d. private placement.
7. Which of the following is not a service provided by financial institutions?
a. Buying the businesses of customers
b. Investing customers savings in stocks and bonds
c. Paying savers interest on deposited funds
d. Lending money to customers
8. Government usually
a. borrows funds directly from financial institutions.
b. maintains permanent deposits with financial institutions.
c. is a net supplier of funds.
d. is a net demander of funds.
9. By definition, the money market involves the buying and selling of
a. funds that mature in more than one year.
b. flows of funds.
c. stocks and bonds.
d. short-term funds.
10. The ______ is created by a financial relationship between suppliers and demanders of
short-term funds.
a. financial market
b. money market
c. stock market
d. capital market
11. Firms that require funds from external sources can obtain them from
a. financial markets.
b. private placement.
c. financial institutions.
d. All of the above.
12. The two key financial markets are
a. money market and capital market.
b. capital market and secondary market.
c. primary market and secondary market.
d. primary market and money market.
13. Long-term debt of a business or corporation typically has maturities of between
a. 6 months and 1 year.
b. 1 and 5 years.
c. 5 and 20 years.
d. 10 and 30 years.
14. If a bond pays $1,000 plus interest at maturity, $1,000 is called the
a. par value.
b. long-term value.
c. stated value.
d. Market value.
15. ______ is hired by a firm to find prospective buyers for its new stock or bond issue.
a. A commercial loan officer
b. An investment banker
c. A securities analyst
d. A trust officer
16. The major securities traded in the capital markets are
a. stocks and bonds.
b. bonds and commercial paper.
c. commercial paper and Treasury bills.
d. Treasury bills and certificates of deposit.
17. International Advisors, Inc. (IAI) is receiving a payment of 100,000 Euros in three
months. The spot rate for the Euro is currently $0.92 per Euro, but IAI has entered into a
three- month forward contract with their bank at $0.94 per Euro. How much will IAI
receive in three months?
a. $92,000 b. $94,000 c. $106,383 d. $108,696
18. Long-term debt instruments used by both government and business are known as
a. bonds. b. equities. c. stocks. d. bills.
19. The ______ stock exchange is a primary market where new public issues are sold.
a. regional
b. American
c. New Y ork
d. over-the-counter
20. You are purchasing a 1-year Treasury bill with a par value of $10,000 and a price of
$9,600. If you hold the Treasury bill until maturity, how much will your return be?
a. 4.00% b. 4.17% c. 5.25% d. 9.60%

Chapter 2-3
1. Which should have the higher risk premium on its interest rates, a corporate
bond with a Moodys Baa rating or a corporate bond with a C rating? Why?
2. Why do U.S. Treasury Bills have lower interest rates than large-denomination
negotiable bank CDs?
3. Risk premiums on corporate bonds are usually anti-cyclical; that is they
decrease during business cycle expansions and increase during recessions?
Why?
4. If bonds of different maturities are close substitutes, their interest rates are
more likely to move together. Is this statement true, false or uncertain? Explain
your answer.
5. If yield curves, on average, were flat, what would this say about the liquidity
premiums in the term structure? Would you be more or less willing to accept the
pure expectations theory?
6. If a yield curve looks like the one shown here, what is the market predicting
about future short-term interest rates? What might the yield curve indicate
about the inflation rate in the future?

7. If the yield curve looks like the one below, what is the market predicting about
the movement of future short-term interest rates? What might the yield curve
indicate about the inflation rate in the future?

8. What effect would reducing income tax rates have on the interest rates of
municipal bonds? Would interest rates of Treasury securities be affected, and, if
so, how?
Exercise:
1. Assuming that the expectations theory is the correct theory of the term
structure, calculate the interest rates in the term structure for maturities of 1 to
5 years and plot the resulting yield curves for the following series of 1-year
interest rates over the next 5 years:
a. 5%, 7%, 7%, 7%, 7%
b. 5%, 4%, 4%, 4%, 4%
How would your yield curves change if people preferred shorter-term bonds
over longer-term bonds?
2. Government economists have forecasted one-year T-bill rates for the following 5
years:
Year 1-year rate %
1 4.25
2 5.15
3 5.50
4 6.25
5 7.10
You have a liquidity premium of 0.25% for the next two years and 0.50% thereafter.
Would you be willing to purchase a 4-year T-Bond at a 5.75% interest rate?

3. How does the after-tax yield on a $1,000,000 municipal bond with a coupon
rate of 8% paying interest annually, compare with that of a $1,000,000
corporate bond with a coupon rate of 10% paying interest annually? Assume
you are in the 25% tax bracket.
4. Consider the decision to purchase either a 5-year corporate bond or a 5-year
municipal bond. The corporate bond is a 12% annual coupon bond with a
par value of $1,000. It is currently yielding 11.5%. The municipal bond has
an 8.5% annual coupon and a par value of $1,000. It is currently yielding 7%.
Which of the two bonds would be more beneficial to you? Assume that your
marginal tax rate is 35%.
0.00%
1.00%
2.00%
3.00%
4.00%
1 2 3 4 5 6 7 8 9 10
Yield to Maturity
5. Debt is issued by Southeastern Corporation currently yields 12%. A
municipal bond of equal risk currently yields 8%. At what marginal tax rate
would an investor be indifferent between these two bonds?
6. One year T-bill rates are expected to steadily increase by 150 basis points per
year over the next six years. Determine the required interest rate on a three-
year T-bond and a six-year T-bond if the current 1-year interest rate is 7.5%.
Assume that the expectations hypothesis for interest rates holds.
7. The one year interest rate over the next 10 years will be 3%, 4.5%, 6%, 7.5%,
9%, 10.5%, 13%, 14.5%, 16% and 17.5%. Using the expectations theory,
what will be the interest rates on a 3-year, 6-year and 9-year bond?
8. Using the information from the previous question, now assume that
investors prefer holding short-term bonds. A liquidity premium of 10 basis
points is required for each year of a bonds maturity. What will be the
interest rate on a 3-year, 6-year and 9-year bond?
9. Which bond will produce a greater return if the expectations theory were to
hold true, a two-year bond with an interest rate of 15% or two 1-year bonds
with sequential interest payments of 13% and 17%?
10. Little Monsters Inc., borrowed $1,000,000 for two years from NorthernBank
Inc., at an 11.5% interest rate. The current risk-free rate is 2%, and Little
Monsters financial conditions warrants a default risk premium of 3% and a
liquidity risk premium of 2%. The maturity risk premium for a two-year loan
is 1%, and inflation is expected to be 3% next year. What does this
information imply about the rate of inflation in the second year?
11. One year T-bill rates are 2% currently. If interest rates are expected to go up
after three years by 2% every year, what should be the required interest rate
on a 10-year bond issued today? Assume that the expectations theory holds.
12. One year T-bill rates over the next four years are expected to be 3%, 4%, 5%
and 5.5%. If four-year T-Bonds are yielding 4.5%, what is the liquidity
premium on this bond?
13. At your favorite bond store, Bonds-R-Us, you see the following prices
a. 1 year $100 zero selling for $90.19
b. Three-year 10% coupon $1,000 par bond selling for $1,000
c. Two-year 10% coupon $1,000 par bond selling for $1,000
Assume that the expectations theory for the term structure of interest rates
holds, no liquidity premium exists, and the bonds are equally risky. What is
the implied one-year rate two years from now?
14. You observe the following market interest rates for both borrowing and
lending:
a. One year rate = 5%
b. Two year rate = 6%
c. One year rate one year from now = 7.25%
How can you take advantage of these rates to earn a riskless profit? Assume
that the expectations theory of interest rates holds.
15. If the interest rates on 1 to 5 year bonds are currently 4%, 5%, 6%, 7% and
8%, and the term premiums for 1 to 5 year bonds are 0%, 0.25%, 0.35%,
0.4% and 0.5%, predict what the one-year interest rate will be two years
from now.

39747948 -
Chapter 6

1) What characteristics define the money markets?
2) Is a Treasury bond issued 29 years ago with six months remaining before it
matures a money market instrument?
3) Why do banks not eliminate the need for money markets?
4) Distinguish between a term security and a demand security.
5) What was the purpose motivating regulators to impose interest ceilings on bank
savings accounts? What effect did this eventually have on the money markets?
6) Why does the U.S. government use the money markets?
7) Why do businesses use the money markets?
8) What purpose initially motivated Merrill Lynch to offer money market mutual
funds to its customers?
9. Why are more funds from property and casualty insurance companies than funds
from life insurance companies invested in the money markets?
10. Which of the money market securities is the most liquid and considered the most
risk-free? Why?
11. Distinguish between competitive bidding and non- competitive bidding for Treasury
securities.
12. Who issues federal funds, and what is the usual purpose of these funds?
13. Does the Federal Reserve directly set the federal funds interest rate? How does the
Fed influence this rate?
14. Who issues commercial paper and for what purpose?
15. Why are bankers acceptances so popular for inter-national transactions?
Exercises
1. What would be your annualized discount rate % and your annualized investment
rate % on the purchase of a 182-day Treasury bill for $4,925 that pays $5,000 at
maturity?
2. What is the annualized discount rate % and your annualized investment rate % on
a Treasury bill that you purchase for $9,940 that will mature in 91 days for
$10,000?
3. If you want to earn an annualized discount rate of 3.5%, what is the most you can
pay for a 91-day Treasury bill that pays $5,000 at maturity?
4. What is the annualized discount and investment rate % on a Treasury bill that you
purchase for $9,900 that will mature in 91 days for $10,000?
5. The price of 182-day commercial paper is $7,840. If the annualized investment rate is
4.093%, what will the paper pay at maturity?
6. How much would you pay for a Treasury bill that matures in 182 days and pays
$10,000 if you require a 1.8% discount rate?
7. The price of $8,000 face value commercial paper is $7,930. If the annualized discount
rate is 4%, when will the paper mature? If the annualized investment rate % is 4%, when
will the paper mature?
8. How much would you pay for a Treasury bill that matures in one year and pays
$10,000 if you require a 3% discount rate?
9. The annualized discount rate on a particular money market instrument, is 3.75%. The
face value is $200,000, and it matures in 51 days. What is its price? What would be the
price if it had 71 days to maturity?
10. The annualized yield is 3% for 91-day commercial paper, and 3.5% for 182-day
commercial paper. What is the expected 91-day commercial paper rate 91 days from
now?
11. In a Treasury auction of $2.1 billion par value 91-day
T-bills, the following bids were submitted:

Bidder Bid Amount Price
1 $500 million $0.9940
2 $750 million $0.9901
3 $1.5 billion $0.9925
4 $1 billion $0.9936
5 $600 million $0.9939
If only these competitive bids are received, who will receive T-bills, in what quantity,
and at what price?

12. If the Treasury also received $750 million in non- competitive bids, who will receive
T-bills, in what quantity, and at what price? (Refer to the table under problem 11.)