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FINAL Examination

I. TRUE OR FALSE: Read and understand the statements carefully. Write True if the statement is correct
and False if otherwise. (40 pts)

Debt markets are often referred to generically as the bond market.

Unless a bond defaults, an investor cannot lose money investing in bonds.
Prices for long-term bonds are more volatile than for shorter-term bonds.
Interest-rate risk is the uncertainty that an investor faces because the interest rate at which a bond's future
coupon payments can be invested is unknown.
An increase in the government budget deficit will raise the interest rate on bonds.
An increase in an asset's expected return relative to that of an alternative asset, holding everything else
unchanged, raises the quantity demanded of the asset.
When an economy grows out of a recession, normally the demand for bonds increases and the supply of bonds
A positive liquidity premium indicates that investors prefer long-term bonds over short-term bonds.
Risk occurs when the issuer of the bond is unable or unwilling to make interest payments when promised or
pay off the face value when the bond matures.
An increase in the marginal tax rate would likely increase the demand for tax-exempt bonds, and decrease the
demand for taxable bonds.
When yield curves are downward sloping, long-term interest rates are above short-term interest rates.
If the markets are efficient, the optimal investment strategy will be to buy and hold so as to minimize transaction
Loss aversion means the unhappiness a person feels when he or she suffers a monetary loss exceeds the
happiness the same person experiences from receiving a monetary gain of the same amount.
Having performed well in the past indicates that an investment adviser or a mutual fund will perform well in the
The problem of adverse selection helps to explain why direct finance is more important than indirect finance as
a source of business finance.
In a leveraged buy-out, a firm greatly increases its debt level by issuing junk bonds to finance the purchase of
another firm's stock.
A lower than average PE may mean that the market expects earnings to rise in the future.
A stock's market value will be higher the higher the investor's required rate of return is, all else being equal.
The Dow Jones Industrial Average is the broadest and best indicator of the stock market's day-to-day
In over-the-counter markets, dealers increase the liquidity of thinly traded securities.
Many institutions that make mortgage loans do not want to hold large portfolios of long-term securities, because
it would subject them to unacceptably high interest-rate risk.
Mortgage-backed securities are marketable securities collateralized by a pool of mortgages.
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.
Adjustable-rate mortgages generally have lower initial interest rates than fixed-rate mortgages.
If the peso depreciates relative to the British pound, British sweaters will become more expensive in the
The theory of purchasing power parity cannot fully explain exchange rate movements because fiscal policy
differs across countries.
When workers voluntarily leave work while they look for better jobs, the resulting unemployment is called
frictional unemployment.
Decreased transparency of the monetary policy strategy through communication with the public and the
markets about the plans and objectives of monetary policymakers is an element of inflation targeting.
Money markets are used extensively by businesses both to warehouse surplus funds and to raise short-term
Interest rates on banker's acceptances are low because the risk of default is very low.

For internal use only

31. Banks face the problem of adverse selection in loan markets because bad credit risks are the ones most likely
to seek bank loans.
32. Measuring the sensitivity of bank profits to changes in interest rates by multiplying the gap for several maturity
subintervals by the change in the interest rate is called duration analysis.
33. If interest rates rise by 5 percentage points, then bank profits (measured using gap analysis) will increase
regardless of the income gap.
34. If a bank has more rate-sensitive liabilities than assets, then an increase in interest rates will reduce bank
35. The difference between rate-sensitive liabilities and rate-sensitive assets is known as the duration gap.
36. If a bank has a negative gap, then a decrease in interest rates will increase income.
37. Credit rationing occurs when lenders charge higher interest rates on the loans they make to riskier borrowers.
38. Developing and maintaining long-term customer relationships help to reduce banks' costs of screening and
monitoring borrowers.
39. When a bank receives additional deposits, it gains an equal amount of reserves; when it loses deposits, it loses
an equal amount of reserves.
40. The higher the costs associated with deposit outflows, the more required reserves banks will want to hold.
II. MULTIPLE CHOICE: Read the statements/questions carefully. Select the letter of the best answer from
the given choices. (50 pts)
1. Markets in which funds are transferred from those who have excess funds available to those who have a
shortage of available funds are called
A) Commodity markets.
B) Funds markets.
C) Financial markets.
D) Derivative exchange markets.
2. What makes the Federal Reserve so unique compared to other central banks around the world is its
A) centralized structure.
B) decentralized structure.
C) regulatory functions.
D) Monetary policy functions.
3. The ability of a central bank to set monetary policy goals is
A) political independence.
B) goal independence.
C) policy independence.
D) instrument independence.
4. Regarding central bank independence,
A) the Fed is more independent than the European Central Bank.
B) the European Central Bank is more independent than the Fed.
C) the trend in industrialized nations has been to reduce central bank independence.
D) the Bank of England has the longest tradition of independence of any central bank in the world.
5. The monetary base consists of
A) currency in circulation and reserves.
B) government securities held by the central bank and discount loans.
C) government securities held by the central bank and currency in circulation.
D) discount loans and reserves.
6. An open market sale of securities by the central bank will
A) decrease liabilities of the central bank and not affect assets of the banking system.
B) decrease assets of the nonbank public and decrease assets of the central bank.
C) increase liabilities of the nonbank public and increase assets of the central bank.
D) decrease assets of the banking system and increase assets of the central bank.
7. Price stability is desirable because
A) inflation creates uncertainty, making it difficult to plan for the future.
B) everyone is better off when prices are stable.
C) price stability increases the profitability of the central bank.
D) it guarantees full employment.
8. 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.
9. Finance companies play a unique role in money markets by
A) giving consumers indirect access to money markets.
For internal use only

B) combining consumers' investments to purchase money market securities on their behalf.

C) borrowing in capital markets to finance purchases of money market securities.
D) assisting the government in its sales of Treasury securities.
10. Suppose that you purchase a 182-day Treasury bill for P9,850 that is worth P10,000 when it matures. The
security's annualized yield if held to maturity is about
A) 1.5%
B) 2%
C) 3%
D) 6%
11. Two important characteristics of any financial market are flexibility and
A) risk.
B) innovation.
C) tolerance.
D) capital.
12. The primary reason that individuals and firms choose to borrow long-term is to reduce the risk that interest
rates will ________ before they pay off their debt.
A) rise.
B) fall.
C) become more volatile.
D) become more stable.
13. The ________ value of a bond is the amount that the issuer must pay at maturity.
A) market.
B) present.
C) discounted.
D) face.
14. 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
15. To sell an old bond when interest rates have ________, the holder will have to ________ the price of the bond
until the yield to the buyer is the same as the market rate.
A) risen; lower.
B) risen; raise.
C) fallen; lower.
D) risen; inflate.
16. Securities not listed on one of the exchanges trade in the over-the-counter market. In this exchange, dealers
"make a market" by
A) buying stocks for inventory when investors want to sell.
B) selling stocks from inventory when investors want to buy.
C) doing both of the above.
D) doing neither of the above.
17. A stock currently sells for P25 per share and pays P0.24 per year in dividends. What is an investor's valuation
of this stock if she expects it to be selling for P30 in one year and requires a 15 percent return on equity
A) P30.24
B) P26.30
C) P26.09
D) P27.74
18. Which of the following is not an element of the Gordon growth model of stock valuation?
A) the stock's most recent dividend paid
B) the expected constant growth rate of dividends
C) the required return on investments in equity
D) the stock's expected future price
19. Suppose the average industry PE ratio for auto parts retailers is 20. What is the current price of Auto Zone
stock if the retailer's earnings per share is projected to be P1.85?
A) P21.85
B) P37
C) P10.81
D) P9.25
For internal use only

20. Which of the following are important ways in which mortgage markets differ from stock and bond markets?
A) The usual borrowers in capital markets are government entities, whereas the usual borrowers in mortgage
markets are small businesses.
B) The usual borrowers in capital markets are government entities and large businesses, whereas the usual
borrowers in mortgage markets are small businesses.
C) The usual borrowers in capital markets are government entities and large businesses, whereas the usual
borrowers in mortgage markets are small businesses and individuals.
D) The usual borrowers in capital markets are businesses and government entities, whereas the usual
borrowers in mortgage markets are individuals.
21. A loan for 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 is a/an
A) subprime mortgage.
B) securitized mortgage.
C) insured mortgage.
D) graduated-payment mortgage.
22. The price paid for the rental of borrowed funds (usually expressed as a percentage of the rental of P100 per
year) is commonly referred to as the
A) Aggregate price level.
B) Interest rate.
C) Exchange rate.
D) Inflation rate.
23. Interest rates are important to financial institutions since an interest rate increase ________ the cost of
acquiring funds and ________ the income from assets.
A) Decreases; Decreases.
B) Increases; Decreases.
C) Decreases; Increases.
D) Increases; Increases.
24. Typically, increasing interest rates
A) Discourages corporate investments.
B) Encourages corporate borrowing.
C) Discourages individuals from saving.
D) Encourages corporate expansion.
25. Every financial market performs the following function:
A) It channels funds from lenders-savers to borrowers-spenders.
B) It determines the level of interest rates.
C) It allows loans to be made.
D) It allows common stock to be traded.
26. A country whose financial markets function poorly is likely to
A) Experience economic hardship and financial crises.
B) Enjoy high productivity.
C) increase its standard of living.
D) efficiently allocate its capital resources.
27. The presence of transaction costs in financial markets explains, in part, why
A) Financial intermediaries and indirect finance play such an important role in financial markets.
B) Direct financing is more important than indirect financing as a source of funds.
C) Corporations get more funds through equity financing than they get from financial intermediaries.
D) Equity and bond financing play such an important role in financial markets.
28. A coupon bond pays the owner of the bond
A) a fixed interest payment every period, plus the face value of the bond at the maturity date.
B) the face value of the bond plus an interest payment once the maturity date has been reached.
C) the same amount every month until the maturity date.
D) the face value at the maturity date.
29. An $8,000 coupon bond with a $400 annual coupon payment has a coupon rate of
A) 10%
B) 40%
C) 5%
D) 8%
30. The yield to maturity of a one-year, simple loan of $500 that requires an interest payment of $40 is
A) 8%
B) 5%
C) 12%
D) 12.5%
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31. When the price of a bond is below the equilibrium price, there is excess ________ in the bond market and the
price will ________.
A) Demand; Rise.
B) Supply; Fall.
C) Demand; Fall.
D) Supply; Rise.
32. When the interest rate on a bond is ________ the equilibrium interest rate, there is excess ________ in the
bond market and the interest rate will ________.
A) above; demand; fall
B) above; supply; rise
C) below; supply; fall
D) above; demand; rise
33. From the graph below, the most likely cause of the increase in the equilibrium interest rate from
A) a decrease in the expected inflation rate.
B) an increase in the expected inflation rate.
C) an increase in the price of bonds.
D) a business cycle boom.



34. A corporation suffering big losses might be more likely to suspend interest payments on its bonds, thereby
A) raising the default risk and causing the demand for its bonds to rise.
B) raising the default risk and causing the demand for its bonds to fall.
C) lowering the default risk and causing the demand for its bonds to rise.
D) lowering the default risk and causing the demand for its bonds to fall.
35. Moody's and Standard and Poor's are agencies that
A) help investors collect when corporations default on their bonds.
B) advise municipal bond issuers on the tax exempt status of their bonds.
C) produce information about the probability of default on corporate bonds.
D) maintain liquid markets for corporate bonds.
36. Economists' attempts to explain the term structure of interest rates
A) illustrate how economists modify theories to improve them when they are inconsistent with the empirical
B) illustrate how economists continue to accept theories that fail to explain observed behavior of interest rate
C) prove that the real world is a special case that tends to get short shrift in theoretical models.
D) have proved entirely unsatisfactory to date.
37. A situation in which the price of an asset differs from its fundamental market value
A) indicates that unexploited profit opportunities exist.
B) indicates that unexploited profit opportunities do not exist.
C) need not indicate that unexploited profit opportunities exist.
D) indicates that the efficient market hypothesis is fundamentally flawed.
38. High-yield bonds rated below investment grade by the bond-rating agencies are frequently referred to as
A) Municipal bonds
B) Yankee bonds
C) Fallen angels
D) Junk bonds
39. One problem with basic gap analysis is that it
A) is calculated assuming interest rates on all maturities are equal.
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B) is calculated assuming interest rates on all maturities change by equal amounts.

C) measures the sensitivity of net worth to interest rate changes.
D) does not measure the sensitivity of income to interest rate changes.
For question nos. 14 and 15, refer to the following:
Environmental National Bank has the following:
Rate Sensitive Assets
Fixed Rate Assets
Rate Sensitive Liabilities
Fixed Rate Liabilities

P40 million
60 million
50 million
40 million

40. If interest rates rise by 5 percentage points, then bank profits (measured using gap analysis) will
A) decline by P0.5 million
B) decline by P1.5 million
C) decline by P2.5 million
D) increase by P2.0 million
41. Assuming that the average duration of the bank's assets is four years, while the average duration of its
liabilities is three years, a rise in interest rates from 5 percent to 10 percent will cause the net worth of
Environmental National Banks to _________ by _________ of the total original asset value.
A) decline; 5%
B) decline; 1.3%
C) decline; 6.2%
D) increase; 5%
42. Liabilities that are partially, but not fully, rate-sensitive include
A) Checkable deposits
B) Non-negotiable CDs
C) Fixed rate mortgages
D) Money market deposit accounts
43. Because larger loans create greater incentives for borrowers to engage in undesirable activities that make it
less likely they will repay the loans, banks
A) ration credit, granting borrowers smaller loans than they have requested.
B) ration credit, charging higher interest rates to borrowers who want large loans than to those who want
small loans.
C) ration credit, charging higher fees as a percentage of the loan to borrowers who want large loans than to
those who want small loans.
D) do none of the above.
44. When a lender refuses to make a loan, although borrowers are willing to pay the stated interest rate or even a
higher rate, it is said to engage in
A) constrained lending.
B) Strategic refusal.
C) credit rationing.
D) collusive behavior.
45. Because borrowers, once they have a loan, are more likely to invest in high-risk investment projects, banks
face the
A) Lemon problem.
B) Moral hazard problem.
C) Adverse selection problem.
D) Adverse credit risk problem.
46. Provisions in loan contracts that proscribe borrowers from engaging in specified risky activities are called
A) Proscription bonds.
B) Collateral clauses.
C) Restrictive covenants.
D) Liens.
47. If a decline in interest rates causes the market value of a bank's net worth to rise, then the bank must have a
A) Negative duration gap.
B) Positive duration gap.
C) Negative gap.
D) Positive gap.
48. If a bank has a gap of -P10 million, it can reduce its interest-rate risk by
A) paying a fixed rate on P10 million and receiving a floating rate on P10 million.
B) paying a floating rate on P10 million and receiving a fixed rate on P10 million.
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C) selling P20 million fixed-rate assets.

D) buying P20 million fixed-rate assets.
49. If a bank manager wants to protect the bank against losses that would be incurred on its portfolio of Treasury
securities should interest rates rise, he could _________ options on financial futures.
A) Buy put
B) Buy call
C) Sell put
D) Sell call
50. All other things held constant, premiums on both put and call options will increase when the
A) exercise price increases.
B) volatility of the underlying asset increases.
C) term to maturity decreases.
D) futures price increases.
III. BONUS: This section is not required and optional.
Problem 1
The following information relates to Philippine Banking Company (Millions P):

P 475

First National Bank

Tax rate

Interest rate
of return

Liab. & Equity



Industry Average
Overhead Efficiency
Average Loan Rate (ALR)

Interest Cost


Required: (PLL provision for loan loss)

How much is the bank's net interest margin?
How much is the banks return on assets?
How much is the equity multiplier?
How much should be the net noninterest income (net of noninterest expense) in order for the bank to
have a 12% return on equity?
If the net noninterest income decreased to P16million, how much should be the average loan rate
(ALR) to generate a 12% return on equity?
Problem 2
1. What are the things we should continue doing in ACFINA3 class
2. What are the areas for improvements in ACFINA3 class?

For internal use only