Chapter 05 - Financial Instruments and Markets

Chapter 05
Financial Instruments and Markets
 

Multiple Choice Questions

 

1. Which one of the following statements is false? 

A. Financial executives must design financial securities to meet the needs of the firm and its
investors.
B. Financial instruments are subject to full disclosure requirements.
C. Financial instruments are greatly constrained by law and regulation.
D. Financial instruments are claims against a company's cash flows and assets.
E. None of the above.

2. Which of the following securities has a purely fixed claim against a firm's cash flows? 
A. preferred stock
B. options
C. common stock
D. bonds
E. None of the above.

3. Which of the following securities has a purely residual claim against a firm's cash flows? 
A. preferred stock
B. callable bonds
C. common stock
D. non-callable bonds
E. None of the above.

4. Mike just purchased a bond which pays $40 each year in interest. The $40 interest payment
is also called the: 
A. coupon.
B. par value.
C. discount.
D. call premium.
E. yield.
F. None of the above.

5-1
Chapter 05 - Financial Instruments and Markets

5. Zack owns a bond that will pay him $35 each year in interest plus a $1,000 principal
payment at maturity. The $1,000 principal payment is called the: 
A. coupon.
B. par value.
C. discount.
D. yield.
E. call premium.
F. None of the above.

6. Which one of the following statements is true? 

A. Debt instruments offer residual claims to future cash payouts.
B. Bonds with call provisions will have lower coupon rates than otherwise identical bonds.
C. Bondholders enjoy a direct voice in company decisions.
D. Bonds are low-risk investments that do well in inflationary periods.
E. Preferred shareholders are the first investors to be repaid in bankruptcy liquidation.
F. None of the above.

7. Which one of the following accurately orders the rate of return on financial securities from
highest to lowest over most of recorded market history (the 1900-2010 period)? 
A. Short-term government bills, long-term corporate bonds, long-term government bonds,
common stocks
B. Long-term corporate bonds, long-term government bonds, common stocks, short-term
government bills
C. Common stocks, long-term government bonds, long-term corporate bonds, short-term
government bills
D. Common stocks, long-term corporate bonds, long-term government bonds, short-term
government bills
E. Long-term corporate bonds, common stocks, short-term government bills, long-term
government bonds
F. None of the above.

5-2
Chapter 05 - Financial Instruments and Markets

8. Which one of the following statements is true? 

A. Equity securities offer fixed claims on future cash payouts.
B. Unlike bondholders, for their returns, shareholders rely entirely on price appreciation.
C. In theory, common shareholders exercise very little control over company decisions.
D. Historically, common shareholders have earned a risk premium as compensation for risk
borne in excess of government bonds.
E. Preferred shareholders are the first investors to be repaid in bankruptcy liquidation.
F. None of the above.

9. You bought a yen-denominated corporate bond at the beginning of the year for ¥100,000.
The bond paid 3 percent annual interest and was trading for ¥110,000 at year-end. The
exchange rate was $1 = ¥100 at the beginning of the year and $1 = ¥122 at year-end. What
was your U.S. dollar holding period return on the bond? 
A. 3%
B. 7%
C. 10%
D. 13%
E. 30%
F. None of the above.

10. You bought a yen-denominated corporate bond at the beginning of the year for ¥100,000.
The bond paid 3 percent annual interest and was trading for ¥110,000 at year-end. The
exchange rate was $1 = ¥100 at the beginning of the year and $1 = ¥122 at year-end. What
holding period return, measured in yen, did you earn on the bond? 
A. -18.03%
B. -7.38%
C. -5.03%
D. 3.0%
E. 10.0%
F. None of the above.

5-3
Chapter 05 - Financial Instruments and Markets

11. You bought a yen-denominated corporate bond at the beginning of the year for ¥100,000.
The bond paid 3 percent annual interest and was trading for ¥110,000 at year-end. The
exchange rate was $1 = ¥100 at the beginning of the year and $1 = ¥97 at year-end. What
would be your U.S. dollar holding return on the bond? 
A. 3.09%
B. 6.09%
C. 13%
D. 16.49%
E. 30%
F. None of the above.

12. Which of the following statements are true?

I. Underwriters help private companies access public stock markets through IPOs.
II. Shelf registrations and private placements are examples of seasoned security issues.
III. Issue costs for debt are typically greater than issue costs for equity.
IV. Private equity financing is a common source of financing for startup firms. 
A. I and II only
B. I and III only
C. I, II, and IV only
D. I, III, and IV only
E. I, II, III, and IV
F. None of the above.

13. At the end of fiscal year 2011, Crane Industries, Inc.'s stock price was $30.75. A year later
it was $34.88. Per share dividends over the year were $0.55, while earnings per share were
$1.33. What rate of return did the common stock owners earn in fiscal year 2012? 
A. 1.79%
B. 4.33%
C. 13.43%
D. 15.22%
E. 17.76%
F. None of the above.

5-4
Chapter 05 - Financial Instruments and Markets

14. At the end of fiscal year 2011, Crane Industries, Inc.'s stock price was $30.75. A year later
it was $34.88. Per share dividends over the year were $0.55, while earnings per share were
$1.33. What was the dividend yield in fiscal year 2012? 
A. 1.79%
B. 4.33%
C. 13.43%
D. 15.22%
E. 17.76%
F. None of the above.

15. At the end of fiscal year 2011, Crane Industries, Inc.'s stock price was $30.75. A year later
it was $34.88. Per share dividends over the year were $0.55, while earnings per share were
$1.33. What was the percentage change in the share price in fiscal year 2012? 
A. 1.79%
B. 4.33%
C. 13.43%
D. 15.22%
E. 17.76%
F. None of the above.

16. Which of the following statements related to market efficiency tends to be supported by

current evidence?

I. Markets tend to respond quickly to new information.

II. It is difficult for the typical investor to earn above-average returns without taking above-
average risks.
III. Short-run prices are difficult to predict accurately based on public information.
IV. Markets are most likely weak form efficient. 
A. I and III only
B. II and IV only
C. I and IV only
D. I, III, and IV only
E. I, II, and III only
F. None of the above.

5-5
Chapter 05 - Financial Instruments and Markets

17. Individuals who continually monitor the financial markets seeking mispriced securities: 
A. earn excess profits over the long-term.
B. make the markets increasingly more efficient.
C. are never able to find a security that is temporarily mispriced.
D. are overwhelmingly successful in earning abnormal profits.
E. are always quite successful using only historical price information as their basis of
evaluation.
F. None of the above.

18. Which of the following are the most likely reasons for why a stock price might not react at
all on the day that new information related to the stock issuer is released?

I. Insiders knew the information prior to the announcement

II. Investors need time to digest the information prior to reacting
III. The information has no bearing on the value of the firm
IV. The information was anticipated 
A. I and II only
B. I and III only
C. II and III only
D. II and IV only
E. III and IV only
F. None of the above.

 
 

Short Answer Questions

 

19. Chapter 5 presents evidence that the average annual rate of return on common stocks over
many years has exceeded the return on government bonds in the United States, while returns
on common stocks have also exhibited more volatility than returns on U.S. government
bonds. Suppose that last year, the realized rate of return on government bonds exceeded the
return on common stocks. Your colleague suggests that "last year shows us that investors are
now willing to settle for lower returns on stocks than on bonds." How would you interpret this
result? 

 
 

5-6
Chapter 05 - Financial Instruments and Markets

20. Himmel Corp. wants to raise $100 million in a new stock issue. Its investment banker
indicates that the sale of new stock will require 12 percent underpricing and a 7 percent
spread. (Hint: The underpricing is 12 percent of the current stock price, and the spread is 7
percent of the issue price.)

a. Assuming Himmel's stock price does not change from its current price of $50 per share,
how many shares must the company sell and at what price to the public?
b. How much money will the investment banking syndicates earn on the sale?
c. Is the 12 percent underpricing a cash flow? Is it a cost? If so, to whom? 

 
 

21. If the stock market in the United States is efficient, how do you explain the fact that some
people make very high returns? Would it be more difficult to reconcile very high returns with
efficient markets if the same people made extraordinary returns year after year? 

 
 

22. You believe interest rates will soon fall.

a. Would you rather own a three-year, 6 percent coupon, fixed-rate bond or an equivalent-risk,
three-year, floating-rate bond currently paying 6 percent interest?
b. Would your answer to (a) change if you were contemplating issuing a bond rather than
owning one? If so, how?
c. Would your answer to (a) change if, as an investor, you believed interest rates would soon
rise? If so, why? 

 
 

5-7
Chapter 05 - Financial Instruments and Markets

Chapter 05 Financial Instruments and Markets Answer Key

 
 

Multiple Choice Questions

 

1. Which one of the following statements is false? 

A. Financial executives must design financial securities to meet the needs of the firm and its
investors.
B. Financial instruments are subject to full disclosure requirements.
C. Financial instruments are greatly constrained by law and regulation.
D. Financial instruments are claims against a company's cash flows and assets.
E. None of the above.

Difficulty: 1 Easy
 

2. Which of the following securities has a purely fixed claim against a firm's cash flows? 
A. preferred stock
B. options
C. common stock
D. bonds
E. None of the above.

Difficulty: 1 Easy
 

3. Which of the following securities has a purely residual claim against a firm's cash flows? 
A. preferred stock
B. callable bonds
C. common stock
D. non-callable bonds
E. None of the above.

Difficulty: 1 Easy
 

5-8
Chapter 05 - Financial Instruments and Markets

4. Mike just purchased a bond which pays $40 each year in interest. The $40 interest payment
is also called the: 
A. coupon.
B. par value.
C. discount.
D. call premium.
E. yield.
F. None of the above.

Difficulty: 1 Easy
 

5. Zack owns a bond that will pay him $35 each year in interest plus a $1,000 principal
payment at maturity. The $1,000 principal payment is called the: 
A. coupon.
B. par value.
C. discount.
D. yield.
E. call premium.
F. None of the above.

Difficulty: 1 Easy
 

6. Which one of the following statements is true? 

A. Debt instruments offer residual claims to future cash payouts.
B. Bonds with call provisions will have lower coupon rates than otherwise identical bonds.
C. Bondholders enjoy a direct voice in company decisions.
D. Bonds are low-risk investments that do well in inflationary periods.
E. Preferred shareholders are the first investors to be repaid in bankruptcy liquidation.
F. None of the above.

Difficulty: 2 Medium
 

5-9
Chapter 05 - Financial Instruments and Markets

7. Which one of the following accurately orders the rate of return on financial securities from
highest to lowest over most of recorded market history (the 1900-2010 period)? 
A. Short-term government bills, long-term corporate bonds, long-term government bonds,
common stocks
B. Long-term corporate bonds, long-term government bonds, common stocks, short-term
government bills
C. Common stocks, long-term government bonds, long-term corporate bonds, short-term
government bills
D. Common stocks, long-term corporate bonds, long-term government bonds, short-term
government bills
E. Long-term corporate bonds, common stocks, short-term government bills, long-term
government bonds
F. None of the above.

Difficulty: 1 Easy
 

8. Which one of the following statements is true? 

A. Equity securities offer fixed claims on future cash payouts.
B. Unlike bondholders, for their returns, shareholders rely entirely on price appreciation.
C. In theory, common shareholders exercise very little control over company decisions.
D. Historically, common shareholders have earned a risk premium as compensation for risk
borne in excess of government bonds.
E. Preferred shareholders are the first investors to be repaid in bankruptcy liquidation.
F. None of the above.

Difficulty: 2 Medium
 

5-10
Chapter 05 - Financial Instruments and Markets

9. You bought a yen-denominated corporate bond at the beginning of the year for ¥100,000.
The bond paid 3 percent annual interest and was trading for ¥110,000 at year-end. The
exchange rate was $1 = ¥100 at the beginning of the year and $1 = ¥122 at year-end. What
was your U.S. dollar holding period return on the bond? 
A. 3%
B. 7%
C. 10%
D. 13%
E. 30%
F. None of the above.

The holding period return in yen was [3%*100,000 + 10,000]/100,000 = 13 percent.

Difficulty: 2 Medium
 

5-11
Chapter 05 - Financial Instruments and Markets

10. You bought a yen-denominated corporate bond at the beginning of the year for ¥100,000.
The bond paid 3 percent annual interest and was trading for ¥110,000 at year-end. The
exchange rate was $1 = ¥100 at the beginning of the year and $1 = ¥122 at year-end. What
holding period return, measured in yen, did you earn on the bond? 
A. -18.03%
B. -7.38%
C. -5.03%
D. 3.0%
E. 10.0%
F. None of the above.

You paid $1,000 for the bond (¥100,000/100). At the end of the year, you had interest income
and a yen bond worth a total of $926.23 (¥113,000/122). Your dollar return was -7.38 percent
([$926.23 - $1,000]/$1,000). Another way to find the dollar return is to use the following
equation,

Difficulty: 3 Hard
 

5-12
Chapter 05 - Financial Instruments and Markets

11. You bought a yen-denominated corporate bond at the beginning of the year for ¥100,000.
The bond paid 3 percent annual interest and was trading for ¥110,000 at year-end. The
exchange rate was $1 = ¥100 at the beginning of the year and $1 = ¥97 at year-end. What
would be your U.S. dollar holding return on the bond? 
A. 3.09%
B. 6.09%
C. 13%
D. 16.49%
E. 30%
F. None of the above.

You paid $1,000 for the bond (¥100,000/100). At the end of the year, you had interest income
and a yen bond worth a total of $1,164.95 (¥113,000/97). The U.S. dollar holding period
return would be ($1,164.95 - $1,000)/$1,000 = 16.49%. Alternatively,

Difficulty: 3 Hard
 

12. Which of the following statements are true?

I. Underwriters help private companies access public stock markets through IPOs.
II. Shelf registrations and private placements are examples of seasoned security issues.
III. Issue costs for debt are typically greater than issue costs for equity.
IV. Private equity financing is a common source of financing for startup firms. 
A. I and II only
B. I and III only
C. I, II, and IV only
D. I, III, and IV only
E. I, II, III, and IV
F. None of the above.

Difficulty: 2 Medium
 

5-13
Chapter 05 - Financial Instruments and Markets

13. At the end of fiscal year 2011, Crane Industries, Inc.'s stock price was $30.75. A year later
it was $34.88. Per share dividends over the year were $0.55, while earnings per share were
$1.33. What rate of return did the common stock owners earn in fiscal year 2012? 
A. 1.79%
B. 4.33%
C. 13.43%
D. 15.22%
E. 17.76%
F. None of the above.

Rate of return = ((34.88 + 0.55) - 30.75)/30.75 = 15.22%

Difficulty: 2 Medium
 

14. At the end of fiscal year 2011, Crane Industries, Inc.'s stock price was $30.75. A year later
it was $34.88. Per share dividends over the year were $0.55, while earnings per share were
$1.33. What was the dividend yield in fiscal year 2012? 
A. 1.79%
B. 4.33%
C. 13.43%
D. 15.22%
E. 17.76%
F. None of the above.

Dividend yield = 0.55/30.75 = 1.79%

Difficulty: 1 Easy
 

5-14
Chapter 05 - Financial Instruments and Markets

15. At the end of fiscal year 2011, Crane Industries, Inc.'s stock price was $30.75. A year later
it was $34.88. Per share dividends over the year were $0.55, while earnings per share were
$1.33. What was the percentage change in the share price in fiscal year 2012? 
A. 1.79%
B. 4.33%
C. 13.43%
D. 15.22%
E. 17.76%
F. None of the above.

Percentage change in share price = (34.88- 30.75)/30.75 = 4.13/30.75 = 13.43%.

Difficulty: 1 Easy
 

16. Which of the following statements related to market efficiency tends to be supported by

current evidence?

I. Markets tend to respond quickly to new information.

II. It is difficult for the typical investor to earn above-average returns without taking above-
average risks.
III. Short-run prices are difficult to predict accurately based on public information.
IV. Markets are most likely weak form efficient. 
A. I and III only
B. II and IV only
C. I and IV only
D. I, III, and IV only
E. I, II, and III only
F. None of the above.

Difficulty: 2 Medium
 

5-15
Chapter 05 - Financial Instruments and Markets

17. Individuals who continually monitor the financial markets seeking mispriced securities: 
A. earn excess profits over the long-term.
B. make the markets increasingly more efficient.
C. are never able to find a security that is temporarily mispriced.
D. are overwhelmingly successful in earning abnormal profits.
E. are always quite successful using only historical price information as their basis of
evaluation.
F. None of the above.

Difficulty: 2 Medium
 

18. Which of the following are the most likely reasons for why a stock price might not react at
all on the day that new information related to the stock issuer is released?

I. Insiders knew the information prior to the announcement

II. Investors need time to digest the information prior to reacting
III. The information has no bearing on the value of the firm
IV. The information was anticipated 
A. I and II only
B. I and III only
C. II and III only
D. II and IV only
E. III and IV only
F. None of the above.

Difficulty: 2 Medium
 
 

5-16
Chapter 05 - Financial Instruments and Markets

Short Answer Questions

 

19. Chapter 5 presents evidence that the average annual rate of return on common stocks over
many years has exceeded the return on government bonds in the United States, while returns
on common stocks have also exhibited more volatility than returns on U.S. government
bonds. Suppose that last year, the realized rate of return on government bonds exceeded the
return on common stocks. Your colleague suggests that "last year shows us that investors are
now willing to settle for lower returns on stocks than on bonds." How would you interpret this
result? 

The fact that government bonds earned a higher rate of return than common stocks in one year
is not evidence that investors are suddenly willing to settle for lower returns on stocks than
bonds. It means that investors' expectations were not met or, alternatively, that investors were
surprised. To take on additional risk, risk-averse investors require additional expected return.
But expected returns are not the same as realized returns. Because stocks and bonds are risky,
their returns will fluctuate from year to year, and bonds will earn higher returns than stocks in
some years. But the expected returns of common stocks should always be higher than the
expected returns of government bonds.

Difficulty: 3 Hard
 

5-17
Chapter 05 - Financial Instruments and Markets

20. Himmel Corp. wants to raise $100 million in a new stock issue. Its investment banker
indicates that the sale of new stock will require 12 percent underpricing and a 7 percent
spread. (Hint: The underpricing is 12 percent of the current stock price, and the spread is 7
percent of the issue price.)

a. Assuming Himmel's stock price does not change from its current price of $50 per share,
how many shares must the company sell and at what price to the public?
b. How much money will the investment banking syndicates earn on the sale?
c. Is the 12 percent underpricing a cash flow? Is it a cost? If so, to whom? 

a.

b. Investment bankers' revenue = $3.08 x 2.444 million = $7.528 million.

c. Underpricing is not a cash flow. It is, however, an opportunity cost to current owners
because it means that more shares must be sold to raise $100 million and each share will
represent a smaller ownership interest in the company.

Difficulty: 2 Medium
 

5-18
Chapter 05 - Financial Instruments and Markets

21. If the stock market in the United States is efficient, how do you explain the fact that some
people make very high returns? Would it be more difficult to reconcile very high returns with
efficient markets if the same people made extraordinary returns year after year? 

Earning high returns in an efficient market is like winning at roulette. In any random process,
there will be winners and losers, and some winners might win big. Earning consistently high
returns over time is also possible in an efficient market, just like a gambler on a lucky streak
might win repeatedly at roulette. The relevant question is whether the very high returns or the
length of the winning streak is inconsistent with blind luck or not.

Difficulty: 2 Medium
 

22. You believe interest rates will soon fall.

a. Would you rather own a three-year, 6 percent coupon, fixed-rate bond or an equivalent-risk,
three-year, floating-rate bond currently paying 6 percent interest?
b. Would your answer to (a) change if you were contemplating issuing a bond rather than
owning one? If so, how?
c. Would your answer to (a) change if, as an investor, you believed interest rates would soon
rise? If so, why? 

a. I would rather own a fixed-rate bond because the interest income I receive from a floating-
rate bond will fall as interest rates decline. Equivalently, the market value of the fixed-rate
bond will rise as rates fall, but that of the floating-rate bond will not. (This presumes the
fixed-rate bond is not callable.)
b. My answer would change. I would rather issue a floating-rate bond now because future
interest payments will fall as rates decline.
c. My answer would change. As an investor, I would want to hold a floating-rate bond
because interest income will rise as interest rates rise. Equivalently, the price of the fixed-
income bond will fall as rates rise, while that of the floating-rate bond will not.

Difficulty: 2 Medium
 

5-19