TB 3 7

Financial Markets and Institutions, 7e (Saunders)
Chapter 3 Interest Rates and Security Valuation
1) If interest rates increase, the value of a fixed income contract decreases and vice versa.
Answer: TRUE
Difficulty: 1 Easy
Topic: Impact of Interest Rate Changes on Security Values
Bloom's: Understand
AACSB: Reflective Thinking
Learning Goal: 03-04 Appreciate how security prices are affected by interest rate changes.
Accessibility: Keyboard Navigation
2) At equilibrium a security's required rate of return will be less than its expected rate of return.
Answer: FALSE
Difficulty: 1 Easy
Topic: Various Interest Rate Measures
Bloom's: Understand
Learning Goal: 03-01 Understand the differences in the required rate of return, the expected
rate of return, and the realized rate of return.
3) If a security's realized return is negative, it must have been true that the expected return was
greater than the required return.
Answer: FALSE
Difficulty: 2 Medium
Bloom's: Understand
1
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4) Suppose two bonds of equivalent risk and maturity have different prices such that one is a
premium bond and one is a discount bond. The premium bond must have a greater expected
return than the discount bond.
Answer: FALSE
Bloom's: Understand
5) A bond with an 11 percent coupon and a 9 percent required return will sell at a premium to
par.
Answer: TRUE
Difficulty: 1 Easy
Bloom's: Understand
6) A fairly priced bond with a coupon less than the expected return must sell at a discount from
par.
Answer: TRUE
Difficulty: 1 Easy
Bloom's: Understand
2
7) All else equal, the holder of a fairly priced premium bond must expect a capital loss over the
holding period.
Answer: TRUE
Bloom's: Understand
8) The duration of a four-year maturity 10 percent coupon bond is less than four years.
Answer: TRUE
Difficulty: 1 Easy
Topic: Duration
Bloom's: Remember
Learning Goal: 03-06 Know what duration is.
9) The longer the time to maturity, the lower the security's price sensitivity to an interest rate
change, ceteris paribus.
Answer: FALSE
Difficulty: 1 Easy
Topic: Impact of Maturity on Security Values
Bloom's: Understand
Learning Goal: 03-05 Understand how the maturity and coupon rate on a security affect its
price sensitivity to interest rate changes.
10) The greater a security's coupon, the lower the security's price sensitivity to an interest rate
Answer: TRUE
Difficulty: 1 Easy
Topic: Impact of Coupon Rates on Security Values
Bloom's: Understand
3
11) For a given interest rate change, a 20-year bond's price change will be twice that of a 10-year
bond's price change.
Answer: FALSE
Topic: Impact of Maturity on Security Values
Bloom's: Understand
12) Any security that returns a greater percentage of the price sooner is less price-volatile.
Answer: TRUE
Difficulty: 1 Easy
Bloom's: Understand
13) A zero coupon bond has a duration equal to its maturity and a convexity equal to zero.
Answer: TRUE
Topic: Duration
Bloom's: Understand
14) The lower the level of interest rates, the greater a bond's price sensitivity to interest rate
changes.
Answer: TRUE
Topic: Duration
Bloom's: Understand
Learning Goal: 03-07 Understand how maturity, yield to maturity, and coupon rate affect the
duration of a security.
4
15) The higher a bond's coupon, the lower the bond's price volatility.
Answer: TRUE
Difficulty: 1 Easy
Topic: Duration
Bloom's: Understand
16) Higher interest rates lead to lower bond convexity, ceteris paribus.
Answer: TRUE
Topic: Appendix 3B: More on Convexity
Bloom's: Understand
Learning Goal: 03-08 Understand the economic meaning of duration.
17) A 10-year maturity zero coupon bond will have lower price volatility than a 10-year bond
with a 10 percent coupon.
Answer: FALSE
Difficulty: 1 Easy
Bloom's: Understand
18) Ignoring default risk, if a bond's expected return is greater than its required return, then the
bond's market price must be greater than the present value of the bond's cash flows.
Answer: FALSE
Difficulty: 1 Easy
Bloom's: Understand
5
19) The coupon rate represents the most accurate measure of the bondholder's required return.
Answer: FALSE
Difficulty: 3 Hard
Bloom's: Analyze; Apply
AACSB: Analytical Thinking
20) The higher the interest rate is the higher the duration, all else being equal.
Answer: FALSE
Difficulty: 1 Easy
Topic: Duration
Bloom's: Understand
21) The required rate of return on a bond is

A) the interest rate that equates the current market price of the bond with the present value of all
future cash flows received.
B) equivalent to the current yield for nonpar bonds.
C) less than the E(r) for discount bonds and greater than the E(r) for premium bonds.
D) inversely related to a bond's risk and coupon.
E) None of these choices are correct.
Answer: E
Bloom's: Understand
6
22) Duration is
A) the elasticity of a security's value to small coupon changes.
B) the weighted average time to maturity of the bond's cash flows.
C) the time until the investor recovers the price of the bond in today's dollars.
D) greater than maturity for deep discount bonds and less than maturity for premium bonds.
E) the second derivative of the bond price formula with respect to the YTM.
Answer: B
Topic: Duration
Bloom's: Understand
23) Which of the following bond terms are generally positively related to bond price volatility?
I. Coupon rate
II. Maturity
III. YTM
IV. Payment frequency
A) II and IV only
B) I and III only
C) II and III only
D) II only
E) II, III, and IV only
Answer: D
Difficulty: 3 Hard
Topic: Impact of Maturity on Security Values; Impact of Coupon Rates on Security Values;
Impact of Interest Rate Changes on Security Values
Bloom's: Understand
7
24) The interest rate used to find the present value of a financial security is the
A) expected rate of return.
B) required rate of return.
C) realized rate of return.
D) realized yield to maturity.
E) current yield.
Answer: B
Difficulty: 1 Easy
Bloom's: Understand
25) A security has an expected return less than its required return. This security is
A) selling at a premium to par.
B) selling at a discount to par.
C) selling for more than its PV.
D) selling for less than its PV.
E) a zero coupon bond.
Answer: C
Bloom's: Understand
8
26) A bond that you held to maturity had a realized return of 8 percent, but when you bought it, it
had an expected return of 6 percent. If no default occurred, which one of the following must be
true?
A) The bond was purchased at a premium to par.
B) The coupon rate was 8 percent.
C) The required return was greater than 6 percent.
D) The coupons were reinvested at a higher rate than expected.
E) The bond must have been a zero coupon bond.
Answer: D
Bloom's: Understand
27) You would want to purchase a security if P ________ PV or E(r) ________ r.

A) ≥; ≤
B) ≥; ≥
C) ≤; ≥
D) ≤; ≤
Answer: C
Difficulty: 3 Hard
Bloom's: Understand
9
28) A 10-year annual payment corporate bond has a market price of $1,050. It pays annual
interest of $100 and its required rate of return is 9 percent. By how much is the bond mispriced?
A) $0.00
B) Overpriced by $14.18
C) Underpriced by $14.18
D) Overpriced by $9.32
E) Underpriced by $9.32
Answer: C
Explanation: PV = 100 × PVIFA [9%, 10 yrs.] + 1,000 × PVIF (9%, 10 yrs.) = $1,064.18
Calculator Method:
N = 10
PMT = 100
I/Y = 9
FV = 1,000
Solve for PV which is $1064.18; Market value is underpriced by $14.18.
Topic: Various Interest Rate Measures; Bond Valuation
Bloom's: Analyze; Apply; Evaluate
AACSB: Reflective Thinking; Analytical Thinking
rate of return, and the realized rate of return.; 03-02 Calculate bond values.
10
29) A 12-year annual payment corporate bond has a market price of $925. It pays annual interest
of $60 and its required rate of return is 7 percent. By how much is the bond mispriced?
A) $0.00
B) Overpriced by $7.29
C) Underpriced by $7.29
D) Overpriced by $4.43
E) Underpriced by $4.43
Answer: D
Explanation: FPV = 60 × PVIFA [7%, 12 yrs.] + 1,000 × PVIF (7%, 12 yrs.) = $920.57
Calculator Method:
N = 12
PMT = 60
I/Y = 7
FV = 1,000
Solve for PV which is $920.57; Market value is overpriced by $4.43.
Topic: Various Interest Rate Measures; Bond Valuation
rate of return, and the realized rate of return.; 03-02 Calculate bond values.
11
30) An eight-year corporate bond has a 7 percent coupon rate. What should be the bond's price if
the required return is 6 percent and the bond pays interest semiannually?
A) $1,062.81
B) $1,062.10
C) $1,053.45
D) $1,052.99
E) $1,049.49
Answer: A
Explanation: Price = 35.00 × PVIFA (3%, 16) + 1,000 × PVIF (3%, 16)
Calculator Method:
N = 16
PMT = 35
I/Y = 3
FV = 1,000
Solve for PV which is $1062.81.
Topic: Bond Valuation
Learning Goal: 03-02 Calculate bond values.
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31) A 15-year corporate bond pays $40 interest every six months. What is the bond's price if the
bond's promised YTM is 5.5 percent?
A) $1,261.32
B) $1,253.12
C) $1,250.94
D) $1,263.45
E) $1,264.79
Answer: B
Explanation: Using P/Y2 for semiannual; FV $1,000; PMT $40; N 15 years; and I/Y 5.5
percent. Solve bond price (PV) = $1,253.12.
Calculator Method:
N = 30
PMT = 40
I/Y = 2.75
FV = 1,000
Solve for PV which is $1,253.12.
32) A corporate bond has a coupon rate of 10 percent and a required return of 10 percent. This
bond's price is
A) $924.18.
B) $1,000.00.
C) $879.68.
D) $1,124.83.
E) not possible to determine from the information given.
Answer: B
Explanation: When coupon rate = required return; price = par
Difficulty: 1 Easy
13
33) A 10-year annual payment corporate coupon bond has an expected return of 11 percent and a
required return of 10 percent. The bond's market price is
A) greater than its PV.
B) less than par.
C) less than its E(r).
D) less than its PV.
E) $1,000.00.
Answer: D
Bloom's: Understand
34) An eight-year annual payment 7 percent coupon Treasury bond has a price of $1,075. The
bond's annual E(r) must be
A) 13.49 percent.
B) 5.80 percent.
C) 7.00 percent.
D) 1.69 percent.
E) 4.25 percent.
Answer: B
Explanation: $1,075 = 70 × PVIFA (E(r)%, 8) + 1,000 × PVIF (E(r)%, 8), trial and error or
calculator
Calculator Method:
N=8
PMT = 70
PV = −1,075
FV = 1,000
Solve for I/Y which is 5.80%.
14
35) A six-year annual payment corporate bond has a required return of 9.5 percent and an 8
percent coupon. Its market value is $20 over its PV. What is the bond's E(r)?
A) 8.00 percent
B) 10.21 percent
C) 9.98 percent
D) 9.03 percent
E) 3.53 percent
Answer: D
Explanation: PV = 933.70 = 80 × PVIFA (9.5%, 6 yrs.) + 1,000 × PVIF (9.5%, 6 yrs.); (933.70
+ 20) = 80 × PVIFA (E(r), 6 yrs.) + 1,000 × PVIF (E(r), 6 yrs.), trial and error or calculator
Calculator Method:
First find the Present Value of this bond.
N=6
PMT = 80
I/Y = 9.5
FV = 1,000
Solve for PV which is 933.70.
The market value is 953.70, using this value solve for I/Y to find E(r).
PV = −953.70
PMT = 80
N=6
FV = 1,000
Solve for I/Y to get 9.03%.
Difficulty: 3 Hard
15
36) Corporate Bond A returns 5 percent of its cost in PV terms in each of the first five years and
75 percent of its value in the sixth year. Corporate Bond B returns 8 percent of its cost in PV
terms in each of the first five years and 60 percent of its cost in the sixth year. If A and B have
the same required return, which of the following is/are true?
I. Bond A has a bigger coupon than Bond B.

II. Bond A has a longer duration than Bond B.
III. Bond A is less price-volatile than Bond B.
IV. Bond B has a higher PV than Bond A.
A) III only
B) I, III, and IV only
C) I, II, and IV only
D) II and IV only
E) I, II, III, and IV
Answer: D
Difficulty: 3 Hard
Topic: Various Interest Rate Measures; Duration; Impact of Coupon Rates on Security Values
Bloom's: Analyze; Evaluate
price sensitivity to interest rate changes.; 03-07 Understand how maturity, yield to maturity, and
coupon rate affect the duration of a security.; 03-01 Understand the differences in the required
rate of return, the expected rate of return, and the realized rate of return.
37) A corporate bond returns 12 percent of its cost (in PV terms) in the first year, 11 percent in
the second year, 10 percent in the third year and the remainder in the fourth year. What is the
bond's duration in years?
A) 3.68 years
B) 2.50 years
C) 4.00 years
D) 3.75 years
E) 3.32 years
Answer: E
Explanation: 3.32 = (12% × 1) + (11% × 2) + (10% × 3) + (67% × 4)
Topic: Duration
16
38) A semiannual payment bond with a $1,000 par has a 7 percent quoted coupon rate, a 7
percent promised YTM, and 10 years to maturity. What is the bond's duration?
A) 10.00 years
B) 8.39 years
C) 6.45 years
D) 5.20 years
E) 7.35 years
Answer: E
Explanation: Σ[(t × CFt/(1.035)t)]/($1,000)
Difficulty: 3 Hard
Topic: Duration
39) An annual payment bond with a $1,000 par has a 5 percent quoted coupon rate, a 6 percent
promised YTM, and six years to maturity. What is the bond's duration?
A) 5.31 years
B) 5.25 years
C) 4.76 years
D) 4.16 years
E) 3.19 years
Answer: A
Explanation: Σ[(t × CFt/(1.06)t)]/$950.83
Difficulty: 3 Hard
Topic: Duration
17
40) If an N year security recovered the same percentage of its cost in PV terms each year, the
duration would be
A) N.
B) 0.
C) sum of the years/N.
D) N!/N2.
Answer: C
Difficulty: 3 Hard
Topic: Duration
Bloom's: Understand
41) The ________ the coupon and the ________ the maturity; the ________ the duration of a
bond, ceteris paribus.
A) larger; longer; longer
B) larger; longer; shorter
C) smaller; shorter; longer
D) smaller; shorter; shorter
Answer: E
Difficulty: 3 Hard
Topic: Duration
Bloom's: Understand
18
42) A four-year maturity 0 percent coupon corporate bond with a required rate of return of 12
percent has an annual duration of ________ years.
A) 3.05
B) 2.97
C) 3.22
D) 3.71
E) 4.00
Answer: E
Explanation: Duration of zero coupon bond definition.
Difficulty: 1 Easy
Topic: Duration
43) A decrease in interest rates will

A) decrease the bond's PV.
B) increase the bond's duration.
C) lower the bond's coupon rate.
D) change the bond's payment frequency.
E) not affect the bond's duration.
Answer: B
Topic: Duration
Bloom's: Understand
19
44) A 10-year maturity coupon bond has a six-year duration. An equivalent 20-year bond with
the same coupon has a duration
A) equal to 12 years.
B) less than six years.
C) less than 12 years.
D) equal to six years.
E) greater than 20 years.
Answer: C
Difficulty: 1 Easy
Topic: Duration
Bloom's: Understand
45) A six-year maturity bond has a five-year duration. Over the next year maturity will decline
by one year and duration will decline by
A) less than one year.
B) more than one year.
C) one year.
D) N years.
E) N/(N − 1) years.
Answer: A
Topic: Duration
Bloom's: Analyze
20
46) An annual payment bond has a 9 percent required return. Interest rates are projected to fall
25 basis points. The bond's duration is 12 years. What is the predicted price change?
A) −2.75 percent
B) 33.33 percent
C) 1.95 percent
D) −1.95 percent
E) 2.75 percent
Answer: E
Explanation: −12 × (−0.0025/1.09) = 0.0275
Topic: Duration
47) A bond that pays interest annually has a 6 percent promised yield and a price of $1,025.
Annual interest rates are now projected to fall 50 basis points. The bond's duration is six years.
What is the predicted new bond price after the interest rate change? (Watch your rounding.)
A) $1,042.33
B) $995.99
C) $1,054.01
D) $987.44
Answer: C
Explanation: 1,025 + [−6 × (−0.0050/1.06) × $1,025] = 1,054
Topic: Duration
21
48) A bond that pays interest semiannually has a 6 percent promised yield and a price of $1,045.
Annual interest rates are now projected to increase 50 basis points. The bond's duration is five
years. What is the predicted new bond price after the interest rate change? (Watch your
rounding.)
A) $1,020.35
B) $1,069.65
C) $1,070.36
D) $1,019.64
Answer: D
Explanation: ((−5/1.03) × 0.0050 × $1,045) + $1,045 = 1,019.635
Topic: Duration
49) Convexity arises because

A) bonds pay interest semiannually.
B) coupon changes are the opposite sign of interest rate changes.
C) duration is an increasing function of maturity.
D) present values are a nonlinear function of interest rates.
E) duration increases at higher interest rates.
Answer: D
Bloom's: Understand
22
50) The duration of a 180-day T-Bill is (in years)
A) 0.493.
B) 0.246.
C) 1.
D) 0.
E) indeterminate.
Answer: A
Explanation: 180/365 = 0.493
Difficulty: 1 Easy
Topic: Duration
51) The duration of a 91-day T-Bill is (in years).

A) 0.325
B) 0.249
C) 0.715
D) 0
E) Indeterminate
Answer: B
Explanation: 91/365 = 0.249
Difficulty: 1 Easy
Topic: Duration
52) For large interest rate increases, duration ________ the fall in security prices, and for large
interest rate decreases, duration ________ the rise in security prices.
A) overpredicts; overpredicts
B) overpredicts; underpredicts
C) underpredicts; overpredicts
D) underpredicts; underpredicts
Answer: B
Topic: Duration
Bloom's: Understand
23
53) Suppose you owned stock in a company for the last three years. You originally bought the
stock three years ago for $30 and just sold it for $56. The stock paid an annual dividend of $1.35
on the last day of each of the past three years. What is your realized return on this investment?
A) 15.36 percent
B) 36.14 percent
C) 26.85 percent
D) 37.58 percent
Answer: C
Explanation: Use a financial calculator to solve for IRR as follows:
CF0 = −$30, CF1 = $1.35, CF2 = $1.35, CF3 = $57.35
Compute IRR = 26.85%.
Topic: Equity Valuation
Learning Goal: 03-03 Calculate equity values.
54) You are considering the purchase of a certain stock. You expect to own the stock for the next
four years. The current market price of the stock is $24.50 and you expect to sell it for $55 in
four years. You also expect the stock to pay an annual dividend of $1.25 at the end of year 1,
$1.35 at the end of year 2, $1.45 at the end of year 3 and $1.55 at the end of year 4. What is your
expected return from this investment?
A) 21.78 percent
B) 18.36 percent
C) 26.68 percent
D) 32.85 percent
Answer: C
CF0 = −$24.50, CF1 = $1.25, CF2 = $1.35, CF3 = $1.45, CF4 = $56.55
Compute IRR = 26.68%.
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55) A preferred stock is expected to pay a constant quarterly dividend of $1.25 per quarter into
the future. The required rate of return, Rs, on the preferred stock is 13.5 percent. What is the fair
value (or price) of this stock?
A) $37.04
B) $24.36
C) $52.36
D) $18.65
Answer: A
Explanation: Rs = (4 × 1.25) / 0.135 = 37.04
56) You are evaluating a company's stock. The stock just paid a dividend of $1.75. Dividends are
expected to grow at a constant rate of 5 for long time into the future. The required rate of return
(Rs) on the stock is 12 percent. What is the fair present value?
A) $26.25
B) $22.50
C) $35.26
D) $50.25
Answer: A
Explanation: P0 = (1.75 × 1.05)/(0.12 − 0.05) = 26.25
25
57) A common stock paid a dividend at the end of last year of $3.50. Dividends have grown at a
constant rate of 6 percent per year over the last 20 years, and this constant growth rate is
expected to continue into the future. The stock is currently selling at a price of $35 per share.
What is the expected rate of return on this stock?
A) 18.7 percent
B) 22.5 percent
C) 16.6 percent
D) 8.4 percent
Answer: C
Explanation: E(Rs) = (3.5 × 1.06/35) + 0.06 = 0.166
58) A stock you are evaluating is expected to experience supernormal growth in dividends of 12
percent over the next three years. Following this period, dividends are expected to grow at a
constant rate of 4 percent. The stock paid a dividend of $1.50 last year and the required rate of
return on the stock is 11 percent. Calculate the stock's fair present value.
A) $16.24
B) $21.56
C) $24.25
D) $27.46
Answer: D
Explanation: D1 = 1.5 × 1.12 = 1.68
D2 = 1.68 × 1.12 = 1.88
D3 = 1.88 × 1.12 = 2.11
D4 = 2.11 × 1.04 = 2.19
P3 = 2.19/(0.11 - 0.04) = 31.29
Use the Calculator to solve for the NPV:

CF0 = 0, CF1 = $1.68, CF2 = $1.88, CF3 = $33.40, I/Y = 11 to get NPV = 27.46
Difficulty: 3 Hard
26
59) The basic principle of valuation states that the value of any asset is
A) the present value of all future cash flows generated by the asset.
B) the sum of all future cash flows generated by the asset.
C) the present value of next year's cash flow only.
D) the degree of cash flow riskiness is not a relevant factor in valuation.
Answer: A
Difficulty: 1 Easy
Topic: Bond Valuation; Equity Valuation
Bloom's: Understand
Learning Goal: 03-02 Calculate bond values.; 03-03 Calculate equity values.
60) Is the realized rate of return related to the expected return? the required return? Explain.
Answer: Yes and no. The required return determines the initial size of the coupon and the offer
price and, as the r changes, forces the market price to change. As the buy and sell prices and
reinvestment rates on coupons change, the realized return will be affected. However, the required
return is an ex-ante rate designed to compensate investors for risk. The realized return may be
less than or more than the expected or the required. That is the nature of risk. If you repeated the
same investment with the same terms over and over, you should, on average, earn a realized
return equal to the required return.
Bloom's: Understand; Analyze
27
61) You bought a stock three years ago and paid $45 per share. You collected a $2 dividend per
share each year you held the stock and then you sold the stock for $47 per share. What was your
annual compound rate of return?
A) 8.89 percent
B) 8.51 percent
C) 5.84 percent
D) 4.44 percent
E) 2.96 percent
Answer: C
CF0 = −$45, CF1 = $2, CF2 = $2, CF3 = $49,
Compute for IRR = 5.84%.
Difficulty: 3 Hard
62) Conceptually, why does a bond's price fall when required returns rise on an existing fixed
income security?
Answer: Since the cash flows are set by contract, the only way a new investor can expect to
earn the new higher required return is to pay less for the bond, so the price has to fall. Traders
sell the existing bond in favor of newer, higher rate bonds, dropping the price and raising the
expected return.
Difficulty: 1 Easy
Topic: Impact of Interest Rate Changes on Security Valuation
Bloom's: Understand
Learning Goal: 03-04 Appreciate how security prices are affected by interest rate changes.
28
63) A 15-year, 7 percent coupon annual payment corporate bond has a PV of $1,055.62.
However, you pay $1,024.32 for the bond. By how many basis points is your E(r) different from
your r?
Answer: r = 6.41%
1,055.62 = 70 × [PVIFA15 yr, r] + 1,000 × [PVIFA15yr, r]
E(r) = 6.74%
1,024.32 = 70 × [PVIFA15 yr, E(r)] + 1,000 × [PVIFA15yr, E(r)]
E(r) is 33 basis points more than your r. Calculator Solution:

First solve for the required return:
PV = −1,055.62
FV = 1,000
PMT = 70
N = 15
Solve for I/Y = 6.41%.
Now solve for the E(r):
PV = −1,024.32
FV = 1,000
PMT = 70
N = 15
Solve for I/Y = 6.74%.
The difference between expected return and required return is 0.33% or 33 basis points.
29
64) What is convexity? How does convexity affect duration-based predicted price changes for
interest rates changes?
Answer: Convexity is a measure of the nonlinearity (curvature) of a change in a bond's price

caused by a change in interest rates. The level of convexity increases for greater interest rate
changes. Duration is a linear estimate of a bond's price change as the interest rate changes from
its current level. Due to convexity, the greater the interest rate change, the greater the error in
using duration to estimate the bond's price change. For a multimillion-dollar bond portfolio, the
dollar errors can be quite significant. In abnormal markets, bond investors may face more or less
risk than the bond's duration would imply.
Calculus
Answer: Duration is the first derivative of the bond price formula with respect to a change in
interest rates. As such, it is accurate only for extremely small changes in interest rates. Duration
gives only an approximation of the actual value change for interest rate movements that are
normally observed in the market.
Difficulty: 3 Hard
Bloom's: Understand
30
65) An investor owned a 9 percent annual payment coupon bond for six years that was originally
purchased at a 9 percent required return. She did not reinvest any coupons (she kept the money
under her mattress). She redeemed the bond at par. What was her annual realized rate of return?
What if she did reinvest the coupons but only earned 5 percent on each coupon? Why are your
answers not equal to 9 percent?
Answer: You can't use the bond price formula in this case because of the lack of reinvestment.
First alternative: Do not reinvest the coupons at all.

PV = $1,000 purchase price (coupon = YTM when purchased)
FV = $90 × 6 = $540 + $1,000 par = $1,540
With a financial calculator, input: PV = −1,000, FV = 1,540, N = 6, PMT = 0 and solve for I to
get 7.46%.
Second alternative: reinvest coupons at 5%

PV = $1,000 purchase price (coupon = YTM when purchased)
The future value will be $1,000 plus the sum of the future values of each of the $90 reinvested at
5%. With a financial calculator, first find the sum of the future values of each of the $90. PMT =
90, I = 5, N = 6, PV = 0, and solve for FV1 to get 612.17 and then add $1,000 to this amount to
get the FV = 612.17 + 1,000 = $1,612.17. Finally to solve for r, using the financial calculator,
input FV = 1,612.17, PV = 1,000, N = 6, PMT = 0, and solve for I to get 8.29%.
The realized returns are less than 9 percent because the investor did not reinvest the coupons at
the required rate of return. In order to earn a compound rate of return equal to the promised yield,
an investor must reinvest the coupons and earn the promised yield for the remaining time to
maturity.
Bloom's: Analyze; Apply; Evaluate; Create
66) Explain the effects of coupon and maturity on volatility.
Answer: The longer the maturity, the greater the price sensitivity of an asset with respect to
interest rate changes. The larger the coupon payments, or any interim cash flows, the lower the
price sensitivity of an asset with respect to asset changes. In general, any security that returns a
greater proportion of an investment more quickly will be less price-volatile because this allows
the investor to respond to the interest rate change, minimizing the opportunity cost.
Difficulty: 1 Easy
Topic: Impact of Interest Rate Changes on Security Valuation
Bloom's: Understand
31
67) Which would have a longer duration: (a) a five-year fully amortized installment loan with
semiannual payments or (b) a five-year semiannual payment bond, ceteris paribus. Why?
Answer: The bond will have a longer duration because you receive interest payments only until
maturity, whereas the amortizing loan pays principal and interest throughout the life of the loan.
Hence, the loan pays more (%) money back sooner. That makes the loan less volatile than the
bond.
Difficulty: 1 Easy
Topic: Duration
Bloom's: Understand
68) How does an increase in interest rates affect a security's duration?
Answer: At higher interest rates the PV of more distant cash flows is reduced by a greater
amount than near-term cash flows due to compounding. For example, the PV of the 10th cash
flow falls more than the PV of the first cash flow if rates rise. This shifts a greater portion of the
PV weights to the near-term cash flows, which, in turn, results in a shorter duration. The
converse is true for falling interest rates.
Topic: Duration
Bloom's: Analyze
32
69) An investor is considering purchasing a Treasury bond with a 16-year maturity, a 6 percent
coupon and a 7 percent required rate of return. The bond pays interest semiannually.
a. What is the bond's modified duration?

b. If annual promised yields decrease 30 basis points immediately after the purchase, what is the
predicted price change in dollars based on the bond's duration?
Answer:
a. The bond's price is $908.04 and the bond's modified duration is found as
Σ[(t × CFt/(1.035))t]/($904.66 × 2) = 10.19 years duration;
Modified duration = 10.19/1.035 = 9.85 years
b. With a decrease of 30 basis points in annual promised yields:
Predicted Δ Bond Price = −9.85 × −.0030 = 2.95% or a $ price change of 0.0295 × $904.66 =
$26.72
Difficulty: 3 Hard
Topic: Duration
Learning Goal: 03-06 Know what duration is.; 03-08 Understand the economic meaning of
duration.
70) You have five years until you need to take your money out of your investments to make a
planned expenditure. Right now bonds are promising an 8 percent return. You buy a five-year
duration bond. After you buy the bond, interest rates fall to 6 percent and stay there for the full
five years. You reinvest the coupons and earn 6 percent. Will your realized return be more or less
than the originally promised 8 percent? Explain.
Answer: You will earn the promised 8 percent return. Because you chose a bond with a
duration equal to the five-year time period, the loss in reinvestment income from reinvesting the
coupons at 6 percent instead of 8 percent will just be offset by having a higher-than-expected
sale price of the bond in five years.
Difficulty: 3 Hard
Topic: Duration
Bloom's: Understand
33
71) A nine-year maturity AAA-rated corporate bond has a 6 percent coupon rate. The bond's
promised yield is currently 5.75 percent and the bond sells for its FPV. The bond pays interest
semiannually and has an annual duration of 7.1023 years.
a. What is the bond's convexity?

b. If promised yields decrease to 5.45 percent, what is the bond's predicted new price, including
convexity?
c. Based on your result in b, would you prefer to have a bond with more or less convexity?
Explain.
Answer:
a. Bond's convexity:
rate change 0.00005

CX = 108 × [(ΔP−/P) +
New r 2.8800% 2.8700%
(ΔP+/P)]
P(Old) = $ 1,017.37 P− P+
108 = 100,000,000 $ 1,016.67 $ 1,018.08
ΔP−/P ( 0.000690093) ΔP ($ 0.70208) $ 0.70268
+
ΔP /P 0.000690678
−
[(ΔP /P) +
5.84901E−07
(ΔP+/P)]
=
CX = 58.49006
Convexity
b. With a new promised YTM = 5.45 percent, the YTM change is 30 basis points and the bond's
new predicted price is found as
ΔP/P = -DurMod × ΔYTM + 1/2 × CX × ΔYTM2 = (−6.90385 × −0.0030) + (½ × 58.49006 ×
0.0032) = 2.09748%.
The bond's new price should be $1,017.37 + (2.09748% × $1,017.37) = $1,038.714.
c. An investor would prefer more convexity, with greater convexity or curvature; as yields drop,
the bond's price will increase more.
Difficulty: 3 Hard
34
72) The preferred stock of ACE pays a constant $1.00 per share dividend. The common stock of
ACME just paid a $1.00 dividend per share, but its dividend is expected to grow at 4 percent per
year forever. ABLE common stock also just paid a dividend of $1.00 per share, but its dividend
is expected to grow at 10 percent per year for five years and then grow at 4 percent per year
forever. All three stocks have a 12 percent required return. How much should you be willing to
pay for a share of each stock? Which stock will give you the best return? Explain.
Answer:
ACE: P = 1/0.12 = $8.33
ACME: P = 1(1.04)/(0.12 − 0.04) = $13.00
ABLE: D0 = $1; D1 through D5 grow at 10% per year, D6 = D5 × (1 + g2); P5 = D6/(r − g2); g2 =
4%
g1 D1 D2 D3 D4 D5 D6 g2 r
ABLE 10% 1.1 1.21 1.331 1.4641 1.61051 1.6749304 4.00% 12%
D0 P5 = 20.93663
1 1.1 1.21 1.331 1.4641 22.54714
P0 = $16.62
If the stocks are priced at their fair values as calculated above, all three will give the investor the
same pretax rate of return of 12 percent. A good stock buy is one where the price is less than the
present value of the expected future cash flows, regardless of the expected growth rate in the
cash flows.
Difficulty: 3 Hard
35
Chapter 4 The Federal Reserve System, Monetary Policy, and Interest Rates
1) Federal Reserve interest rate decisions can be vetoed by the U.S. president or the Congress.
Answer: FALSE
Difficulty: 1 Easy
Topic: Major Duties and Responsibilities of the Federal Reserve System: Chapter Overview
Bloom's: Remember
Learning Goal: 04-01 Understand the major functions of the Federal Reserve System.
2) Four seats on the FOMC are allocated to Federal Reserve Bank presidents on an annual
rotating basis.
Answer: TRUE
Difficulty: 1 Easy
Topic: Structure of the Federal Reserve System
Bloom's: Remember
Learning Goal: 04-02 Identify the structure of the Federal Reserve System.
3) The monetary base is the amount of coin and currency in circulation plus reserves.
Answer: TRUE
Difficulty: 1 Easy
Bloom's: Remember
4) Nationally chartered banks are required to become members of the Federal Reserve System.
Answer: TRUE
Difficulty: 1 Easy
Bloom's: Remember
1
5) About 34 percent of all U.S. banks are members of the Federal Reserve System.
Answer: TRUE
Bloom's: Remember
6) The major asset of the Federal Reserve is currency outside banks and the major liability is
U.S. Treasury securities.
Answer: FALSE
Bloom's: Remember
7) The seven members of the Board of Governors of the Federal Reserve System serve 14-year
nonrenewable terms. Each Board member is appointed by the president and confirmed by the
Senate.
Answer: TRUE
Difficulty: 1 Easy
Bloom's: Remember
8) Federal Reserve Board members are appointed by the U.S. president and confirmed by the
Senate for a nonrenewable 14-year term.
Answer: TRUE
Difficulty: 1 Easy
Bloom's: Remember
2
9) If the FOMC wished to generate faster economic growth, they could issue a policy directive to
the Federal Reserve Board Trading Desk to purchase U.S. government securities.
Answer: TRUE
Bloom's: Understand
10) An increase in Treasury securities held by the Fed leads to a decrease in the money supply.
Answer: FALSE
Bloom's: Understand
11) One of the objectives of the FOMC is to formulate policies to promote 100 percent
employment.
Answer: FALSE
Topic: Federal Open Market Committee
Bloom's: Understand
12) During the 2010–2014 period, the Federal Reserve purchased long-term treasury securities as
part of the Quantitative Easing program.
Answer: TRUE
Difficulty: 1 Easy
Topic: Open Market Operations
Bloom's: Remember
Learning Goal: 04-03 Identify the monetary policy tools used by the Federal Reserve.
3
13) Quantitative Easing program initiated by the Federal Reserve during the 2010–2014 period,
involved the purchase of long-term corporate bonds.
Answer: FALSE
Difficulty: 1 Easy
Topic: Open Market Operations
Bloom's: Remember
Learning Goal: 04-04 Appreciate how monetary policy changes affect key economic variables.
14) According to the current FOMC stances, inflation targeting promotes maximum
employment.
Answer: TRUE
Difficulty: 1 Easy
Topic: Effects of monetary tools on various economic variables
Bloom's: Remember
15) Countries with independent central banks are subject to political pressure to conduct
monetary policies with short-term expectations.
Answer: FALSE
Difficulty: 1 Easy
Topic: International Monetary Policies and Strategies
Bloom's: Remember
Learning Goal: 04-05 Understand how central banks around the world adjusted their monetary
policy during the recent financial crisis.
4
16) The primary policy tool used by the Fed to meet its monetary policy goals is
A) changing the discount rate.
B) changing reserve requirements.
C) devaluing the currency.
D) changing bank regulations.
E) open market operations.
Answer: E
Difficulty: 1 Easy
Topic: Monetary Policy Tools
Bloom's: Remember
17) The Federal Reserve System is charged with

A) regulating securities exchanges.
B) conducting monetary policy.
C) providing payment and other services to a variety of institutions.
D) setting bank prime rates.
E) conducting monetary policy and providing payment and other services to a variety of
institutions.
Answer: E
Difficulty: 1 Easy
Bloom's: Remember
18) The ________ is a nationwide network jointly operated by the Fed and private institutions
that electronically process credit and debit transfers of funds.
A) Fedwire
B) ACH
C) CHIPS
D) NASDAQ
E) SWIFT
Answer: B
Difficulty: 1 Easy
Bloom's: Remember
5
19) The ________ is a network linking over 9,000 banks with the Federal Reserve that is used to
transfer deposits and make loan payments between participants.
A) Fedwire
B) ACH
C) CHIPS
D) NASDAQ
E) SWIFT
Answer: A
Difficulty: 1 Easy
Bloom's: Remember
20) Ceteris paribus, if the Fed was targeting the quantity of money supplied and money demand
dropped, the Fed would likely ________. If the Fed was instead targeting interest rates and
money demand dropped, the Fed would likely ________.
A) increase the money supply; do nothing
B) do nothing; decrease the money supply
C) decrease the money supply; do nothing
D) do nothing; increase the money supply
E) increase the money supply; decrease the money supply
Answer: B
Difficulty: 3 Hard
Topic: The Federal Reserve, the Money Supply, and Interest Rates
Bloom's: Understand
6
21) Which of the following is the major monetary policy-making body of the U.S. Federal
Reserve System?
A) FOMC
B) OCC
C) FRB bank presidents
D) U.S. Congress
E) Group of Eight
Answer: A
Difficulty: 1 Easy
Bloom's: Remember
22) The major liability of the Federal Reserve is

A) U.S. Treasury securities.
B) depository institution reserves.
C) currency outside banks.
D) vault cash of commercial banks.
E) gold and foreign exchange.
Answer: C
Bloom's: Remember
23) The major asset of the Federal Reserve is

A) U.S. Treasury securities.
B) depository institution reserves.
C) currency outside banks.
D) vault cash of commercial banks.
E) gold and foreign exchange.
Answer: A
Bloom's: Remember
7
24) The Fed funds rate is the rate that
A) banks charge for loans to corporate customers.
B) banks charge to lend foreign exchange to customers.
C) the Federal Reserve charges on emergency loans to commercial banks.
D) banks charge each other on loans of excess reserves.
E) banks charge securities dealers to finance their inventory.
Answer: D
Bloom's: Remember
25) The discount rate is the rate that

A) banks charge for loans to corporate customers.
B) banks charge to lend foreign exchange to customers.
C) banks charge each other on loans of excess reserves.
D) banks charge securities dealers to finance their inventory.
E) the Federal Reserve charges on loans to commercial banks.
Answer: E
Bloom's: Remember
26) The Fed offers three types of discount window loans. ________ credit is offered to small
institutions with demonstrable patterns of financing needs, ________ credit is offered for short-
term temporary funds outflows, and ________ credit may be offered at a higher rate to troubled
institutions with more severe liquidity problems.
A) Seasonal; extended; adjustment
B) Extended; adjustment; seasonal
C) Adjustment; extended; seasonal
D) Seasonal; primary; secondary
E) Adjustment; seasonal; extended
Answer: D
Bloom's: Understand
8
27) Before 2003 the discount window loan rate was set
A) below the target Fed funds rate.
B) above the target Fed funds rate.
C) equal to the target Fed funds rate.
D) equal to the repurchase rate.
Answer: A
Bloom's: Remember
28) A decrease in reserve requirements could lead to an

A) increase in bank lending.
B) increase in the money supply.
C) increase in the discount rate.
D) increase in bank lending and an increase in the money supply.
E) increase in bank lending and an increase in the discount rate.
Answer: D
Bloom's: Understand
9
29) Bank A has an increase in deposits of $20 million dollars and all bank reserve requirements
are 10 percent. Bank A loans out the full amount of the deposit increase that is allowed. This
amount winds up deposited in Bank B. Bank B lends out the full amount possible as well and
this amount winds up deposited in Bank C. What is the total increase in deposits resulting from
these three banks?
A) $48.00 million
B) $54.20 million
C) $56.33 million
D) $57.10 million
E) $60.00 million
Answer: B
Explanation: 20 + (20 × 0.90) + (18 × 0.90)
30) The Fed changes reserve requirements from 10 percent to 7 percent, thereby creating $900
million in excess reserves. The total change in deposits (with no drains) would be
A) $3,000 million.
B) $15,625 million.
C) $12,857 million.
D) $3,795 million.
Answer: C
Explanation: (1/0.07) × $900 million
10
31) If the Fed wishes to stimulate the economy, it could
I. buy U.S. government securities.

II. raise the discount rate.
III. lower reserve requirements.
A) I and III only

B) II and III only
C) I and II only
D) II only
E) I, II, and III
Answer: A
Bloom's: Understand
32) Currently the Fed sets monetary policy by targeting

A) the Fed funds rate.
B) the prime rate.
C) the level of nonborrowed reserves.
D) the level of borrowed reserves.
E) the stock market.
Answer: A
Difficulty: 1 Easy
Bloom's: Remember
11
33) From October 1983 to July 1993, the Federal Reserve targeted
A) the Fed funds rate.
B) borrowed reserves.
C) nonborrowed reserves.
D) M1.
E) M3.
Answer: B
Bloom's: Remember
34) Assume oil prices rise in the United States, generating concerns that inflation may increase.
If the Fed wishes to ensure that inflation does not get out of hand, the Fed could
A) intervene in the currency markets to push the value of the dollar down.
B) decrease the discount rate.
C) lower the target Fed funds rate.
D) lower the target money supply growth rate.
E) reduce reserve requirements at banks.
Answer: D
Bloom's: Understand
12
35) The Fed changes reserve requirements from 10 percent to 14 percent, thereby eliminating
$750 million in excess reserves. The total change in deposits (with no drains) would be
(rounded)
A) $7.917 billion.
B) $6.630 billion.
C) $5.357 billion.
D) $4.934 billion.
Answer: C
36) The Fed increases bank reserves in the system by $75 million. If there are no drains, the
expected change in bank deposits is
A) $82.5 million.
B) $945 million.
C) $750 million.
D) $1,500 million.
E) $655 million.
Answer: C
13
37) If the Fed is targeting interest rates and money demand increases, an appropriate policy
response would be to
A) increase reserve requirements.
B) increase the discount rate.
C) buy U.S. Treasury securities from government bond dealers.
D) increase government spending.
Answer: C
Bloom's: Understand
38) The major monetary policy-making arm of the Federal Reserve is the
A) Board of Governors.
B) Council of Federal Reserve Bank presidents.
C) Office of the Comptroller of the Currency.
D) Federal Reserve Bank of New York.
Answer: E
Explanation: The Federal Open Market Committee is the correct answer.
Bloom's: Remember
14
39) In the area of bank supervision, which of the following are functions of the Federal Reserve
Banks?
I. Examinations of state member banks

II. Approval of member bank and bank holding company acquisitions
III. Deposit insurance
A) I only
B) I and II only
C) II and III only
D) I and III only
E) I, II, and III
Answer: B
Bloom's: Remember
40) The Check 21 Act, effective in October 2004, does which of the following?
A) Allows bank customers to better take advantage of bank float
B) Requires banks to immediately clear all customer deposits
C) Prohibits the Fed from being involved in check clearing to prevent unfair competition with
private check clearing agencies
D) Authorizes the use of an electronic image to facilitate paperless check clearing
E) Eliminates all fees on checking
Answer: D
Bloom's: Remember
15
41) A bank has $770 million in checkable deposits. The bank has $85 million in reserves. The
bank's required reserves are ________ and its excess reserves are ________.
A) $85 million; $0
B) $770 million; $85 million
C) $89 million; $21 million
D) $685 million; $8.5 million
E) $77 million; $8 million
Answer: E
Explanation: Required = 10% (770); Excess = 85 − 10% (770)
42) The Federal Reserve does all but which one of the following?
A) Conducts monetary policy
B) Supervises and regulates bank activities
C) Serves as the commercial bank for the U.S. Treasury
D) Operates check clearing and wire transfer facilities
E) Insures deposits
Answer: E
Bloom's: Remember
43) Which of the following is not a goal of monetary policy?

A) Moderate long-term interest rates.
B) Stable interest rates.
C) High employment.
D) Stable prices.
E) All of these choices are correct.
Answer: B
Bloom's: Remember
16
44) Which of the following is not a program initiated by world's major central banks during the
financial crisis of 2007 to avoid a deep worldwide recession?
A) Expansion of retail deposit insurance
B) Capital injections
C) Purchase of U.S. dollars
D) Debt guarantees
E) Asset purchases/guarantees
Answer: C
Bloom's: Remember
45) What are the intended consequences from charging an interest on excess reserves by Central
banks?
A) Banks lend less money.
B) Interest rates increase.
C) Banks deposits increase.
D) Banks lend more money.
Answer: D
Bloom's: Remember
17
46) In the aftermath of the 2007 financial crisis, the Fed used several programs to increase
liquidity, including ________.
A) expansion of the discount window
B) setting up the Term Auction Facility
C) lending to investment banks
D) purchase of long-term treasury bonds
Answer: E
Bloom's: Remember
47) What are the four major functions of the Federal Reserve System?
Answer:
1. Conducts monetary policy.
2. Supervises and regulates depository institutions.
3. Maintains the stability of the financial system.
4. Provides payment and other services to institutions.
Difficulty: 1 Easy
Bloom's: Remember
18
48) The 12 Federal Reserve Banks perform what functions?
Answer:
1. Assist in monetary policy.
2. Supervise and regulate district state-chartered member banks and bank holding companies.
3. Write regulations to implement consumer protection laws and establish programs to promote
access to credit and community development.
4. Serve as commercial banks for the U.S. Treasury.
5. Distribute and replace currency.
6. Provide check clearing services.
7. Provide wire transfer services.
8. Provide economic research for monetary policy.
Bloom's: Remember
49) How do Federal Reserve Banks generate income? Do they require supplemental funding
from Congress?
Answer:
 Interest earned on government securities acquired in open market transactions
 Interest earned on reserves that banks are required to deposit at the Fed
 Fees from services and membership fees
 The Fed does not need supplemental funding from Congress.
Difficulty: 1 Easy
Bloom's: Remember
19
50) Why did the Fed switch from increasing rates prior to 2007 to reducing interest rates in 2007
and 2008?
Answer: The growing problems in the housing markets led to problems in the subprime
mortgage markets. Many financial institutions held or guaranteed mortgage-backed securities,
which were becoming increasingly risky in 2007 and early 2008. It became apparent that banks
had made too many risky mortgage-backed loans with borrowed funds. Lenders to these
institutions were wary of accepting mortgage collateral, causing short-term funding problems at
banks and investment banks. The Fed began to aggressively cut interest rates to help the
mortgage market, particularly the subprime portion, and to encourage economic growth. Banks
were cutting risky lending because of the problems in their mortgage loans and mortgage-backed
securities, and the resulting "credit crunch" (banks' unwillingness to lend) led to rapidly slowing
economic growth.
Difficulty: 3 Hard
Bloom's: Understand
51) What are the main responsibilities of the FOMC?
Answer: Promote full employment; promote economic growth; promote price stability; promote
sustainable pattern of international trade.
Difficulty: 1 Easy
Bloom's: Remember
52) Explain how a change in open market operations can affect a new college graduate.
Answer: If the Fed increases bank reserves by buying securities, interest rates on all loan types
will be affected. For instance, when interest rates fall, corporations will likely have more projects
with positive NPVs, leading to more spending and more jobs. A college graduate is then more
likely to get hired, and your interest rates on new cars, homes, and so forth, will likely be lower,
not to mention that the value of your stock holdings would probably go up.
Difficulty: 1 Easy
Bloom's: Understand
20
53) How have recent changes in discount window credit programs affected the use of this tool
for monetary policy?
Answer: In the past, the discount rate was kept below the Fed funds rate to allow troubled
banks that could not obtain private credit to borrow on an emergency basis. Changes in the
announced discount rate signaled to investors about the way the Fed wanted interest rates to
move. Under the new rules, however, the discount rate is generally tied to the current Fed funds
rate target. This largely eliminates the use of the discount rate as a signal to the market. In recent
years the FOMC has announced a target Fed funds target rate and the discount rate is adjusted as
the Fed funds target is changed.
In early 2008 the Fed opened the discount window to nonbank brokers and dealers who were
experiencing liquidity problems in their mortgage portfolios. Securities firms could exchange
some of their illiquid mortgage assets with the Fed for liquid Treasury securities.
Difficulty: 3 Hard
Bloom's: Understand
54) Explain how the deposit multiplier works.
Answer: Suppose the Fed increases bank reserves via open market operations. The bank now
has too many excess reserves that earn no interest, so it seeks to loan out the funds. The lent
funds are deposited in another bank. The second bank keeps some funds in the form of required
reserves and lends the rest. The second loan is also redeposited at another bank and a portion of
those funds is lent again, and so forth. At the limit, a change in reserves increases deposits by the
amount equal to Δreserves x 1/reserve requirement.
Bloom's: Understand
21
55) The Fed wishes to expand the money supply. What three things can it do? Which has the
most predictable effects? Be specific.
Answer: Buy U.S. government securities.

Decrease the discount rate.
Decrease reserve requirements.
Buying U.S. government securities has the most predictable effect.
Difficulty: 1 Easy
Bloom's: Remember
56) Is there a trade-off between controlling domestic inflation and maintaining a sustainable
pattern of international trade?
Answer: Yes. If the United States curtails money supply growth to the point that U.S. inflation
is lower than inflation elsewhere, the dollar will tend to appreciate against foreign currencies.
With a strong dollar, the United States will tend to import more and export less, possibly leading
to a large and potentially unsustainable trade deficit.
Bloom's: Understand
22
57) Suppose that oil prices hit an all-time high of $200 a barrel, driving U.S. inflation up to 7
percent per year. At the same time, weak U.S. growth and increasing foreign competition have
generated unacceptably high levels of unemployment in the United States. You are the chair of
the Federal Reserve. What do you suggest?
Answer: This is a very difficult scenario for the Fed chair. It is called stagflation and the
combination of high inflation and unemployment reduces the effectiveness of any monetary
policy action to provide sustained relief to the economy's problem. Increasing bank excess
reserves and lowering interest rates may reduce unemployment temporarily, but these actions
will also likely exacerbate inflation, drive up wages, and with a higher labor supply cost, will
eventually drive unemployment back up. The end result is that the employed and the
unemployed face higher prices. Alternative policy actions may include fiscal spending, removing
the factor(s) causing the problems (such as a supply constraint causing a lack of oil availability),
or perhaps stimulating greater global growth to get U.S. domestic demand growing.
Difficulty: 3 Hard
Bloom's: Understand; Analyze; Evaluate
58) What does the 2004 Check 21 Law allow? Why was this Law passed? Does it benefit the
customer or banks? Explain.
Answer: The Check 21 Law authorizes the use of an electronic image as a substitute document
for a paper check and helps move the financial system toward paperless, electronic transfers. It
was passed because of the September 11 attacks that grounded cargo planes that fly checks all
over the country. Switching to electronic check images saves an estimated $3 billion per year for
the banking industry. If these cost savings are passed on to customers in the form of better
deposit rates or reduced checking fees, customers benefit. However, the Law facilitates speedier
clearing of checks that reduces customer's ability to "play the float." The float is the time period
between tendering a check and your account being debited, which used to be as many as several
days. Checks may now instantly clear.
23
59) What supervisory and regulatory authority does the Fed have under current law?
Answer:
1. The authority to conduct examinations and inspections of member banks, bank holding
companies, and foreign bank offices by teams of bank examiners
2. The authority to require banks to suspend bank activities deemed excessively risky or in
violation of federal laws
3. The authority to approve or not allow mergers and acquisitions and other line of business
restrictions for both banks and bank holding companies
Bloom's: Remember
60) Why do changes in reserve requirements have less predictable effects on the money supply
in comparison to changes in open market operations?
Answer: Changing the reserve requirements changes the multiplier effect and large changes in
the money supply may result. However, it is difficult to predict the level of excess reserves held
by banks, the willingness of banks to make loans instead of investments, and the uncertainty
about how much money the public will redeposit into the banking system. Therefore, the true
new multiplier is difficult to estimate; hence, the net effect on the money supply is somewhat
unpredictable.
Difficulty: 3 Hard
24
Chapter 5 Money Markets
1) Everything else equal, an effective annual rate will be greater than the bond equivalent yield
on the same security.
Answer: TRUE
Difficulty: 1 Easy
Topic: Yields on Money Market Securities
Bloom's: Understand
Learning Goal: 05-01 Define money markets.
2) Money markets exist to help reduce the opportunity cost of holding cash balances.
Answer: TRUE
Difficulty: 1 Easy
Topic: Money Markets
Bloom's: Understand
3) The majority of money market securities are low-denomination, low-risk investments

designed to appeal to individual investors with excess cash.
Answer: FALSE
Difficulty: 1 Easy
Bloom's: Understand
4) Commercial paper is a short-term obligation of the U.S. government issued to cover

government budget deficits and to refinance maturing government debt.
Answer: FALSE
Difficulty: 1 Easy
Topic: Money Market Securities
Bloom's: Remember
Learning Goal: 05-02 Identify the major types of money market securities.
1
5) Commercial paper, Treasury bills, and banker's acceptance rates are all quoted as discount
yields.
Answer: TRUE
Bloom's: Remember
Learning Goal: 05-01 Define money markets.; 05-02 Identify the major types of money market
securities.
6) Euro commercial paper is a short-term obligation of the European Central Bank.
Answer: FALSE
Difficulty: 1 Easy
Topic: Euro money markets
Bloom's: Remember
Learning Goal: 05-05 Examine the extent to which foreign investors participate in U.S. money
markets.
7) The U.S. Treasury switched from a discriminating price auction to a single price auction
because the latter lowered the average price paid by investors.
Answer: FALSE
Difficulty: 1 Easy
Bloom's: Understand
Learning Goal: 05-03 Examine the process used to issue Treasury securities.
8) In the T-bill secondary market the ask yield will normally be less than the bid yield.
Answer: TRUE
Bloom's: Understand
2
9) The largest secondary money market in the United States is the secondary market for T-bills.
Answer: TRUE
Difficulty: 1 Easy
Bloom's: Remember
10) Fed funds are short-term unsecured loans while repos are short-term secured loans.
Answer: TRUE
Bloom's: Understand
11) 360/n times the difference between the face value and the current value divided by the face
value gives you the discount yield on an instrument.
Answer: TRUE
Difficulty: 3 Hard
Bloom's: Remember
12) The bond equivalent yield times 365/360 is equal to the single payment yield.
Answer: FALSE
Bloom's: Remember
3
13) LIBOR is the rate that would be charged when banks borrow from other banks in Eurodollar
market.
Answer: TRUE
Difficulty: 1 Easy
Bloom's: Remember
markets.
14) Maturities on Eurodollar CDs are usually more than one year.
Answer: FALSE
Difficulty: 1 Easy
Bloom's: Remember
markets.
15) In general, the federal funds rate is slightly lower than the LIBOR.
Answer: TRUE
Difficulty: 1 Easy
Bloom's: Remember
markets.
4
16) For the purposes for which they are used, money market securities should have which of the
following characteristics?
I. Low trading costs

II. Little price risk
III. High rate of return
IV. Life greater than one year
A) I and III
B) II and IV
C) III and IV
D) I and II
E) I, II, and III
Answer: D
Difficulty: 1 Easy
Bloom's: Remember
17) Money market securities exhibit which of the following?
I. Large denomination
II. Maturity greater than one year
III. Low default risk
IV. Contractually determined cash flows
A) I, II, and III

B) I, III, and IV
C) II, III, and IV
D) II and IV
E) I, II, III, and IV
Answer: B
Bloom's: Remember
5
18) A repo is in essence a collateralized
A) banker's acceptance.
B) certificate of deposit.
C) Fed funds loan.
D) commercial paper loan.
E) Eurodollar deposit.
Answer: C
Bloom's: Remember
19) A short-term unsecured promissory note issued by a company is

A) commercial paper.
B) a T-bill.
C) a repurchase agreement.
D) a negotiable CD.
E) a banker's acceptance.
Answer: A
Difficulty: 1 Easy
Bloom's: Remember
20) A time draft payable to a seller of goods with payment guaranteed by a bank is a
A) commercial paper security.
B) T-bill.
C) repurchase agreement.
D) negotiable CD.
E) banker's acceptance.
Answer: E
Difficulty: 1 Easy
Bloom's: Understand
6
21) In the T-bill auction process, the competitive bidder is guaranteed a ________ and a
noncompetitive bidder is guaranteed a ________.
A) minimum price; maximum price.
B) maximum price; minimum price.
C) maximum price; given quantity.
D) minimum price; maximum quantity.
Answer: C
Bloom's: Understand
22) A dealer is quoting a $10,000 face 180-day T-bill quoted at 2.75 bid, 2.65 ask. You could
buy this bill at ________ or sell it at ________.
A) $9,869.23; $9,864.36.
B) $9,864.36; $9,869.23.
C) $9,867.50; $9,862.50.
D) $9,862.50; $9,867.50.
Answer: C
Explanation: Buy at 10,000 × [1 − (0.0265 × 180/360)]; sell at 10,000 × [1 − (0.0275 ×
180/360)].
7
23) Rates on federal funds and repurchase agreements are stated
A) on a bond equivalent basis with a 360-day year.
B) on a bond equivalent basis with a 365-day year.
C) as a discount yield with a 360-day year.
D) as an EAR.
E) as a discount yield with a 365-day year.
Answer: A
Bloom's: Remember
24) The discount yield on a T-bill differs from the T-bill's bond equivalent yield (BEY) because
I. the discount yield is the return per dollar of face value and the BEY is a return per dollar
originally invested.
II. a 360-day year is used on the discount yield and the BEY uses 365 days.
III. the discount yield is calculated without compounding, and the BEY is calculated with
compounding.
A) I only
B) II only
C) I and II only
D) II and III only
E) I, II, and III
Answer: C
Difficulty: 3 Hard
Bloom's: Understand
8
25) The following formula is used to calculate the ________ of a money market investment.
A) EAR
B) APR
C) single-payment yield
D) discount yield
E) BEY
Answer: C
Bloom's: Remember
26) The rate of return on a repo is

A) determined by the rate of return on the underlying collateral.
B) strongly affected by the current Fed funds rate at the time of the repo.
C) determined at the time of the repo.
D) determined by the rate of return on the underlying collateral and determined at the time of the
repo.
E) strongly affected by the current Fed funds rate at the time of the repo and determined at the
time of the repo.
Answer: E
Bloom's: Understand
9
27) Which one of the following statements about commercial paper is not true? Commercial
paper issued in the United States
A) is an unsecured short-term promissory note.
B) has a maximum maturity of 270 days.
C) is virtually always rated by at least one ratings agency.
D) has no secondary market.
E) carries an interest rate above the prime rate.
Answer: E
Bloom's: Remember
28) A negotiable CD
A) is a bank-issued transactions deposit.
B) is a registered instrument.
C) is a bank-issued time deposit.
D) has denominations ranging from $50,000 to $10 million.
E) pays discount interest.
Answer: C
Bloom's: Remember
29) A 180-day $3 million CD has a 4.25 percent annual rate quote. If you buy the CD, how much
will you collect in 180 days?
A) $3,047,439
B) $3,045.678
C) $3,062,877
D) $3,063,750
E) $3,127,500
Answer: D
Explanation: $3 million × [1 + (0.0425 × 180/360)]
10
30) A banker's acceptance is
A) a time draft drawn on the exporter's bank.
B) a method to help importers evaluate the creditworthiness of exporters.
C) a liability of the importer and the importer's bank.
D) an add-on instrument.
E) for greater than one year maturity.
Answer: C
Bloom's: Remember
31) The most liquid of the money market securities are

B) banker's acceptances.
C) T-bills.
D) Fed funds.
E) repurchase agreements.
Answer: C
Difficulty: 1 Easy
Bloom's: Remember
32) In dollars outstanding in 2016, the largest money market security was
B) banker's acceptances.
C) T-bills.
D) Fed funds and repos.
Answer: D
Bloom's: Remember
11
33) You buy a $10,000 par Treasury bill at $9,575 and sell it 60 days later for $9,675. What was
your EAR?
A) 4.44 percent
B) 6.29 percent
C) 6.35 percent
D) 6.52 percent
E) 6.67 percent
Answer: D
Explanation: (9,675/9,575)(365/60) − 1 = .06524 = 6.52%
34) LIBOR is generally ________ the Fed funds rate because foreign bank deposits are generally
________ than domestic bank deposits.
A) greater than; less risky
B) less than; more risky
C) the same as; equally risk
D) greater than; more risky
E) less than; less risky
Answer: D
Topic: International Aspects of Money Markets
Bloom's: Understand
markets.
12
35) A U.S. exporter sells $150,000 of furniture to a Latin American importer. The exporter
requires the importer to obtain a letter of credit. When the bank accepts the draft, the exporter
discounts the 120-day note at a 5.25 percent discount. What is the exporter's true effective annual
financing cost?
A) 5.52 percent
B) 5.42 percent
C) 5.34 percent
D) 5.29 percent
E) 5.25 percent
Answer: A
Explanation: 150,000 × [1 − (0.0525 × 120/360)] = 147,375; (150,000/147,375) 365/120 − 1 =
5.52%
Difficulty: 3 Hard
36) A Chinese exporter sells $200,000 of toys to a French importer. The Chinese exporter
requires the French importer to obtain a letter of credit. When the bank accepts the draft, the
exporter discounts the 90-day note at a 4 percent discount. What is the exporter's true effective
annual financing cost?
A) 4.00 percent
B) 4.04 percent
C) 4.10 percent
D) 4.16 percent
E) 4.22 percent
Answer: D
Explanation: 200,000 × [1 − (0.04 × 90/360)] = 198,000; (200,000/198,000) 365/90 − 1 = 4.16%
Difficulty: 3 Hard
13
37) If a $10,000 par T-bill has a 3.75 percent discount quote and a 90-day maturity, what is the
price of the T-bill to the nearest dollar?
A) $9,625.
B) $9,906.
C) $9,908.
D) $9,627.
Answer: B
Explanation: 10,000 × [1 − (0.0375 × 90/360)] = 9,906
38) A 90-day T-bill is selling for $9,900. The par is $10,000. The effective annual return on the
T-bill is (watch your rounding)
A) 4.00 percent.
B) 4.16 percent.
C) 4.10 percent.
D) 4.04 percent.
E) 4.21 percent.
Answer: B
Explanation: (10,000/9,900)(365/90) − 1
14
39) Suppose that $10 million face value commercial paper with a 270-day maturity is selling for
$9.55 million. What is the BEY on the paper?
A) 4.71 percent
B) 6.42 percent
C) 6.37 percent
D) 6.28 percent
E) 4.50 percent
Answer: C
Explanation: ((10 million/9.55 million) − 1) × (365/270)
40) A $2 million jumbo CD is paying a quoted 3.55 percent interest rate on 180-day maturity
CDs. How much money will you have at maturity if you invest in the CD?
A) $2,000,000
B) $2,035,014
C) $2,035,500
D) $2,071,000
E) $2,088,400
Answer: C
Explanation: 2,000,000 × [1 + (0.0355 × 180/360)]
15
41) From 1990 to 2016, which one of the following money market securities actually declined in
terms of dollar amount outstanding?
A) Commercial paper
B) Treasury bills
C) Federal funds and repos
D) Negotiable CDs
E) Banker's acceptances
Answer: E
Bloom's: Remember
42) A 50-day maturity money market security has a bond equivalent yield of 3.60 percent. The
security's EAR is
A) 3.69 percent.
B) 3.61 percent.
C) 3.55 percent.
D) 3.87 percent.
E) 3.66 percent.
Answer: E
Explanation: EAR = (1 + (0.0360/(365/50))) 365/50 − 1 = 3.66%
Difficulty: 3 Hard
43) In a Treasury auction, preferential bidding status is granted to

A) competitive bidders.
B) noncompetitive bidders.
C) short sale committed bidders.
D) commercial bank bidders.
E) no group of bidders.
Answer: B
Difficulty: 1 Easy
Bloom's: Remember
16
44) If your firm enters into an overnight reverse repurchase agreement, your firm is
A) borrowing Fed funds temporarily.
B) selling a security now while agreeing to buy it back tomorrow.
C) giving an unsecured loan to the counterparty.
D) procuring a banker's acceptance.
Answer: E
Bloom's: Understand
45) Eurodollar CDs would include

A) CDs denominated in Euros.
B) dollar investments by European entities in the United States.
C) dollars deposited in Caribbean banks.
D) dollars deposited in Europe.
E) dollars deposited in Caribbean banks and dollars deposited in Europe.
Answer: E
Topic: International Aspects of Money Markets
Bloom's: Remember
markets.
46) Which of the following descriptions does not apply to money market securities?
A) Short-term
B) Low-risk
C) Highly liquid
D) Long maturity
E) High denominations
Answer: D
Difficulty: 1 Easy
Bloom's: Remember
17
47) The most active and important participant in the U.S. money market
A) is the U.S. Treasury.
B) are the large banks.
C) are the investment banks.
D) are the insurance companies.
E) is the Federal Reserve.
Answer: E
Difficulty: 1 Easy
Topic: Money markets participants
Bloom's: Remember
Learning Goal: 05-04 List the main participants in money markets.
48) The most significant borrower in the U.S. money markets?

A) Are commercial banks
B) Are large corporations
C) Is the U.S. Treasury
D) Are the investment banks
E) Are the insurance companies
Answer: C
Difficulty: 1 Easy
Topic: Money markets participants
Bloom's: Remember
49) A noncompetitive bid for Treasury bill auction provides

A) all noncompetitive bidders the same price.
B) all competitive bidders the same price.
C) all noncompetitive bidders the same quantity.
D) all noncompetitive bidders lesser price than the competitive bidders.
E) all competitive bidders the same quantity.
Answer: A
Topic: Treasury Bills
Bloom's: Understand
18
50) What is the price of 182-day money market security with face value of $7,000 if the BEY is
3.574%?
A) $6,877.44
B) $6,925.48
C) $6,634.47
D) $6,725.36
E) $6,452.39
Answer: A
Explanation: (7,000 − P)/P × 365/182 = 0.03574
(7,000 − P)/P = 0.01782
P = $6,877.44
Difficulty: 3 Hard
51) Why do most money market securities have large denominations?
Answer: The market has developed for institutional investors because institutional investors
have large enough quantities of money to make it costly for them to not invest their excess funds.
For most individual investors, the dollars lost by not keeping fully invested in interest-bearing
assets is very minimal.
Difficulty: 1 Easy
Bloom's: Understand
52) Given the functions of the money markets, why is it necessary for money market securities to
have a maturity of one year or less and low default risk?
Answer: Because these markets are designed to provide safe investments with little or no
chance of principal loss. If you could lose principal, you would be very unlikely to invest funds
that are shortly needed. Low default risk implies that the promised cash flows will in all
likelihood be paid in full and on time. The short maturity ensures that the value of these
securities will be relatively insensitive to interest rate changes and, also, there is not much time
for the issuer's condition to change—this also limits the risk.
Bloom's: Understand
19
53) What is the difference between a discriminating auction and a single price auction? How is
the final price determined in a single price auction? Why did the Treasury switch to a single
price auction?
Answer: In a discriminating price auction, different bidders pay a different price for the same
securities. In a single price auction, all successful bidders pay the same price, regardless of the
specific price they bid. The final price is set as the lowest price of the competitive bids accepted.
The Treasury switched to single price auctions because they found that in single price auctions,
there tended to be more winning bidders and that bidders bid more aggressively (made higher
bids), resulting in overall higher bid prices and revenues for the government.
Difficulty: 3 Hard
Bloom's: Understand
54) A government securities dealer needs to make a 7 percent pretax annual return on $10
million of capital employed to make it worthwhile to make a market in T-bills. If the bid
discount on $10,000 face value 90-day T-bills is 3.50 percent, and the dealer can expect to do
5,200 round trip deals today, what must the ask discount be? Hint: A round trip is a buy and a
sell transaction.
Answer: Bid Price = $10,000 × [1 − .035 × (90/360)] = $9,913

$10 million × (0.07/365) = (Required Ask Price − $9,913) × 5,200 deals
Required Ask = $9,913.37
Ask Discount = (($10,000 − $9,913.37)/$10,000) × (360/90) = 3.465%
Difficulty: 3 Hard
Learning Goal: 05-01 Define money markets.; 05-02 Identify the major types of money market
securities.
20
55) How does a repo differ from a Fed funds transaction? How do their rates compare?
Answer: A repo is basically a collateralized loan, whereas Fed funds are uncollateralized. The
repo rate will typically be slightly below the equivalent maturity Fed funds rate because the
repos are collateralized. Repos are likely to be for longer maturity than Fed funds, although both
may involve transfers of deposits held at the Fed. Fed funds loans can be arranged more quickly
because no change of title of securities is involved.
Bloom's: Understand
56) As a corporate treasurer who is unsure how soon funds will be needed, which type of money
market investment might you prefer? Explain the trade-offs. Would your answer differ if you had
a definite time period during which you would not need the money? Explain.
Answer: If liquidity is a primary concern, then T-bills may be the best choice because they are
by far the most liquid. They also typically offer the lowest rate of return because of government
backing and high liquidity. If you knew for certain (or with high probability) that the funds will
not be needed, then term repos, commercial paper, or banker's acceptances may offer better rates
of return.
Topic: Money Market Securities; Money Market Participants
Learning Goal: 05-02 Identify the major types of money market securities.; 05-04 List the main
participants in money markets.
21
57) A corporate treasurer is looking to invest about $4 million for 60 days. Commercial paper
rates are a 3.65 percent discount and CD rates are 3.66 percent. Comparing the bond equivalent
yields over a 365-day year, which is the best alternative? What is the opportunity cost of leaving
the funds idle? (Watch your rounding.)
Answer: Find the BEY on each

CP: Price = $4 million × [1 − 0.0365 × (60/360)] = $3,975,667
[($4 million/$3,975,667) − 1] × (365/60) = 3.7233% BEY
CD: $4 million × [1 + 0.0366 × (60/360)] = $4,024,400
[($4,024,400/$4 million) − 1] × (365/60) = 3.7108% BEY
The best deal is the CP and the opportunity cost is 3.7233%.
Difficulty: 3 Hard
Topic: Money Market Securities; Money Market Participants
Learning Goal: 05-02 Identify the major types of money market securities.; 05-04 List the main
58) How does a banker's acceptance (BA) help create more international trade?
Answer: Importers do not wish to pay until they receive the goods and exporters do not wish to
ship until they receive payment. The creation of a BA allows the exporter to ship prior to receipt
of payment, while substituting the creditworthiness of a large international bank for the unknown
creditworthiness of the importer.
Difficulty: 1 Easy
Bloom's: Understand
59) Who are the major participants in money markets?
Answer: U.S. Treasury

Commercial banks
Federal Reserve
Brokers and dealers
Corporations
Other financial institutions
Difficulty: 1 Easy
Topic: Money Market Participants
Bloom's: Remember
22
60) One-hundred-eighty-day commercial paper can be bought at a 3.75 percent discount. What
are the bond equivalent yield and the effective annual rate on the commercial paper? Why do
these rates differ?
Answer: Commercial paper price/100 of par = 100 × (1 − (0.04 × 180/360)) = 98

Effective annual rateCP = (100/98)365/180 − 1 = 4.182%
Bond equivalent yield = [(100 − 98)/98] × 365/180 = 4.139%
The discount quote is an annual quote calculated as (Par − Price)/Par, assuming that there are
360 days in a year. The bond equivalent yield is an annual rate calculated as (Par − Price)/Price,
which is the normal way to express a percentage return ($ return per $ invested), assuming that
there are 365 days in the year. The effective annual return or EAR is the same as the bond
equivalent yield, except that the EAR annualizes the rate of return assuming the proceeds from
each 180-day period are reinvested during the next 180-day period, and so on.
Bloom's: Understand; Analyze; Apply
61) You are a corporate treasurer for Esso Oil. The quoted rate on dollar-denominated euro
commercial paper has just blipped down recently. Your firm can issue $10 million of 180-day
euro commercial paper in the London markets at 3.45 percent. You can also invest the proceeds
in the United States in comparable maturity negotiable dollar-denominated CDs, which are
quoting 3.95 percent. Ignoring any transactions costs, how much money, if any, can Esso make
by borrowing in the euro markets and investing in the United States? Is this a good deal or not?
Should you expect it to last? Explain.
Answer: Initial proceeds from issuing euro commercial paper (CP) = $10 million × [1 −
(0.0345 × 180/360)] = $9,827,500; invest the proceeds of $9,827,500 in 180-day CDs and you
will wind up with $9,827,500 × [1 + (0.0395 × 180/360)] = $10,021,593.
Repay the $10,000,000 owed on the CP and Esso will clear $21,593.
If the CDs are not very risky, then this represents an arbitrage opportunity for Esso; because they
are not using their own money, the rate of return is infinite. Since this is an arbitrage strategy, we
would not expect this big a difference in the rates to persist. (Exxon constructed a similar
arbitrage several years ago using euro commercial paper and T-bills.)
Difficulty: 3 Hard
Topic: Money Market Securities; International Aspects of Money Markets; Money Market
Participants
Bloom's: Analyze; Evaluate
Learning Goal: 05-02 Identify the major types of money market securities.; 05-05 Examine the
extent to which foreign investors participate in U.S. money markets.; 05-04 List the main
23
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Finance 320 Exam 2 Chapters 5,6,7,8,9

Terms in this set (32)
True or False: True

When you borrow money, the
interest rate on the borrowed
money is the price you pay to be
able to convert your future loan
payments into money today.
True or False: False

When there are large numbers of
people looking to save their money
and there is little demand for loans,
one would expect interest rates to
be high.
True or False: False

The annual percentage rate
indicates the amount of interest,
including the effect of any
compounding.
Which of the following would be D) The investment will be for a long period of time.
LEAST likely to lower the interest
rate that a bank offers a borrower?
A) The number of borrowers

seeking funds is low.
B) The expected inflation rate is
expected to be low.
C) The borrower is judged to have
a low degree of risk.
D) The investment will be for a long
period of time.

What is the effective annual rate A) the interest rate that would earn the same interest with
(EAR)? annual compounding
A) the interest rate that would earn

the same interest with annual
compounding
B) the ratio of the number of the
annual percentage rate to the
number of compounding periods
per year
C) the discount rate for an n-year
time interval, where n may be more
than one year or less than or equal
to one year (a fraction)
D) the cash flows from an
investment over a one-year period
divided by the number of times that
interest is compounded during the
year
A bank offers a loan that will 6.17%

require you to pay 6% interest
compounded monthly. EAR = {(1 + APR)/m}m } - 1; EAR = {( 1 + 0.06)/12}12 - 1; 0.0617 ×
Approximately how much EAR 100 = 6.17%
charged by the bank?
1.94%
A bank pays interest quarterly with
an EAR of 8%. What is the periodic
First convert the EAR to APR with quarterly compounding,
interest rate applicable per
which equals 7.77%; now divide this by 4 to get the
quarter?
periodic interest rate = 1.94%.
Howard is saving for a long holiday. $388

He deposits a fixed amount every
month in a bank account with an First calculate the APR using an EAR of 7.5% and monthly
EAR of 7.5%. If this account pays compounding, which comes to 7.25%. Then using a periodic
interest every month then how rate of 7.25/12, calculate the payment over 24 months that
much should he save from each gives a future value (FV) of $10,000
monthly paycheck in order to have
$10,000 in the account in two years'
time?

An 8% APR with monthly C) Can use the financial calculator or the formula EAR = {(1
compounding is closest to which of + 0.08 / 12}12 - 1 = 8.3%.
the following?
A) an EAR of 6.7%
B) an EAR of 7.72%
C) an EAR of 8.3%
D) an EAR of 8.5%
Which of the following best A) the quoted interest rate which considered with the
describes the annual percentage compounding period gives the effective interest rate
rate?
A) the quoted interest rate which

considered with the compounding
period gives the effective interest
rate
B) the effective annual rate after
compounding is taken into account
C) the discount rate when
compounded more than once a
year or less than once a year
D) the discount rate when it is
divided by the number of times it is
compounded in a year
A graphic designer needs a laptop C) Leasing costs $399 more than buying
for audio/video editing, and notices
that they can elect to pay $2900 for Using a periodic rate of 7/12% per month, calculate the
a Dell XPS laptop, or lease from the present value (PV) of an annuity of $79 for 48 months; then
manufacturer for monthly payments subtract $2900 to calculate the advantage of leasing.
of $79 each for four years. The
designer can borrow at an interest
rate of 7% APR compounded
monthly. What is the cost of leasing
the laptop over buying it outright?
Which of the following accounts B) one that pays 1.0% per month
has the highest EAR?
Calculate the EAR for each choice and pick the highest: A
A) one that pays 6.1% every six = 12.57%; B=12.68%; C = 12.6%; D = 12.55%.
months
B) one that pays 1.0% per month
C) one that pays 12.6% per year
D) one that pays 3% every three
months

Drew receives an inheritance that C) $365,322
pays him $50,000 every three
months for the next two years. First calculate the APR with quarterly compounding, which
Which of the following is closest to equals 8.24%; then using a periodic interest rate of 8.24/4%,
the present value (PV) of this calculate the present value (PV) of an annuity of $50,000
inheritance if the interest rate is 8.5% for eight periods.
(EAR)?
A) $354,223
B) $364,309
C) $365,322
D) $400,000
Given the APR of four investments, A) Investment A

which offers the highest EAR?
Calculate the EAR for each; A = 5.70%; B = 5.68%; C =
Investment A: 5.64%; D = 5.65%
Rate of Return: 5.7%
Compounding: Yearly
Investment B:
Compounding: Semiannually
Investment C:
Compounding: Monthly
Investment D:
Compounding: Weekly
A bank offers an account with an C) Semiannual Compounding

APR of 6% and an EAR of 6.09%.
How does the bank compound Using an APR = 6%, calculate the EAR for the
interest for this account? compounding periods given in each choice:
A = 6.18%; B = 6.17%; C = 6.09%; D = 6%.
A) weekly compounding
B) monthly compounding
C) semiannual compounding
D) annual compounding
What is the present value (PV) of an $33,730

investment that pays $10,000 every
year for four years if the interest rate Calculate EAR = 7.1859%; Calculate PV Annuity = $33,730
is 7% APR, compounded quarterly?

A small foundry agrees to pay $29,770
$250,000 two years from now to a
supplier for a given amount of Calculate the EAR = 5.64%; calculate APR with quarterly
coking coal. The foundry plans to compounding = 5.52%; calculate the payment for 8
deposit a fixed amount in a bank quarters with $250,000 as future value (FV).
account every three months,
starting three months from now, so
that at the end of two years the
account holds $250,000. If the
account pays 5.5% APR
compounded monthly, how much
must be deposited every three
months?
Emma runs a small factory that D) Buy, since the present value (PV) of the lease is $32,108
needs a vacuum oven for brazing more than the cost of the oven.
small fittings. She can purchase the
model she needs for $180,000 up Calculate PV lease payments = $212,108; subtract $180,000
front, or she can lease it for five to get $32,108.
years for $4200 per month. She can
borrow at 7% APR, compounded
monthly. Assuming that the oven
will be used for five years, should
she purchase the oven or should
she lease it?
A) Lease, since the present value

(PV) of the lease is $12,224 less than
the cost of the oven.
B) Lease, since the present value
(PV) of the lease is $8642 less than
C) Lease, since the present value
(PV) of the lease is $2212 less than
D) Buy, since the present value (PV)
of the lease is $32,108 more than

Which of the following statements False:
is FALSE? D) The annual percentage rate indicates the amount of
interest including the effect of compounding.
A) Because interest rates may be
quoted for different time intervals, it True:
is often necessary to adjust the A) Because interest rates may be quoted for different time
interest rate to a time period that intervals, it is often necessary to adjust the interest rate to a
matches that of our cash flows. time period that matches that of our cash flows.
B) The effective annual rate B) The effective annual rate indicates the amount of
indicates the amount of interest that interest that will be earned at the end of one year.
will be earned at the end of one C) The annual percentage rate indicates the amount of
year. simple interest earned in one year.
C) The annual percentage rate
indicates the amount of simple
interest earned in one year.
D) The annual percentage rate
indicates the amount of interest
including the effect of
The effective annual rate (EAR) for A) 8.30%

a loan with a stated APR of 8%
compounded monthly is closest A) EAR = (1 + APR / k)k - 1 = (1 + 0.08 / 12)12 - 1 = 0.083 or 8.3%.
to?
A) 8.30%
B) 8.33%
C) 8.00%
D) 8.24%
The effective annual rate (EAR) for C) 10.38%

a loan with a stated APR of 10%
compounded quarterly is closest EAR = (1 + APR / k)k - 1 = (1 + 0.10 / 4)4 - 1 = 0.1038 or 10.38%
to:
A) 10.52%
B) 10.25%
C) 10.38%
D) 10.00%
The effective annual rate (EAR) for C) 4.08%

a savings account with a stated
APR of 4% compounded daily is EAR = (1 + APR / k)k - 1 = (1 + 0.04 / 365)365 - 1 = 0.04088 or
closest to: 4.08%
A) 4.00%
B) 4.10%
C) 4.08%
D) 4.06%
Which alternative offers you the D) Investment D
highest effective rate of return?
EAR (A) = (1 + APR / k)k - 1 = (1 + 0.0625 / 1)1 - 1 = 0.0625 or
Investment A: 6.250%
Rate: 6.25%
Compounded: Annually EAR (B) = (1 + APR / k)k - 1 = (1 + 0.0610 / 365)365 - 1 =
0.06289 or 6.289%
Investment: B
Rate:6.10% EAR (C) = (1 + APR / k)k - 1 = (1 + 0.06125 / 4)4 - 1 = 0.06267 or
Compounded: Daily 6.267%
Investment: C EAR (D) = (1 + APR / k)k - 1 = (1 + 0.0612 / 12)12 - 1 = 0.06295 or

Rate: 6.125% 6.300%
Compounded: Quarterly
Investment: D
Rate: 6.120%
Compounded: Monthly
Which alternative offers you the A) Investment A

lowest effective rate of return?
EAR (A) = (1 + APR / k)k - 1 = (1 + 0.0625 / 1)1 - 1 = 0.0625 or
Investment A: 6.250%
Rate: 6.25%
Compounded: Annually EAR (B) = (1 + APR / k)k - 1 = (1 + 0.0610 / 365)365 - 1 =
0.06289 or 6.289%
Investment: B
Rate:6.10% EAR (C) = (1 + APR / k)k - 1 = (1 + 0.06125 / 4)4 - 1 = 0.06267 or
Compounded: Daily 6.267%
Investment: C EAR (D) = (1 + APR / k)k - 1 = (1 + 0.0612 / 12)12 - 1 = 0.06295 or

Rate: 6.125% 6.300%
Investment: D
Rate: 6.120%
Compounded: Monthly

The highest effective rate of return Investment D: 6.300%
you could earn on any of these
investments is closest to: EAR (A) = (1 + APR / k)k - 1 = (1 + 0.0625 / 1)1 - 1 = 0.0625 or
6.250%
Investment A:
Rate: 6.25% EAR (B) = (1 + APR / k)k - 1 = (1 + 0.0610 / 365)365 - 1 =
Compounded: Annually 0.06289 or 6.289%
Investment: B EAR (C) = (1 + APR / k)k - 1 = (1 + 0.06125 / 4)4 - 1 = 0.06267 or

Rate:6.10% 6.267%
Compounded: Daily
EAR (D) = (1 + APR / k)k - 1 = (1 + 0.0612 / 12)12 - 1 = 0.06295 or
Investment: C 6.300%
Rate: 6.125%
Investment: D
Rate: 6.120%
Compounded: Monthly
The lowest effective rate of return Investment A: 6.250%

you could earn on any of these
investments is closest to: EAR (A) = (1 + APR / k)k - 1 = (1 + 0.0625 / 1)1 - 1 = 0.0625 or
6.250%
Investment A:
Rate: 6.25% EAR (B) = (1 + APR / k)k - 1 = (1 + 0.0610 / 365)365 - 1 =
Compounded: Annually 0.06289 or 6.289%
Investment: B EAR (C) = (1 + APR / k)k - 1 = (1 + 0.06125 / 4)4 - 1 = 0.06267 or

Rate:6.10% 6.267%
Compounded: Daily
EAR (D) = (1 + APR / k)k - 1 = (1 + 0.0612 / 12)12 - 1 = 0.06295 or
Investment: C 6.300%
Rate: 6.125%
Investment: D
Rate: 6.120%
Compounded: Monthly

Given: Your firm needs to invest in a D) 6.14%
new delivery truck. The life
expectancy of the delivery truck is EAR = (1 + APR / k)k - 1 = (1 + 0.06 / 4)4 - 1 = 0.06136 or 6.14%
five years. You can purchase a new
delivery truck for an upfront cost of
$200,000, or you can lease a truck
from the manufacturer for five years
for a monthly lease payment of
$4000 (paid at the end of each
month). Your firm can borrow at 6%
APR with quarterly compounding.
The effective annual rate on your

firm's borrowings is closest to:
A) 6.00%
B) 6.24%
C) 6.17%
D) 6.14%
Given: Your firm needs to invest in a C) 0.498%

expectancy of the delivery truck is EAR = (1 + APR / k)k - 1 = (1 + 0.06 / 4)4 - 1 = 0.06136 or 6.14%
five years. You can purchase a new Monthly rate = (1 + EAR)(1/12) - 1= (1.06136)(1/12) - 1 =
delivery truck for an upfront cost of 0.004975 = 0.498%
from the manufacturer for five years
for a monthly lease payment of
month). Your firm can borrow at 6%
APR with quarterly compounding.
The monthly discount rate that you

should use to evaluate the truck
lease is closest to:
A) 0.487%
B) 0.512%
C) 0.498%
D) 0.500%

Given: Your firm needs to invest in a B) $207,050
expectancy of the delivery truck is First we need to calculate the monthly discount rate for
five years. You can purchase a new the lease arrangement. EAR = (1 + APR / k)k - 1 = (1 + 0.06 /
delivery truck for an upfront cost of 4)4 - 1 = 0.06136 or 6.14%
from the manufacturer for five years Monthly rate = (1 + EAR)(1/12) - 1= (1.06136)(1/12) - 1 =
for a monthly lease payment of 0.004975 = 0.4975%
month). Your firm can borrow at 6% Now we can apply the PVA formula to calculate the PV of
APR with quarterly compounding. the lease or by calculator:
I = 0.4975
The present value (PV) of the lease N = 60 (5 years × 12 months/yr)
payments for the delivery truck is FV = 0
closest to: PMT = $4000
A) $206,900 Compute PV = 207,051.61.
B) $207,050
C) $207,680
D) $198,420
You are considering purchasing a B) $527

new automobile that will cost you
$28,000. The dealer offers you 4.9% First we need the monthly interest rate = APR / k = 0.049 / 12
APR financing for 60 months (with = 0.004083 or 0.4083%.
payments made at the end of the
month). Assuming you finance the
entire $28,000 and finance through
the dealer, your monthly payments
will be closest to:
A) $1454
B) $527
C) $467
D) $478
You are considering purchasing a C) $736

new truck that will cost you
$34,000. The dealer offers you 1.9% First we need the monthly interest rate = APR / k = 0.019 / 12
APR financing for 48 months (with = 0.001583 or 0.1583%.
payments made at the end of the
month). Assuming you finance the Now:
entire $34,000 and finance through PV = 34000
the dealer, your monthly payments I = 0.1583
will be closest to: FV = 0
A) $708 N = 48
B) $594 Compute PMT = $736.15.
C) $736
D) $1086

You are purchasing a new home C) $1,540
and need to borrow $250,000 from
a mortgage lender. The mortgage First we need the monthly interest rate = APR / k = 0.0625 /
lender quotes you a rate of 6.25% 12 = 0.005208 or 0.5208%.
APR for a 30-year fixed rate
mortgage. The mortgage lender Now:
also tells you that if you are willing PV = 250,000 (no points)
to pay two points, they can offer I = 0.5208
you a lower rate of 6.0% APR for a FV = 0
30-year fixed rate mortgage. One N = 360 (30 years × 12 months) Compute PMT = $1539.29.
point is equal to 1% of the loan
value. So if you take the lower rate
and pay the points, you will need to
borrow an additional $5000 to
cover points you are paying the
lender.
Assuming you do not pay the

points and borrow from the
mortgage lender at 6.25%, then
your monthly mortgage payment
(with payments made at the end of
the month) will be closest to:
A) $1570
B) $1530
C) $1540
D) $1500
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3636 chapter 3
1. If interest rates increase, the value t

of a fixed income contract
decreases and vice versa.
2. At equilibrium, a security's f
required rate of return will be less
than its expected rate of return.
3. If a security's realized return is f

negative, it must have been true
that the expected return was
greater than the required return.
4. Suppose two bonds of f

equivalent risk and maturity have
different prices such that one is a
premium bond and one is a
discount bond. The premium bond
must have a greater expected
return than the discount bond.
5. A bond with an 11 percent t

coupon and a 9 percent required
return will sell at a premium to par.
6. A fairly priced bond with a t

coupon less than the expected
return must sell at a discount from
par.
3636 chapter 3
7. All else equal, the holder of a t
fairly priced premium bond must
expect a capital loss over the
holding period.
8. The duration of a four-year t

maturity 10 percent coupon bond is
less than four years.
9. The longer the time to maturity, f

the lower the security's price
sensitivity to an interest rate
10. The greater a security's coupon, t

the lower the security's price
sensitivity to an interest rate
11. For a given interest rate change, f

a 20-year bond's price change will
be twice that of a 10-year bond's
price change.
12. Any security that returns a t

greater percentage of the price
sooner is less price-volatile.
13. A zero coupon bond has a t

duration equal to its maturity and a
convexity equal to zero.
14. The lower the level of interest t

rates, the greater a bond's price
sensitivity to interest rate changes.
15. The higher a bond's coupon, the t

lower the bond's price volatility.
16. Higher interest rates lead to t

lower bond convexity, ceteris
paribus.
17. A 10-year maturity zero coupon t

bond will have lower price
volatility than a 10-year bond with a
10 percent
3636 coupon.
chapter 3
18. Ignoring default risk, if a bond's f
expected return is greater than its
required return, then the bond's
market price must be greater than
the present value of the bond's
cash flows.
19. The required rate of return on a e

bond is
A. the interest rate that equates the

current market price of the bond
with the present value of all future
cash flows received.
B. equivalent to the current yield for

non-par bonds.
C. less than the E(r) for discount

bonds and greater than the E(r) for
premium bonds.
D. inversely related to a bond's risk

and coupon.
E. none of the options.
20. Duration is b
A. the elasticity of a security's value

to small coupon changes.
B. the weighted average time to

maturity of the bond's cash flows.
C. the time until the investor

recovers the price of the bond in
today's dollars.
D. greater than maturity for deep

discount bonds and less than
maturity for premium bonds.
E. the second derivative of the

bond price formula with respect to
the YTM.
3636 chapter 3
21. Which of the following bond d
terms are generally positively
related to bond price volatility?
I. Coupon rate
II. Maturity
III. YTM
IV. Payment frequency
A. II and IV only
B. I and III only
C. II and III only
D. II only
E. II, III, and IV only
22. The interest rate used to find the b

present value of a financial security
is the
A. expected rate of return.
B. required rate of return.
C. realized rate of return.
D. realized yield to maturity.
E. current yield.
3636 chapter 3
23. A security has an expected c
return less than its required return.
This security is
A. selling at a premium to par.
B. selling at a discount to par.
C. selling for more than its PV.
D. selling for less than its PV.
E. a zero coupon bond.
24. A bond that you held to d

maturity had a realized return of 8
percent, but when you bought it, it
had an expected return of 6
percent. If no default occurred,
which one of the following must be
true?
A. The bond was purchased at a

premium to par.
B. The coupon rate was 8 percent.
C. The required return was greater

than 6 percent.
D. The coupons were reinvested at

a higher rate than expected.
E. The bond must have been a zero

coupon bond.
3636 chapter 3
25. You would want to purchase a c
security if P ____________ PV or E(r)
____________ r.
A. ≥; ≤
B. ≥; ≥
C. ≤; ≥
D. ≤; ≤
26. A 10-year annual payment c

corporate bond has a market price
of $1,050. It pays annual interest of
$100 and its required rate of return
is 9 percent. By how much is the
bond mispriced?
A. $0.00
B. Overpriced by $14.18
C. Underpriced by $14.18
D. Overpriced by $9.32
E. Underpriced by $9.32
PV = 100 × PVIFA [9%, 10 yrs.] + 1,000
× PVIF (9%, 10 yrs.) = $1,064.18
3636 chapter 3
27. A 12-year annual payment d
corporate bond has a market price
of $925. It pays annual interest of
$60 and its required rate of return is
7 percent. By how much is the bond
mispriced?
A. $0.00
B. Overpriced by $7.29
C. Underpriced by $7.29
D. Overpriced by $4.43
E. Underpriced by $4.43
FPV = 60 × PVIFA [7%, 12 yrs.] + 1,000
× PVIF (7%, 12 yrs.) = $920.57
28. An eight-year corporate bond a

has a 7 percent coupon rate. What
should be the bond's price if the
required return is 6 percent and the
bond pays interest semiannually?
A. $1,062.81
B. $1,062.10
C. $1,053.45
D. $1,052.99
E. $1,049.49
Price = 35.00 × PVIFA (3%, 16) + 1,000
× PVIF (3%, 16)
3636 chapter 3
29. A 15-year corporate bond pays a
$40 interest every six months. What
is the bond's price if the bond's
promised YTM is 5.5 percent?
A. $1,261.32
B. $1,253.12
C. $1,250.94
D. $1,263.45
E. $1,264.79
Using P/Y2 for semiannual; FV
$1,000; PMT $40; N 15 years; and I/Y
5.5 percent. Solve bond price (PV)
= $1,253.12.
30. A corporate bond has a coupon b

rate of 10 percent and a required
return of 10 percent. This bond's
price is
A. $924.18.
B. $1,000.00.
C. $879.68.
D. $1,124.83.
E. not possible to determine from

the information given.
3636 chapter 3
31. A 10-year annual payment d
corporate coupon bond has an
expected return of 11 percent and a
required return of 10 percent. The
bond's market price is
A. greater than its PV.
B. less than par.
C. less than its E(r).
D. less than its PV.
E. $1,000.00.
32. An eight-year annual payment 7 b

percent coupon Treasury bond has
a price of $1,075. The bond's annual
E(r) must be
A. 13.49 percent.
B. 5.80 percent.
C. 7.00 percent.
D. 1.69 percent.
E. 4.25 percent.
$1,075 = 70 × PVIFA (E(r)%, 8) + 1,000
× PVIF (E(r)%, 8), trial and error or
calculator
3636 chapter 3
33. A six-year annual payment d
corporate bond has a required
return of 9.5 percent and an 8
percent coupon. Its market value is
$20 over its PV. What is the bond's
E(r)?
A. 8.00 percent
B. 10.21 percent
C. 9.98 percent
D. 9.03 percent
E. 3.53 percent
PV = 933.70 = 80 × PVIFA (9.5%, 6
yrs.) + 1,000 × PVIF (9.5%, 6 yrs.);
(933.70 + 20) = 80 × PVIFA (E(r), 6
yrs.) + 1,000 × PVIF (E(r), 6 yrs.), trial
and error or calculator
3636 chapter 3
34. Corporate Bond A returns 5 d
percent of its cost in PV terms in
each of the first five years and 75
percent of its value in the sixth year.
Corporate Bond B returns 8
percent of its cost in PV terms in
each of the first five years and 60
percent of its cost in the sixth year.
If A and B have the same required
return, which of the following is/are
true?
I. Bond A has a bigger coupon than

Bond B.
II. Bond A has a longer duration
than Bond B.
III. Bond A is less price-volatile
than Bond B.
IV. Bond B has a higher FPV than
Bond A.
A. III only
B. I, III, and IV only
C. I, II, and IV only
D. II and IV only
E. I, II, III, and IV
3636 chapter 3
35. A corporate bond returns 12 e
percent of its cost (in PV terms) in
the first year, 11 percent in the
second year, 10 percent in the third
year and the remainder in the fourth
year. What is the bond's duration in
years?
A. 3.68 years
B. 2.50 years
C. 4.00 years
D. 3.75 years
E. 3.32 years
3.32 = (12% 1) + (11% 2) + (10% 3) +
(67% 4)
36. A semiannual payment bond e

with a $1,000 par has a 7 percent
quoted coupon rate, a 7 percent
promised YTM, and 10 years to
maturity. What is the bond's
duration?
A. 10.00 years
B. 8.39 years
C. 6.45 years
D. 5.20 years
E. 7.35 years
Σ[(t CFt/(1.035)t)]/(2 $1,000)
3636 chapter 3
37. An annual payment bond with a a
$1,000 par has a 5 percent quoted
coupon rate, a 6 percent promised
YTM, and six years to maturity.
What is the bond's duration?
A. 5.31 years
B. 5.25 years
C. 4.76 years
D. 4.16 years
E. 3.19 years
Σ[(t*CFt/(1.06)t)]/$950.83
38. If an N year security recovered c

the same percentage of its cost in
PV terms each year, the duration
would be
A. N.
B. 0.
C. sum of the years/N.
D. N!/N2.
E. none of the options.
39. The ___________ the coupon and the e

______________ the maturity; the __________
the duration of a bond, ceteris
paribus.
A. larger; longer; longer
B. larger; longer; shorter
C. smaller; shorter; longer
D. smaller; shorter; shorter
E. None of the options presented

3636 chapter 3
40. You bought a stock three years c
ago and paid $45 per share. You
collected a $2 dividend per share
each year you held the stock and
then you sold the stock for $47 per
share. What was your annual
compound rate of return?
A. 8.89 percent
B. 8.51 percent
C. 5.84 percent
D. 4.44 percent
E. 2.96 percent
Use a financial calculator to solve
for IRR as follows: CFO = -$45, CO1
= $2, FO1 = 1, CO2 = $2, FO2 = 1, FO3
= $47, FO3 = 1 Compute for IRR =
5.82%.
41. A four-year maturity 0 percent e

coupon corporate bond with a
required rate of return of 12 percent
has an annual duration of
_______________ years.
A. 3.05
B. 2.97
C. 3.22
D. 3.71
E. 4.00
3636 chapter 3
42. A decrease in interest rates will b
A. decrease the bond's PV.
B. increase the bond's duration.
C. lower the bond's coupon rate.
D. change the bond's payment

frequency.
E. not affect the bond's duration.
43. A 10-year maturity coupon bond c

has a six-year duration. An
equivalent 20-year bond with the
same coupon has a duration
A. equal to 12 years.
B. less than six years.
C. less than 12 years.
D. equal to six years.
E. greater than 20 years.
44. A six-year maturity bond has a a

five-year duration. Over the next
year maturity will decline by one
year and duration will decline by
A. less than one year.
B. more than one year.
C. one year.
D. N years.
E. N/(N-1) years.
3636 chapter 3
45. An annual payment bond has a e
9 percent required return. Interest
rates are projected to fall 25 basis
points. The bond's duration is 12
years. What is the predicted price
change?
A. -2.75 percent
B. 33.33 percent
C. 1.95 percent
D. -1.95 percent
E. 2.75 percent
-12 × (-0.0025/1.09)
46. A bond that pays interest c

annually has a 6 percent promised
yield and a price of $1,025. Annual
interest rates are now projected to
fall 50 basis points. The bond's
duration is six years. What is the
predicted new bond price after the
interest rate change? (Watch your
rounding.)
A. $1,042.33
B. $995.99
C. $1,054.01
D. $987.44

1,025 + [-6 × (-0.0050/1.06) × $1,025]
3636 chapter 3
47. A bond that pays interest d
semiannually has a 6 percent
promised yield and a price of
$1,045. Annual interest rates are
now projected to increase 50 basis
points. The bond's duration is five
years. What is the predicted new
bond price after the interest rate
change? (Watch your rounding.)
A. $1,020.35
B. $1,069.65
C. $1,070.36
D. $1,019.64

((-5/1.03) × 0.0050 × $1,045) + $1,045
48. Convexity arises because d
A. bonds pay interest semiannually.
B. coupon changes are the

opposite sign of interest rate
changes.
C. duration is an increasing function

of maturity.
D. present values are a nonlinear

function of interest rates.
E. duration increases at higher

interest rates.
3636 chapter 3
49. The duration of a 180-day T-Bill a
is (in years)
A. 0.493.
B. 0.246.
C. 1.
D. 0.
E. indeterminate.
180/365
50. For large interest rate increases, b

duration _____________ the fall in
security prices, and for large
interest rate decreases, duration
______________ the rise in security prices.
A. overpredicts; overpredicts
B. overpredicts; underpredicts
C. underpredicts; overpredicts
D. underpredicts; underpredicts

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Social Science / Economics / Finance
finance 3636 chapter 5

Everything else equal, an effective annual rate will be

true greater than the bond equivalent yield on the same
security.
Money markets exist to help reduce the opportunity cost

true
of holding cash balances
The majority of money market securities are low-

false denomination, low-risk investments designed to appeal to
individual investors with excess cash.
Commercial paper is a short-term obligation of the U.S.

false government issued to cover government budget deficits
and to refinance maturing government debt.
Commercial paper, Treasury bills, and banker's

true
acceptance rates are all quoted as discount yields.
Euro commercial paper is a short-term obligation of the

false
European Central Bank.
The U.S. Treasury switched from a discriminating price

false auction to a single price auction because the latter
lowered the average price paid by investors.
In the T-bill secondary market the ask yield will normally

true
be less than the bid yield.
The largest secondary money market in the United States

true
is the secondary market for T-bills.
Fed funds are short-term unsecured loans while repos are

true
short-term secured loans.
360/n times the difference between the face value and the
current value divided by the face value gives you the
true
discount yield on an instrument.
The bond equivalent yield times 365/360 is equal to the

false
single payment yield.
For the purposes for which they are used, money market
securities should have which of the following
characteristics?

Low trading costs, little price risk

A. I and III
B. II and IV
C. III and IV
D. I and II
E. I, II, and III
14. Money market securities exhibit which of the following?
IV. Contractually determined cash flows
large denomination, low default

risk, contractually determined cash A. I, II, and III
flows
B. I, III, and IV
C. II, III, and IV
D. II and IV
E. I, II, III, and IV

15. A repo is in essence a collateralized
A. banker's acceptance.
B. certificate of deposit.
fed funds loan
C. Fed funds loan.
D. commercial paper loan.
E. Eurodollar deposit.
16. A short-term unsecured promissory note issued by a

company is
A. commercial paper.
commercial paper B. a T-bill.
C. a repurchase agreement.
D. a negotiable CD.
E. a banker's acceptance.
A time draft payable to a seller of goods, with payment

guaranteed by a bank is a
A. commercial paper security.
bankers acceptance B. T-bill.
C. repurchase agreement.
D. negotiable CD.
E. banker's acceptance.

18. In the T-bill auction process, the competitive bidder is
guaranteed a ______________ and a noncompetitive bidder is
guaranteed a _______________.
A. minimum price; maximum price

max price;given quantity
B. maximum price; minimum price
C. maximum price; given quantity
D. minimum price; maximum quantity
E. none of the options
19. A dealer is quoting a $10,000 face 180-day T-bill quoted

at 2.75 bid, 2.65 ask. You could buy this bill at ______________ or
sell it at _______________.
$9867.50; $9862.5
A. $9,869.23; $9864.36
Buy at 10,000 × [1-(0.0265 ×

B. $9864.36; $9,869.23
180/360)]; sell at 10,000 × [1-(0.0275
× 180/360)]
C. $9,867.50; $9,862.50
D. $9,862.50; $9,867.50
20. Rates on Federal funds and repurchase agreements are

stated
A. on a bond equivalent basis with a 360-day year.

on a bond equivalent basis with a
360 day year B. on a bond equivalent basis with a 365-day year.
C. as a discount yield with a 360-day year.
D. as an EAR.
E. as a discount yield with a 365-day year.

21. The discount yield on a T-bill differs from the T-bill's
bond equivalent yield (BEY) because
I. the discount yield is the return per dollar of face value

and the BEY is a return per dollar originally invested.
-the discount yield is the return per II. a 360-day year is used on the discount yield and the
dollar of face value and the BEY is BEY uses 365 days.
a return per dollar originally III. the discount yield is calculated without compounding,
invested. and the BEY is calculated with compounding.
and
a 360-day year is used on the A. I only
discount yield and the BEY uses

365 days. B. II only
C. I and II only
D. II and III only
E. I, II, and III
22. The following formula is used to calculate the _____________

of a money market investment.
A. EAR
single payment yield
B. APR
C. single-payment yield
D. discount yield
E. BEY

23. The rate of return on a repo is
A. determined by the rate of return on the underlying

collateral.
strongly affected by the current B. strongly affected by the current Fed funds rate at the
Fed funds rate at the time of the time of the repo.
repo and determined at the time of
the repo. C. determined at the time of the repo.
D. determined by the rate of return on the underlying

collateral and determined at the time of the repo.
E. strongly affected by the current Fed funds rate at the

time of the repo and determined at the time of the repo.
24. Which one of the following statements about

commercial paper is NOT true?
Commercial paper issued in the United States
A. is an unsecured short-term promissory note.

carries an interest rate above the
prime rate B. has a maximum maturity of 270 days.
C. is virtually always rated by at least one ratings agency.
D. has no secondary market.
E. carries an interest rate above the prime rate.
25. A negotiable CD
A. is a bank-issued transactions deposit.
B. is a registered instrument.
is a bank issued time deposit
C. is a bank-issued time deposit.
D. has denominations ranging from $50,000 to $10 million.
E. pays discount interest.

26. A 180-day $3 million CD has a 4.25 percent annual rate
quote. If you buy the CD, how much will you collect in 180
days?
A. $3,047,439
$3,063,750
B. $3,045.678
$3 million × [1 + (0.0425 × 180/360)]
C. $3,062,877
D. $3,063,750
E. $3,127,500
27. A banker's acceptance is
A. a time draft drawn on the exporter's bank.
B. a method to help importers evaluate the

a liability of the importer and the
creditworthiness of exporters.
importers bank
C. a liability of the importer and the importer's bank.
D. an add-on instrument.
E. for greater than one year maturity.
28. The most liquid of the money market securities are
B. banker's acceptances.
t bills
C. T-bills.
D. Fed funds.
E. repurchase agreements.

In dollars outstanding in 2013, the largest money market
security was
t bills
B. banker's acceptances.
C. T-bills.
D. Fed funds and repos.
30. You buy a $10,000 par Treasury bill at $9,575 and sell it
60 days later for $9,675. What was your EAR?
A. 4.44 percent
6.52 percent (9,675/9,575)(365/60) -

B. 6.29 percent
1 = .06524 = 6.52%
C. 6.35 percent
D. 6.52 percent
E. 6.67 percent
31. LIBOR is generally _______________ the Fed funds rate

because foreign bank deposits are generally ________________
domestic bank deposits.
A. greater than; less risky than

greater than; riskier than
B. less than; riskier than
C. the same as; of equal risk to
D. greater than; riskier than
E. less than; less risky than

A U.S. exporter sells $150,000 of furniture to a Latin
American importer. The exporter requires the importer to
obtain a letter of credit. When the bank accepts the draft,
the exporter discounts the 120-day note at a 5.25 percent
discount. What is the exporter's true effective annual
financing cost?
5.52 percent A. 5.52 percent
B. 5.42 percent
C. 5.34 percent
D. 5.29 percent
E. 5.25 percent
33. A Chinese exporter sells $200,000 of toys to a French

importer. The Chinese exporter requires the French
importer to obtain a letter of credit. When the bank
accepts the draft, the exporter discounts the 90-day note
at a 4 percent discount. What is the exporter's true
effective annual financing cost?
4.16
A. 4.00 percent
200,000 [1-(0.04 90/360)] = 198,000;
(200,000/198,000)365/90 -1 = 4.16%
B. 4.04 percent
C. 4.10 percent
D. 4.16 percent
E. 4.22 percent

34. If a $10,000 par T-bill has a 3.75 percent discount quote
and a 90-day maturity, what is the price of the T-bill to the
nearest dollar?
A. $9,625
$9906
B. $9,906
10,000 [1-(0.0375 90/360)] = 9,906 C. $9,908
D. $9,627
35. A 90-day T-bill is selling for $9,900. The par is $10,000.

The effective annual return on the T-bill is (watch your
rounding)
A. 4.00 percent.
4.16 percent
B. 4.16 percent.
(10,000/9,900)(365/90) - 1
C. 4.10 percent.
D. 4.04 percent.
E. 4.21 percent.
36. Suppose that $10 million face value commercial paper

with a 270-day maturity is selling for $9.55 million. What is
the BEY on the paper?
A. 4.71 percent
6.37 percent
B. 6.42 percent
C. 6.37 percent
D. 6.28 percent
E. 4.50 percent

37. A $2 million jumbo CD is paying a quoted 3.55 percent
interest rate on 180-day maturity CDs. How much money
will you have at maturity if you invest in the CD?
A. $2,000,000
$2,035,500
B. $2,035,014
2,000,000 [1 + (0.0355180/360)]
C. $2,035,500
D. $2,071,000
E. $2,088,400
38. From 1990 to 2013, which one of the following money

market securities actually declined in terms of dollar
amount outstanding?
A. commercial paper
bankers acceptances
B. treasury bills
C. federal funds and repos
D. negotiable CDs
E. banker's acceptances
39. A 50-day maturity money market security has a bond

equivalent yield of 3.60 percent. The security's EAR is
A. 3.69 percent.
3.66 percent
B. 3.61 percent.
EAR = (1 + (0.0360/(365/50)))365/50
- 1 = 3.66%
C. 3.55 percent
D. 3.87 percent.
E. 3.66 percent.

40. In a Treasury auction, preferential bidding status is
granted to
A. competitive bidders.
noncompetitive bidders B. noncompetitive bidders.
C. short sale committed bidders.
D. commercial bank bidders.
E. no group of bidders.
41. If your firm enters into an overnight reverse repurchase

agreement, your firm is
A. borrowing Fed funds temporarily.
none of the options B. selling a security now while agreeing to buy it back
tomorrow.
C. giving an unsecured loan to the counterparty.
D. procuring a banker's acceptance.
42. Eurodollar CDs would include
A. CDs denominated in euros.
B. dollar investments by European entities in the United

dollars deposited in Caribbean
States.
banks and dollars deposited in
Europe.
C. dollars deposited in Caribbean banks.
D. dollars deposited in Europe.
E. dollars deposited in Caribbean banks and dollars

deposited in Europe.
90% off Plus
FIN CH5 SG
For the purposes for which they are D

used, money market securities
should have which of the following
characteristics?
Multiple Choice
I and III
II and IV
III and IV
I and II
I, II, and III
Money market securities exhibit B

which of the following?
IV. Contractually determined cash
flows
Multiple Choice
I, II, and III
I, III, and IV
II, III, and IV
II and IV
I, II, III, and IV
FIN CH5 SG
A repo is in essence a C
collateralized
Multiple Choice
banker's acceptance.
certificate of deposit.
Fed funds loan.
commercial paper loan.
Eurodollar deposit.
A short-term unsecured promissory A

note issued by a company is
Multiple Choice
commercial paper.
a T-bill.
a repurchase agreement.
a negotiable CD.
a banker's acceptance.
A time draft payable to a seller of E

goods with payment guaranteed by
a bank is a
Multiple Choice
commercial paper security.
T-bill.
repurchase agreement.
negotiable CD.
banker's acceptance.
In the T-bill auction process, the C

competitive bidder is guaranteed a
______________ and a noncompetitive
bidder is guaranteed a _______________.
Multiple Choice
minimum price; maximum price.
maximum price; minimum price.
maximum price; given quantity.
minimum price; maximum quantity.
None of these choices are correct.
FIN CH5 SG
A dealer is quoting a $10,000 face C
180-day T-bill quoted at 2.75 bid,
2.65 ask. You could buy this bill at
______________ or sell it at _______________.
Multiple Choice
$9,869.23; $9,864.36.
$9,864.36; $9,869.23.
$9,867.50; $9,862.50.
$9,862.50; $9,867.50.
Rates on federal funds and A

repurchase agreements are stated
Multiple Choice
360-day year.
365-day year.
as a discount yield with a 360-day
year.
as an EAR.
as a discount yield with a 365-day
year.
The discount yield on a T-bill differs C

from the T-bill's bond equivalent
yield (BEY) because
I. the discount yield is the return per
dollar of face value and the BEY is
a return per dollar originally
invested.
II. a 360-day year is used on the
discount yield and the BEY uses
365 days.
III. the discount yield is calculated
without compounding, and the BEY
is calculated with compounding.
Multiple Choice
I only
II only
I and II only
II and III only
I, II, and III
FIN CH5 SG
The following formula is used to C
calculate the _____________ of a money
market investment.
PF−P0P0×360n
Multiple Choice
EAR
APR
single-payment yield
discount yield
BEY
The rate of return on a repo is E

Multiple Choice
-determined by the rate of return
on the underlying collateral.
-strongly affected by the current
Fed funds rate at the time of the
repo.
-determined at the time of the repo.
-determined by the rate of return
on the underlying collateral and
determined at the time of the repo.
-strongly affected by the current
Fed funds rate at the time of the
repo and determined at the time of
the repo.
Which one of the following E

statements about commercial
paper is not true? Commercial
paper issued in the United States
Multiple Choice
is an unsecured short-term
promissory note.
has a maximum maturity of 270
days.
is virtually always rated by at least
one ratings agency.
has no secondary market.
carries an interest rate above the
prime rate. Correct
FIN CH5 SG
Upgrade to remove ads Only $47.88/year
A negotiable CD C
Multiple Choice
is a bank-issued transactions
deposit.
is a registered instrument.
is a bank-issued time deposit.
has denominations ranging from
$50,000 to $10 million.
pays discount interest.
A 180-day $3 million CD has a 4.25 D

percent annual rate quote. If you
buy the CD, how much will you
collect in 180 days?
Multiple Choice
$3,047,439
$3,045.678
$3,062,877
$3,063,750 Correct
$3,127,500
A banker's acceptance is C
Multiple Choice
a time draft drawn on the exporter's
bank.
a method to help importers
evaluate the creditworthiness of
exporters.
a liability of the importer and the
importer's bank.
an add-on instrument.
for greater than one year maturity.
FIN CH5 SG
The most liquid of the money C
market securities are
Multiple Choice
commercial paper.
banker's acceptances.
T-bills.
Fed funds.
repurchase agreements.
In dollars outstanding in 2016, the D

largest money market security was
Multiple Choice
commercial paper.
banker's acceptances.
T-bills.
Fed funds and repos.
You buy a $10,000 par Treasury bill D

at $9,575 and sell it 60 days later for
$9,675. What was your EAR?
Multiple Choice
4.44 percent
6.29 percent
6.35 percent
6.52 percent
6.67 percent
LIBOR is generally _______________ the D

Fed funds rate because foreign
bank deposits are generally
________________ than domestic bank
deposits.
Multiple Choice
greater than; less risky
less than; more risky
the same as; equally risk
greater than; more risky
less than; less risky
FIN CH5 SG
A U.S. exporter sells $150,000 of A
furniture to a Latin American
importer. The exporter requires the
importer to obtain a letter of credit.
When the bank accepts the draft,
the exporter discounts the 120-day
note at a 5.25 percent discount.
What is the exporter's true effective
annual financing cost?
Multiple Choice
5.52 percent
5.42 percent
5.34 percent
5.29 percent
5.25 percent
A Chinese exporter sells $200,000 D

of toys to a French importer. The
Chinese exporter requires the
French importer to obtain a letter of
credit. When the bank accepts the
draft, the exporter discounts the
90-day note at a 4 percent
discount. What is the exporter's true
effective annual financing cost?
Multiple Choice
4.00 percent
4.04 percent
4.10 percent
4.16 percent
4.22 percent
If a $10,000 par T-bill has a 3.75 B

percent discount quote and a 90-
day maturity, what is the price of the
T-bill to the nearest dollar?
Multiple Choice
$9,625.
$9,906.
$9,908.
$9,627.
FIN CH5 SG
A 90-day T-bill is selling for $9,900. B
The par is $10,000. The effective
annual return on the T-bill is (watch
your rounding)
Multiple Choice
4.00 percent.
4.16 percent.
4.10 percent.
4.04 percent.
4.21 percent.
Suppose that $10 million face value C

commercial paper with a 270-day
maturity is selling for $9.55 million.
What is the BEY on the paper?
Multiple Choice
4.71 percent
6.42 percent
6.37 percent
6.28 percent
4.50 percent
A $2 million jumbo CD is paying a C

quoted 3.55 percent interest rate on
180-day maturity CDs. How much
money will you have at maturity if
you invest in the CD?
Multiple Choice
$2,000,000
$2,035,014
$2,035,500
$2,071,000
$2,088,400
From 1990 to 2016, which one of the E

following money market securities
actually declined in terms of dollar
amount outstanding?
Multiple Choice
Commercial paper
Treasury bills
Federal funds and repos
Negotiable CDs
Banker's acceptances
FIN CH5 SG
A 50-day maturity money market E
security has a bond equivalent
yield of 3.60 percent. The security's
EAR is
Multiple Choice
3.69 percent.
3.61 percent.
3.55 percent.
3.87 percent.
3.66 percent.
In a Treasury auction, preferential B

bidding status is granted to
Multiple Choice
competitive bidders.
noncompetitive bidders.
short sale committed bidders.
commercial bank bidders.
no group of bidders.
If your firm enters into an overnight D

reverse repurchase agreement,
your firm is
Multiple Choice
borrowing Fed funds temporarily.
selling a security now while
agreeing to buy it back tomorrow.
giving an unsecured loan to the
counterparty.
procuring a banker's acceptance.
Eurodollar CDs would include E

Multiple Choice
CDs denominated in Euros.
dollar investments by European
entities in the United States.
banks.
dollars deposited in Europe.
banks and dollars deposited in
Europe.
FIN CH5 SG
Which of the following descriptions D
does not apply to money market
securities?
Multiple Choice
Short-term
Low-risk
Highly liquid
Long maturity
High denominations
The most active and important E

participant in the U.S. money market
Multiple Choice
is the U.S. Treasury.
are the large banks.
are the investment banks.
are the insurance companies.
is the Federal Reserve.
The most significant borrower in the C

U.S. money markets?
Multiple Choice
Are commercial banks
Are large corporations
Is the U.S. Treasury
Are the investment banks
Are the insurance companies
A noncompetitive bid for Treasury A

bill auction provides
Multiple Choice
all noncompetitive bidders the
same price.
all competitive bidders the same
price.
all noncompetitive bidders the
same quantity.
all noncompetitive bidders lesser
price than the competitive bidders.
all competitive bidders the same
quantity.
FIN CH5 SG
What is the price of 182-day money A
market security with face value of
$7,000 if the BEY is 3.574%?
Multiple Choice
$6,877.44
$6,925.48
$6,634.47
$6,725.36
$6,452.39

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Financial Markets and Institutions, 7e (Saunders)

Chapter 3 Interest Rates and Security Valuation

21) The required rate of return on a bond is

27) You would want to purchase a security if P ________ PV or E(r) ________ r.

I. Bond A has a bigger coupon than Bond B.

43) A decrease in interest rates will

49) Convexity arises because

51) The duration of a 91-day T-Bill is (in years).

P3 = 2.19/(0.11 - 0.04) = 31.29

Use the Calculator to solve for the NPV:

1,055.62 = 70 × [PVIFA15 yr, r] + 1,000 × [PVIFA15yr, r]

1,024.32 = 70 × [PVIFA15 yr, E(r)] + 1,000 × [PVIFA15yr, E(r)]

E(r) is 33 basis points more than your r. Calculator Solution:

Now solve for the E(r):

Answer: Convexity is a measure of the nonlinearity (curvature) of a change in a bond's price

First alternative: Do not reinvest the coupons at all.

Second alternative: reinvest coupons at 5%

66) Explain the effects of coupon and maturity on volatility.

68) How does an increase in interest rates affect a security's duration?

a. What is the bond's modified duration?

a. What is the bond's convexity?

rate change 0.00005

17) The Federal Reserve System is charged with

22) The major liability of the Federal Reserve is

23) The major asset of the Federal Reserve is

25) The discount rate is the rate that

28) A decrease in reserve requirements could lead to an

I. buy U.S. government securities.

A) I and III only

32) Currently the Fed sets monetary policy by targeting

I. Examinations of state member banks

43) Which of the following is not a goal of monetary policy?

51) What are the main responsibilities of the FOMC?

54) Explain how the deposit multiplier works.

Answer: Buy U.S. government securities.

3) The majority of money market securities are low-denomination, low-risk investments

4) Commercial paper is a short-term obligation of the U.S. government issued to cover

6) Euro commercial paper is a short-term obligation of the European Central Bank.

I. Low trading costs

17) Money market securities exhibit which of the following?

A) I, II, and III

19) A short-term unsecured promissory note issued by a company is

26) The rate of return on a repo is

31) The most liquid of the money market securities are

43) In a Treasury auction, preferential bidding status is granted to

45) Eurodollar CDs would include

48) The most significant borrower in the U.S. money markets?

49) A noncompetitive bid for Treasury bill auction provides

51) Why do most money market securities have large denominations?

Answer: Bid Price = $10,000 × [1 − .035 × (90/360)] = $9,913

Answer: Find the BEY on each

59) Who are the major participants in money markets?

Answer: U.S. Treasury

Answer: Commercial paper price/100 of par = 100 × (1 − (0.04 × 180/360)) = 98

Finance 320 Exam 2 Chapters 5,6,7,8,9

True or False: True

True or False: False

True or False: False

A) The number of borrowers

Finance 320 Exam 2 Chapters 5,6,7,8,9

A) the interest rate that would earn

A bank offers a loan that will 6.17%

Howard is saving for a long holiday. $388

27) You would want to purchase a security if P PV or E(r) r.