1) Conflicts of interest may arise within the credit rating agencies because

A) the investors pay the credit agencies for ratings.

B) the issuers of debt securities pay the credit agencies for ratings.
C) the credit rating agencies provide auditing services to issuers of debt securities.
D) the credit rating agencies are involved in offering credit counselling to investors.
Answer: B) Conflicts of interest in credit rating agencies can arise because they are
compensated by the issuers of debt securities for providing credit ratings. This
compensation structure may create incentives for rating agencies to provide favorable
ratings to maintain their business relationships with issuers.

2) A conflict of interest can occur for accounting firms when the firms both
A) provide auditing services and non-audit consulting services.
B) provide non-audit services and tax advice.
C) enter data and record data.
D) monitor data and underwrite securities.
Answer: A) A conflict of interest can occur for accounting firms when they provide
both auditing services and non-audit consulting services to the same client. This dual
role can create conflicts because the firm may prioritize its consulting services, which
are more profitable, over its auditing responsibilities.

3) Reducing risk through the purchase of assets whose returns do not always move
together is
A) diversification.
B) intermediation.
C) intervention.
D) discounting.
Answer: A) Reducing risk through the purchase of assets whose returns do not always
move together is called diversification. By holding a diversified portfolio of assets, an
investor can reduce the impact of individual asset risk.

4) A lesson of the Enron collapse is that government regulation

A) always fails.
B) can reduce but not eliminate asymmetric information.
C) increases the problem of asymmetric information.
D) should be reduced.
Answer: B) The lesson from the Enron collapse is that government regulation can help
reduce but not completely eliminate asymmetric information problems in financial
markets.

5) The riskiness of an asset that is unique to the particular asset is

A) systematic risk.
B) portfolio risk.
C) investment risk.
D) Non-systematic risk.
 Answer: D) The riskiness of an asset that is unique to that particular asset is known as
non-systematic risk or idiosyncratic risk. This risk can be reduced through
diversification.

6) The risk of a well-diversified portfolio depends only on the ________ risk of the assets
in the portfolio.
A) systematic
B) non-systematic
C) portfolio
D) investment
Answer: A) The risk of a well-diversified portfolio depends primarily on the systematic
risk of the assets in the portfolio. Non-systematic risk can be diversified away.

7) The result of the too-big-to-fail policy is that ________ banks will take on ________
risks, making bank failures more likely.
A) small; fewer
B) small; greater
C) big; fewer
D) big; greater
Answer: D) The too-big-to-fail policy can lead to larger banks taking on greater risks
because they may believe that they will be bailed out by the government in case of
financial distress, making bank failures more likely.

8) The primary purpose of deposit insurance is to

A) improve the flow of information to investors.
B) prevent banking panics.
C) protect bank shareholders against losses.
D) protect bank employees from unemployment.
Answer: B) The primary purpose of deposit insurance is to prevent banking panics by
guaranteeing that depositors will not lose their funds even if a bank fails.

9) The government safety net creates ________ problem because risk -loving
entrepreneurs might find banking an attractive industry.
A) an adverse selection
B) a moral hazard
C) a lemons
D) a revenue
Answer: A) the government safety net creates an adverse selection problem because
risk-loving entrepreneurs might find banking an attractive industry.

10) The ________ the returns on two securities move together, the ________ benefit there
is from diversification.
A) less; more
B) less; less
C) more; more
D) more; greater
Answer: A) The less the returns on two securities move together (i.e., the lower the
correlation between their returns), the more benefit there is from diversification.
Diversification is most effective when assets have low correlations, as it reduces
portfolio risk