Chapter Two

Financial Markets and Institutions

This chapter contains 25 multiple-choice questions.

Multiple Choice

1. A market that has no one specific location is termed a(n) ________ market.

(a) over-the-counter
(b) geographic location
(c) intermediary
(d) conceptual

Answer: (a)

2. Incentive problems take a variety of forms and include:

(a) moral hazard

(b) adverse selection
(c) principal-agent
(d) all of the above

Answer: (d)

3. Life annuities are examples of ________ problems.

(a) moral hazard

(b) adverse selection
(c) principal-agent
(d) all of the above
 Answer: (b)

4. ________ instruments are also called fixed-income instruments.

(a) Debt
(b) Equity
(c) Derivative
(d) All of the above

Answer: (a)

5. ________ securities are financial instruments that derive their value from the prices of
one or more other assets.

(a) Debt
(b) Equity
(c) Derivative
(d) Fixed-income

Answer: (c)

6. A put option gives its holder the right to ________ some asset at a specified price on or
before some specified expiration date.

(a) sell
(b) buy
(c) loan
(d) borrow

Answer: (a)
7. The ________ curve depicts the relation between interest rates on fixed-income
instruments issued by the U.S. Treasury and the maturity of the instrument.

(a) long-term
(b) short-term
(c) yield
(d) exchange rate

Answer: (c)

Questions 8 and 9 are intended to be calculated as a pair.

8. Suppose you are a French investor, who wants a safe investment in terms of francs. You
are investing for one year and the interest rate on a one-year French government bond is
5% and at the same time it is 9% on a U.S. government bond. The exchange rate is
currently 6.15 French francs to the dollar. Suppose you invest $1,000 in a U.S. bond. Also
suppose that a year from now the French franc/dollar exchange rate is 6.50 French francs
to the dollar. What will be the realized French franc rate of return on the U.S. bond?

(a) 5.69%
(b) 9.00%
(c) 15.2%
(d) 7.00%

Answer: (c)

9. In question 14, what would the exchange rate at year’s end have to be in order for the
French investor to earn exactly 4% per year on the investment in U.S. bonds?

(a) 6.20 FF/$

(b) 5.87 FF/$
 (c) 6.40 FF/$
(d) 5.42 FF/$

Answer: (b)

10. You invest in a stock that costs $45.50 per share. It pays a cash dividend during the year
of $1.20 and you expect its price to be $49 at year’s end. What is your expected rate of
return if you sell the stock for $49 at the end of the year?
(a) 2.64%
(b) 7.69%
(c) 10.33%
(d) –5.05%

Answer: (c)

11. You invest in a stock that costs $45.50 per share. It pays a cash dividend during the year
of $1.20 and you expect its price to be $49 at year’s end. What is your realized rate of
return if the stock’s price is actually $42 at year’s end?
(a) –5.05%
(b) 18.02%
(c) 10.33%
(d) 5.05%

Answer: (a)

12. ________ is an investment strategy that seeks to match the returns of a specified stock
market index.

(a) Indexing
(b) Benchmarking
 (c) Replicating
(d) Diversifying

Answer: (a)

13. Suppose the risk-free nominal interest rate on a one-year U.S. Treasury bill is 6% per
year and the expected rate of inflation is 4% per year. What is the expected real rate of
return on the T-bill?

(a) 2%
(b) 5%
(c) 1.92%
(d) 1.89%

Answer: (c)

14. Currently you have a bank account containing $6,000, which earns interest at a rate of 4%
per year. You also have an unpaid balance on your credit card of $3,000 on which you are
paying an interest rate of 18% per year. If the time frame is one year, the arbitrage
opportunity you face is:

(a) $420
(b) $540
(c) $120
(d) $300

Answer: (a)

15. ________ are firms whose primary function is to help businesses, governments, and
other entities raise funds to finance their activities by issuing securities.
 (a) Closed-end funds
(b) Investment banks
(c) Asset management funds
(d) Open-end funds

Answer: (b)

16. In the United States, the ________ establishes the precise disclosure requirements that
must be satisfied for a public offering of securities.

(a) Financial Accounting Standards Board

(b) World Bank
(c) Federal Reserve
(d) Securities and Exchange Commission

Answer: (d)

17. The Dow Jones Industrial Index has some major defects, which include:

(a) It is not broadly diversified enough to accurately reflect the wide spectrum of
stocks in the United States.
(b) It corresponds to a portfolio strategy that is unsuitable as a performance
benchmark.
(c) It only includes the 30 largest corporations.
(d) (a) and (b)

Answer: (d)

18. ________ invest their funds in a new businesses and help the management team get the
firm to the point at which it is ready to “go public.”

(a) Investment banks

 (b) Venture capitalists
(c) Asset management firms
(d) Mutual funds

Answer: (b)

19. Which of the following represents a defined-contribution pension plan?

(a) A pension plan into which the employer and employee make regular contributions.
(b) A pension plan whose benefit is determined by a formula that takes into account
years of service, wages, and salary.
(c) A pension plan whose benefit formula is 1% of retirement salary for each year of
service.
(d) All of the above

Answer: (a)

20. Net asset value is defined as the ________.

(a) future value of all assets held divided by the number of shares outstanding
(b) book value of all securities held divided by the number of shares outstanding
(c) market value of all securities held divided by the number of shares outstanding
(d) book value of all assets held divided by the number of shares outstanding

Answer: (c)
21. A country’s ________ provides the supply of local currency and operates the clearing
system for the banks.

(a) stock exchange

(b) underwriter
(c) central bank
(d) investment bank

Answer: (c)

22. Which of the following statements is most correct?

(a) closed-end mutual funds do not redeem or issue shares at NAV

(b) closed-end mutual fund prices can differ from NAV
(c) shares of closed-end funds are traded through brokers
(d) all of the above are correct

Answer: (d)

23. Rules for trading securities serve the function of ________.

(a) recognizing when government inaction is the best choice

(b) standardizing procedures to keep transaction costs low
(c) presenting financial information in a standardized format
(d) establishing arbitrary rules to ensure the maximum revenue from transaction fees

Answer: (b)
24. For the period 1926-2003, which of the following asset classes provided the highest
average rate of return?

(a) Long-term U.S. Treasury bonds

(b) U.S. T-bills
(c) Inflation
(d) Small stock

Answer: (d)

25. The ________ is the unit of account for computing the real rate of return.

(a) nominal interest rate on stock

(b) standardized basket of consumption goods
(c) country’s rate of inflation
(d) none of the above

Answer: (b)