ECON 305.25272 Money and Banking
Homework 1 Answer Key
Due by Wednesday, February 4, 2015
Please hand in both your scantron and this homework IN CLASS.
Full Score: 25 points
Multiple Choice (There exists one and only one correct choice. Each question is
worth 0.5 points. Total score: 30*0.5=15)
1) When an individual obtains a car loan and makes all of the regular monthly
payments, the sum of the payments made will exceed the purchase price of the car. This
is due primarily to the core principle:
A) risk requires compensation.
B) information is the basis for decisions.
C) markets determine prices and allocate resources.
D) time has value.
2) The primary function of central banks is to:
A) increase risk and volatility to increase compensation.
B) control inflation, as well as help reduce the size and frequency of business cycle
fluctuations.
C) increase the uncertainty that firms face in making investment decisions.
D) eliminate the need for banks to collect financial information.
3) U.S. monetary policy is best described as:
A) aimed at keeping inflation low and stable and growth high and stable.
B) determining the denominations of a country's currency.
C) one of the most important functions of congress.
D) attempting to keep inflation constant at zero percent.
4) The future value of $100 at a 5% per year interest rate at the end of one year is:
A) $95.00
B) $105.00
C) $97.50
D) $107.50
5) If a saver has a positive rate of time preference then the present value of $100 to be
received 1 year from today is:
A) more than $100.
B) not calculable.
C) less than 100.
D) unknown to the saver.
6) Suppose that Ray Allen, a basketball player for the Miami Heat, will become a free
agent at the end of this NBA season. Suppose that Allen is considering two possible
contracts from different teams. Note that the salaries are paid at the end of EACH year.
The interest rate is 10%. Based on this information, which of the following is true?
A) Allen should take the Seattle contract because it has a higher present value.
B) Allen should take the Portland contract because it has a higher present value.
C) Allen is indifferent between the two contracts because they are both worth $12
million.
D) Allen is indifferent between the two contracts because they are both worth $10.9
million.
7) The value of $100 left in a savings account earning 5% a year, will be worth what
amount after ten years?
A) $150.00
B) $160.50
C) $159.84
D) $162.89
8) Which of the following best expresses the future value of $100 left in a savings
account earning 3.5% for three and a half years?
A) $100(1.035)3.5
B) $100(0.35)3.5
C) $100 × 3.5 × (1.035)
D) $100(1.035)3/2
9) In reading the national business news, you hear that mortgage rates increased by 50
basis points. If mortgage rates were initially at 6.5%, what are they after this increase?
A) 6.55%
B) 7.0%
C) 11.5%
D) 56.5%
10) If a bond has a face value of $1000 and a coupon rate of 4.25%, the bond owner will
receive annual coupon payments of:
A) $425.00
B) $4.25
C) $42.50
D) a value that cannot be determined from the information provided.
11) If a lender wants to earn a real interest rate of 3% and expects inflation to be 3%,
he/she should charge a nominal interest rate that:
A) is at least 7%.
B) is anything above 0%.
C) equals the real rate desired plus expected inflation.
D) equals the real rate desired less expected inflation.
12) The price of a coupon bond will increase as the:
A) face value decreases.
B) yield increases.
C) coupon payments increase.
D) term to maturity is shorter.
13) An individual who is risk-averse:
A) never takes risks.
B) accepts risk but only when the expected return is very small.
C) requires larger compensation when the risk increases.
D) will accept a lower return as risk rises.
14) The variance of a portfolio of assets:
A) decreases as the number of assets increases.
B) increases as the number of assets increase.
C) approaches 0 as the number of assets decreases.
D) approaches 1 as the number of assets increases.
15) If an investment offered an expected payoff of $100 with $0 variance, you would
know that:
A) half of the time the payoff is $100 and the other half it is $0.
B) the payoff is always $100.
C) half of the time the payoff is $200 and the other half it is $0.
D) half of the time the payoff is $200 and the other half it is $50.
16) Systematic risk:
A) is the risk eliminated through diversification.
B) represents the risk affecting a specific company.
C) cannot be eliminated through diversification.
D) is another name for risk unique to an individual asset.
17) Unique risk is another name for:
A) market risk.
B) systematic risk.
C) the risk premium.
D) idiosyncratic risk.
18) The risk premium for an investment:
A) is negative for U.S. treasury securities.
B) is a fixed amount added to the risk-free return, regardless of the level of risk.
C) increases with risk.
D) is zero (0) for risk-averse investors.
19) A $600 investment has the following payoff frequency: a quarter of the time it will
be $0; three quarters of the time it will pay off $1000. Its standard deviation and value at
risk respectively are:
A) $750; $600
B) $433; $600
C) $0; $1000
D) $433; $1000
20) The standard deviation is generally more useful than the variance because:
A) it is easier to calculate.
B) variance is a measure of risk, where standard deviation is a measure of return.
C) standard deviation is calculated in the same units as payoffs and variance isn't.
D) it can measure unquantifiable risk.
21) An investor puts $2,000 into an investment that will pay $2,500 one-fourth of the
time; $2,000 one-half of the time, and $1,750 the rest of the time. What is the investor's
expected return?
A) 12.5%
B) $250.00
C) 6.25%
D) 3.125%
22) If a one-year zero-coupon bond has a face value of $100, is purchased for $94, and
is held to maturity the:
A) holding period return will exceed the yield to maturity.
B) yield to maturity will exceed the holding period return.
C) yield to maturity will be 6.38%.
D) holding period return is 6.0%.
23) The holding period return has relevance because:
A) most bonds are held by the original purchaser until maturity.
B) most bonds are held by the original purchaser until they mature.
C) bonds are frequently traded.
D) current yields are not that important to bondholders.
24) The holding period return on a bond:
A) can never be more than the yield to maturity.
B) will equal the yield to maturity if the bond is purchased for face value and sold at a
lower price.
C) will be less than the yield to maturity if the bond is sold for more than face value.
D) will be less than the yield to maturity if the bond is sold for less than face value.
25) A 30-year Treasury bond as a face value of $1,000, price of $1,200 with a $50
coupon payment. Assume the price of this bond decreases to $1,100 over the next year.
The one-year holding period return is equal to:
A) -9.17%.
B) -8.33%.
C) -4.17%.
D) -3.79%.
26) If a bond's purchase price equals the face value the:
A) coupon rate equals the current yield, which is less than the yield to maturity.
B) current yield equals the yield to maturity, which exceeds the coupon rate.
C) coupon rate equals the yield to maturity, which equals the current yield.
D) coupon rate does not equal the current yield, which does not equal the yield to
maturity.
27) A $1,000 face value bond purchased for $965.00, with an annual coupon of $60,
and 20 years to maturity has a:
A) current yield and coupon rate equal to 6.22% and a coupon rate above this.
B) current yield equal to 6.22% and a coupon rate below this.
C) coupon rate equal to 6.00% and a current yield below this.
D) yield to maturity and current yield equal to 6.00%.
28) When the price of a bond is above face value the yield to maturity:
A) is below the coupon rate.
B) will be above the coupon rate.
C) will equal the current yield.
D) will equal the coupon rate.
29) Most home mortgages are good examples of:
A) consols.
B) zero-coupon bonds.
C) coupon bonds.
D) fixed-payment loans.
30) A 10-year Treasury note as a face value of $1,000, price of $1,200, and a 7.5%
coupon rate. Based on this information, we know the:
A) present value is greater than its price.
B) current yield is equal to 8.33%.
C) coupon payment on this bond is equal to $75.
D) coupon payment on this bond is equal to $90.
Short Essay (Each question is worth 2.5 points. Total score: 4*2.5=10)
1) What are the five core principles of Money and Banking? Explain each principle.
#1) Time has value; #2) Risk requires compensation; #3) Information is the basis for
decisions; #4) Markets determine prices and allocate resources; #5) Stability improves
welfare.
2) A lender expects to earn a real interest rate of 4.5% over the next 12 months. She
charges a 9.25% (annual) nominal rate for a 12-month loan. What inflation rate is she
expecting? If the lender is in a 30% marginal tax bracket, the borrower in a 25%
marginal tax bracket, and they both have the same inflation expectations, what are the
real after-tax rates each expects?
The first part she expected an inflation rate of 4.75%. We obtain this answer using the
Fisher equation where i = r + πe. For the second part we need to use a variation of the
Fisher equation. The lender receives an after-tax nominal rate of 6.475% from which
we subtract the inflation rate of 4.75% and the lender expects a real after-tax rate of
1.725%. The borrower expects to pay an after-tax real rate of 2.188%.
3) An individual faces two alternatives for an investment: Asset A has the following
probability return schedule:
Asset B has a certain return of 8.0%. If the individual selects asset A does she violate
the principle of risk aversion? Explain.
Asset A provides an expected return of 8.65%. For the investor the 0.65% premium
may be a large enough differential to compensate for the additional risk, so she may still
be "risk averse".
4) Calculate the holding period return for a $1,000 face value bond with a $60 annual
coupon purchased for $970.00 and sold three years later for $1,060.00.
9.02%. Here we have to consider the present value of the three coupon payments as
well as the present value of the capital gain that results from purchasing the bond for
$970 and selling it for $1,060.
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