eTOPIC 1: OVERVIEW OF FINANCIAL SYSTEMSf

TEST 1

SECTION1: Match the terms with suitable explanations

Terms Explanations
1. Interest rate a. Financial institutions that accept deposits and make loans
2. Risk sharing b. A financial market in which longer-term debt and equity
instruments are traded
3. Stock c. A debt security that promises to make payments periodically for
a specified period of time.
4. Lender-savers d. The market in which exchange rates are determined.
5. Bond e. Institutions (such as banks, insurance companies, mutual funds,
pension funds, and finance companies) that borrow funds from
people who have saved and then make loans to others.
6. Financial intermediation f. The process of indirect finance whereby financial intermediaries
link lender-savers and borrower-spenders.
7. Primary market g. Markets in which funds are transferred from people who have a
surplus of available funds to people who have a shortage of
available funds.
8. Banks h. The cost of borrowing or the price paid for the rental of funds
9. Secondary market i. A financial market in which new issues of a security are sold to
initial buyers.
10. Money markets j. A secondary market in which dealers at different locations who
have an inventory of securities stand ready to buy and sell
securities to anyone who comes to them and is willing to accept
their prices.
11. Borrower-spenders k. The process by which financial intermediaries create and sell
assets with risk characteristics that people are comfortable with
and then use the funds they acquire by selling these assets to
purchase other assets that may have far more risk.
12. Foreign exchange market l. A financial market in which securities that have previously been
issued can be resold.
m. A claim on the borrower’s future income that is sold by the
13. Capital market borrower to the lender.
14. Financial markets n. A security that is a claim on the earnings and assets of a
corporation
15. Financial instrument o. Financial markets where only short-term debt instruments are
traded.
16. Over-the-counter market p. Non-profit institutions mutually organized and owned by their
members (depositors). Their primary objective is to satisfy the
depository and lending needs of their members, who have to
belong to a particular group
17. Credit unions q. The units who have saved can lend funds.
18. Wholesale market r. The units with a shortage of funds must borrow funds to finance
their spending

19. Risk s. Market where extremely large transactions occur, as for money
market funds or foreign currency
20. Financial intermediaries t. The degree of uncertainty associated with the return on an asset

SECTION 2: Fill in the gaps using the words below

funds payment structural secondary adjust

insurance functions mechanisms entities debt
organized exchanges primary equity theft or fire capital
depository over-the-counter transfer money parameters
contractual savings investment

2.1. The main (1)______________ of financial systems are to:

• provide the (2) ______________ by which funds can be transferred from units in surplus to units with a
shortage of (3) ______________ in order to directly or indirectly facilitate lending and borrowing
• enable wealth holders to (4) ______________ the composition of their portfolios
• provide (5) ______________ mechanisms, e.g. cheques, debit cards and credit cards
• provide mechanisms for risk (6) ______________, e.g. insurance contracts allow a party such as a firm or
household to transfer the risk of loss of wealth due to (7) ______________ to another party such as an (8)
______________ company.

2.2. From a (9) ______________ point of view a financial system can be seen in terms of the (10)
______________ that compose the system. A financial system comprises financial markets, securities and
financial intermediaries.
- Financial markets can be classified on the basis of several (11) ______________: the nature of the
financial securities traded ((12) ______________ versus (13) ______________ markets), forms of
organization ((14) ______________ versus (15) ______________ markets), maturity of the
financial instruments traded ((16) ______________ markets versus (17) ______________
markets).
- Financial securities traded in financial markets are (18) ______________ instruments (bonds, notes
and bills), and (19) ______________ instruments (common and preferred stocks).
- Financial intermediaries comprise (20) ______________ institutions (commercial banks, savings
and loan associations and credit unions), (21) ______________ institutions (insurance companies
and pension funds), and (22) ______________ intermediaries (mutual funds, finance companies,
investment banks and securities firms).
SECTION 3: Read & answer

According to the text, are the following statements true or false?

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SECTION 4: Write a paragraph to describe the figure below.

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eTOPIC 2: COMPARATIVE FINANCIAL SYSTEMSf

TEST 2

SECTION1: Match the terms with suitable explanations

Terms Explanations
1. Asymmetric information a. Wealth, either financial or physical, that is employed to produce
more wealth.
2. Bank failure b. The process of opening up to flows of capital and financial firms
from other nations.
3. Financial panic c. Claims to share in the net income and assets of a corporation
4. Bubble d. The problem that occurs when people who do not pay for
information take advantage of the information that other people
e. have paid for.
5. Capital f. The widespread collapse of financial markets and intermediaries in
an economy
6. Equities g. The inequality of knowledge that each party to a transaction has
about the other party.
7. Financial crisis h. A situation in which a bank cannot satisfy its obligation to pay its
depositors and other creditors and so goes out of business.
8. Financial globalization i. The relative ease and speed with which an asset can be converted
into cash
9. Free-rider problem j. A major disruption in financial markets, characterized by sharp
declines in asset prices and the failures of many financial and
nonfinancial firms.
10. Liquidity k. A situation in which the price of an asset differs from its
fundamental market value.

SECTION 2: Fill in the gaps using the words below

costs intermediate extremes alternatives

higher lower market-based bank-based
information asymmetry allocation Financial systems
1. (1)________, i.e. financial intermediaries and financial markets, are important for economic growth.
They can lead to a more efficient (2)________ of resources because they reduce the (3)________ of
moving funds between borrowers and lenders, and help overcome an (4)________ between borrowers
and lenders. If they do not function well the economy can not operate efficiently and economic growth
will be negatively affected.

2. Financial markets and intermediaries are (5)________ that perform more or less the same functions but
in different ways. Broadly speaking, financial markets provide (6)________ cost arms length debt or
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equity finance to a smaller group of firms able to obtain such finance, while financial intermediaries
offer finance with a (7)________ cost reflecting the expense of uncovering information and ongoing
monitoring.

3. Financial systems fall in between the two (8)________. The UK and the USA are examples of
(9)________ financial systems, where markets are more important than banks; while Japan and
Germany are examples of (10)________ financial systems, where the opposite situation occurs. Several
other financial systems are (11)________ cases, where both markets and banks are important like
France, Italy and Spain.

SECTION 3: Write B for bank-based systems, M for market-based systems in the gaps below

The two types of financial systems have different implications for:

• Households’ asset allocation: in the (1)________, equity is a much more important component of
household assets than in the (2)________ ; the reverse is true for cash, cash equivalents and bonds.
• The role of indirect intermediation (pension funds, insurance companies, mutual funds): individuals’
indirect investments through intermediaries are dominant in the (3)________, whereas individuals’ direct
participation to the stock market is high in the (4)________, especially the USA.
• Firms’ financing: in the (5)________ , loans from financial intermediaries are more important for corporate
finance than marketable securities, but at a lesser extent than in the (6)________.

SECTION 4: Put P next to the four main factors have caused financial crises
1. _____Global warming
2. _____Trafficking
3. _____Money laundering
4. _____An increase in interest rates
5. _____An increase in uncertainty
6. _____An increase in oil price
7. _____Technology innovation
8. _____Unemployment
9. _____Problems in the banking sector
10. _____Civil war
11. _____Stock market decline

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e TOPIC 3: ROLES OF FINANCIAL INTERMEDIARIESf

SECTION 1 - Match the terms with the explanations

Terms Explanations
1 Financial intermediaries A The problem occurs when people do not pay for
information that others have to pay for.
2 Differences in preferences B A moral hazard problem that occurs when the
of lenders and borrowers managers in control act in their own interest rather
than in the interest of the owners due to differing set
of incentives.
3 Asset transformation C The inequality of knowledge that each party to a
transaction has about the other party.
4 Transaction costs D The time and money spent trying to exchange
financial assets, goods, or services.
5 Asymmetric information E Institutions that borrow funds from people who have
saved and then make loans to others

6 Adverse selection F The risk that one party to a transaction will engage
in behavior that is undesirable from the other party’s
point of view.
7 Moral hazard G Savings that can be achieved through increased size.
8 Free-rider problem H The conflicting requirements of lenders (needs for a
high degree of liquidity in their asset holdings) and
borrowers (needs for permanent or long-term
capital).
9 Principle-agent problem I The problem created by asymmetric information
before a transaction occurs: the people who are the
most undesirable from the other party’s point of
view are the ones who are most likely to want to
engage in the financial transaction.
10 Economies of scale K The process by which the financial intermediaries
turn risky assets into sales assets for investors.
11 Economies of scope L Increased business that cab e achieved by offering
many products in one easy-to-reach location.

SECTION 2 – Match the solutions with their problems. Some solutions are used more than once.

Differences in Transaction Liquidity needs Asymmetric information

preferences of costs Adverse Moral hazard
lenders and selection
borrowers Equity Debt
markets markets
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1. Screening loan applications 2. Economies of scale

3. Liquidity insurance 4. Diversifying risk
5. Debt contracts 6. Private production and sale of information
7. Expertise 8. Financial intermediaries
9. Economies of scope 10. Monitoring and enforcement of restrictive covenants
11. Government regulation 12. Pooling risks
13. Monitoring 14. Making debt contracts incentive-compatible

SECTION 3 – Choose the best answers for the questions below

1. The presence of transaction costs in financial markets explains, in part, why

(a) financial intermediaries and indirect finance play such an important role in financial markets.
(b) equity and bond financing play such an important role in financial markets.
(c)corporations get more funds through equity financing than they get from financial intermediaries.
(d) direct financing is more important than indirect financing as a source of funds.

2. Financial intermediaries can substantially reduce transaction costs per dollar of transactions because
their large size allows them to take advantage of
(a) poorly informed consumers.
(b) standardization.
(c) economies of scale.
(d) their market power.

3. Through risk-sharing activities, a financial intermediary _________ its own risk and _________ the
risks of its customers.
(a) reduces; increases
(b) increases; reduces
(c) reduces; reduces
(d) increases; increases

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4. The presence of _________ in financial markets leads to adverse selection and moral hazard problems
that interfere with the efficient functioning of financial markets.
(a) noncollateralized risk
(b) free-riding
(c) asymmetric information
(d) costly state verification

5. When the lender and the borrower have different amounts of information regarding a transaction,
_________ is said to exist.
(a) asymmetric information
(b) adverse selection
(c) moral hazard
(d) fraud

6. When the potential borrowers who are the most likely to default are the ones most actively seeking a
loan, _________ is said to exist.
(a) asymmetric information
(b) adverse selection
(c) moral hazard
(d) fraud

7. When the borrower engages in activities that make it less likely that the loan will be repaid, _________
is said to exist.
(a) asymmetric information
(b) adverse selection
(c) moral hazard
(d) fraud

8. The concept of adverse selection helps to explain

(a) which firms are more likely to obtain funds from banks and other financial intermediaries, rather than
from the securities markets.
(b) why indirect finance is more important than direct finance as a source of business finance.
(c) why direct finance is more important than indirect finance as a source of business finance.
(d) only (a) and (b) of the above.
(e) only (a) and (c) of the above.

9. Adverse selection is a problem associated with equity and debt contracts arising from
(a) the lender’s relative lack of information about the borrower’s potential returns and risks of his investment
activities.
(b) the lender’s inability to legally require sufficient collateral to cover a 100 percent loss if the borrower
defaults.
(c) the borrower’s lack of incentive to seek a loan for highly risky investments.
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(d) none of the above.

10. When the least desirable credit risks are the ones most likely to seek loans, lenders are subject to the
(a) moral hazard problem.
(b) adverse selection problem.
(c) shirking problem.
(d) free-rider problem.
(e) principal-agent problem.

11. Financial institutions expect that

(a) moral hazard will occur, as the least desirable credit risks will be the ones most likely to seek out loans.
(b) opportunistic behavior will occur, as the least desirable credit risks will be the ones most likely to seek
out loans.
(c) borrowers will commit moral hazard by taking on too much risk, and this is what drives financial
institutions to take steps to limit moral hazard.
(d) none of the above will occur.

12. Successful financial intermediaries have higher earnings on their investments because they are better
equipped than individuals to screen out good from bad risks, thereby reducing losses due to
(a) moral hazard.
(b) adverse selection.
(c) bad luck.
(d) financial panics.

13. In financial markets, lenders typically have inferior information about potential returns and risks
associated with any investment project. This difference in information is called
(a) comparative informational disadvantage.
(b) asymmetric information.
(c) variant information.
(d) caveat venditor.

Homework
Summary
Financial intermediaries

Why – exist

- To solve or reduce………………………………………………………………………………...

………………………………………………………………………………………………………
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………………………………………………………………………………………………………

What – types

- Def: ……………………………………………………………………………………………….

………………………………………………………………………………………………………

- Types: …………………………………………………………………………………………….

………………………………………………………………………………………………………

………………………………………………………………………………………………………

………………………………………………………………………………………………………

………………………………………………………………………………………………………

………………………………………………………………………………………………………

How – solve/reduce (Explain solutions used by financial intermediaries in details)

………………………………………………………………………………………………………

………………………………………………………………………………………………………

………………………………………………………………………………………………………

………………………………………………………………………………………………………

………………………………………………………………………………………………………

………………………………………………………………………………………………………

………………………………………………………………………………………………………

………………………………………………………………………………………………………

………………………………………………………………………………………………………

………………………………………………………………………………………………………

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e TOPIC 4: BANKING AND MANAGEMENT OF FINANCIAL INSTITUTIONSf

SECTION 1 - Match the terms with the explanations

Terms Explanations
1 Asset management A The risk that changes in market interest rates will cause
fluctuations in a bond's price. Also, the risk of suffering
losses as a result of unanticipated changes in market
interest rates.
2 Balance sheet B Trading financial instruments, and the generation of fee
income, Involves trading financial instruments and
generating income that affect bank profits but do not
appear on the bank's balance sheet
3 Credit risk C how a bank handles its loans and other assets
4 Interest-rate risk D Commercial banks uses of funds
5 Liability management E An accounting device used to analyze transactions
6 Liquidity management F Financial risk that an obligation will not be paid and a
loss will result.
7 Off balance sheet G the decision made by a bank to maintain sufficient liquid
activities assets to meet the bank's obligations to depositors.
8 Bank liabilities H Commercial banks sources of funds

9 Bank assets I a record of the financial situation of an institution on a

particular date by listing its assets and the claims against
those assets
10 T-account K type of management where bank relies on its liabilities to
provide liquidity; supplements asset management, but
does not replace it.

SECTION 2 - Multiple Choice Questions

1) All else the same, if a bank has more rate-sensitive liabilities than assets, then a(n) _____ in interest
rates will _____ bank profits.
A) increase; increase B) increase; reduce
C) decline; reduce D) decline; not affect

2) Which of the following are primary concerns of the bank manager?

A) maintaining sufficient reserves to minimize the cost to the bank of deposit outflows
B) extending loans to borrowers who will pay high interest rates, but who are also good credit risks
C) acquiring funds at a relatively low cost, so that profitable lending opportunities can be realized
D) all of the above

3) Duration analysis involves comparing the average duration of the bank's _____ to the average
duration of its _____.
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A) securities portfolio; non-deposit liabilities
B) loan portfolio; non-deposit liabilities
C) loan portfolio; deposit liabilities
D) assets; liabilities

4) Examples of off-balance-sheet activities include

A) loan sales.
B) foreign exchange market transactions.
C) trading in financial futures.
D) all of the above.

5) Which of the following statements are true?

A) A bank’s assets are its sources of funds.
B) A bank’s liabilities are its uses of funds..
C) A bank’s balance sheet shows that total assets equal total liabilities plus equity capital.
D) all of the above.

6) Which of the following statements is true?

A) A bank’s assets are its uses of funds.
B) A bank’s assets are its sources of funds.
C) A bank’s liabilities are its uses of funds.
D) Only (B) and (C) of the above are true.

7) Which of the following are reported as liabilities on a bank’s balance sheet?

A) Reserves
B) Checkable deposits
C) Loans
D) Deposits with other banks

8) The most important category of assets on a bank’s balance sheet is

A) discount loans.
B) securities.
C) loans.
D) cash items in the process of collection.
9) Banks earn profits by selling ______ with attractive combinations of liquidity, risk, and return, and
using the proceeds to buy _____ with a different set of characteristics.
A) loans; deposits.
B) securities; deposits.
C) liabilities; assets.
D) assets; liabilities.

10) In general, banks make profits by selling _____ liabilities and buying _____ assets.
A) long-term; shorter-term.
B) short-term; longer-term.
C) illiquid; liquid.
D) risky; risk-free.

11) The following tools help solve ADVERSE SELECTION PROBLEMS in financial markets:
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A) private production and sale of credit ratings for individuals and firms
B) government regulation to increase information to investors
C) use of financial intermediaries that specialize in the gathering of information about would-be
borrowers
D) inclusion of collateral requirements in loan contracts as a quality signal
E) all of the above

12) Which of the following is NOT a tool used by corporations to reduce PRINCIPAL-AGENT
PROBLEMS
A) Stockholders engage in costly state verification by auditing an observing management.
B) Venture capital firms provide funds to new firms in exahcnge for equity and membership
on the board of directors.
C) Firms issue equity instead of debt because principal-agent problems are smaller with
equity.
D) Governments regulate firms by imposing standard accounting principles and punishing
fraud

13) PRINCIPAL-AGENT PROBLEMS are said to occur in financial markets when

A) ownership of assets is separated from the control of these assets.
B) people who do not pay for information take advantage of the information that other people have
paid for by observing their behavior.
C) high-risk borrowers are successfully able to pass themselves off as low-risk borrowers when
applying for loans.
D) the cost per dollar loaned declines as the size of the loan increases.

14) Most U.S. FINANCIAL CRISES have begun with one or more of the following “trigger
events”:
A) a rise in interest rates.
B) a decline in the stock market.
C) a deterioration in banks’ balance sheets.
D) an increase in uncertainty resulting, for example, from a failure of a prominent financial or
nonfinancial institution.
E) all of the above

15) Some of the key reasons why banks and other financial intermediaries are able to reduce or
eliminate information problems and transaction costs include:
A) banks can spread their loan costs over large pools of depositors (lenders).
B) bank loans are typically made in private, which gives bankers a greater incentive to engage in costly
information gathering.
C) banks can include collateral requirements in loan contracts, which can act as a signal regarding the
type of borrower (high or low risk).
D) all of the above.

SECTION 3 – Answer questions (Homework)

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1. Rank the following bank assets from most to least liquid:
a. Commercial loans
b. Securities
c. Reserves
d. Physical capital
2. If the bank you own has no excess reserves and a sound customer comes in asking for a loan, should you
automatically turn the customer down, explaining that you don’t have any excess reserves to loan out? Why
or why not? What options are available for you to provide the funds your customer needs?
3. If you are a banker and expect interest rates to rise in the future, would you want to make short-term or
long-term loans?
4. “Bank managers should always seek the highest return possible on their assets.” Is this statement true,
false, or uncertain? Explain your answer.
5. “Banking has become a more dynamic industry because of more active liability management.” Is this
statement true, false, or uncertain? Explain your answer.

15

e TOPIC 5: RISK MANAGEMENT IN BANKING f

SECTION 1 - Match the terms with the explanations

Terms Explanations
1 Collateral A The decision made by a bank to maintain sufficient liquid
assets to meet the bank’s obligations to depositors.
2 Credit risk B A measurement of the sensitivity of the market value of
a bank’s assets and liabilities to changes in interest rates
3 Credit rationing C The risk arising from the possibility that the borrower
will default.
4 Default D A situation in which the party issuing a debt instrument
is unable to make interest payments or pay off the amount
owed when the instrument matures.
5 Duration E The possible reduction in returns that is associated with
changes in interest rates.
6 Duration gap analysis F The risk that a firm may run out of cash needed to pay
bills and to keep the firm operating.
7 Income gap analysis G The average lifetime of a debt security’s stream of
payments.
8 Interest-rate risk H A measurement of the sensitivity of bank profits to
changes in interest rates, calculated by subtracting the
amount of rate-sensitive liabilities minus rate-sensitive
assets.
9 Liquidity management I Property that is pledged to the lender to guarantee
payment in the event that the borrower should be unable
to make debt payments.
10 Liquidity risk K A lender’s refusing to make loans even though borrowers
are willing to pay the stated interest rate or even a higher
rate or restricting the size of loans to less than the amount
being sought.

SECTION 2 – Match the risks with the banks’ techniques

Credit risk Interest rate risk

11. Screening & Monitoring 15. Collateral

12. Income gap analysis 16. Duration gap analysis
13. Compensating balances 17. Long-term customer relationships

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14. Credit rationing 18. Loan commitments

SECTION 3 – Multiple Choice Questions

19) Banks face the problem of _____ in loan markets because bad credit risks are the ones most likely to
seek bank loans.

A) adverse selection

B) moral hazard

C) moral suasion

D) intentional fraud

20) If borrowers with the most risky investment projects seek bank loans in higher proportion to those
borrowers with the safest investment projects, banks are said to face the problem of

A) adverse credit risk.

B) adverse selection.

C) moral hazard.

D) lemon lenders.

21) Because borrowers, once they have a loan, are more likely to invest in high-risk investment projects,
banks face the

A) adverse selection problem.

B) lemon problem.

C) adverse credit risk problem.

D) moral hazard problem.

22) Banks’ attempts to solve adverse selection and moral hazard problems help explain loan management
principles such as

A) screening and monitoring of loan applicants.

B) collateral and compensating balances.

C) credit rationing.

D) all of the above.

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23) Banks attempt to screen good from bad credit risks to reduce the incidence of loan defaults. To do this,
banks

A) specialize in lending to certain industries or regions.

B) write restrictive covenants into loan contracts.

C) expend resources to acquire accurate credit histories of their potential loan customers.

D) do all of the above.

24) A bank’s commitment (for a specified future period of time) to provide a firm with loans up to a given
amount at an interest rate that is tied to a market interest rate is called

A) credit rationing.

B) a line of credit.

C) continuous dealings.

D) none of the above.

25) Long-term relationships between banks and their customers and lines of credit

A) reduce the costs of information collection.

B) make it easier for banks to screen good from bad risks.

C) enable banks to deal with moral hazard contingencies that are neither anticipated nor specified in
restrictive covenants.

D) do all of the above.

26) Compensating balances

A) are a particular form of collateral commonly required on commercial loans.

B) are a required minimum amount of funds that a borrower (i.e., a firm receiving a loan) must keep in a
checking account at the bank.

C) allow banks to monitor firms’ check payment practices which can yield information about their
borrowers’ financial conditions.

D) all of the above.

27) A bank that wants to monitor the check payment practices of its commercial borrowers, so that moral
hazard can be prevented, will require borrowers to

A) place a bank officer on their board of directors.

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B) place a corporate officer on the bank’s board of directors.

C) keep compensating balances in a checking account at the bank.

D) do all of the above.

28) When a lender refuses to make a loan, although borrowers are willing to pay the stated interest rate or
even a higher rate, the bank is said to engage in

A) coercive bargaining.

B) strategic holding out.

C) credit rationing.

D) collusive behavior.

29) Credit rationing occurs when a bank

A) refuses to make a loan of any amount to a borrower, even when she is willing to pay a higher interest
rate.

B) restricts the size of the loan to less than the borrower would like.

C) does either (A) or (B) of the above.

D) does neither (A) nor (B) of the above.

30) Which of the following are not rate-sensitive assets?

A) Securities with a maturity of less than one year.

B) Variable-rate mortgages.

C) Fixed-rate mortgages.

D) All of the above are rate-sensitive assets.

31) Liabilities that are partially, but not fully, rate-sensitive include

A) checkable deposits.

B) federal funds.

C) non-negotiable CDs.

D) fixed-rate mortgages.

32) If a bank has more rate-sensitive liabilities than assets, then a(n) ______ in interest rates will _____
bank profits.

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A) increase; increase

B) increase; reduce

C) decline; reduce

D) decline; not affect

33) The difference between rate-sensitive liabilities and rate-sensitive assets is known as the

A) duration.

B) interest-sensitivity index.

C) rate-risk index.

D) gap.

34) Measuring the sensitivity of bank profits to changes in interest rates by multiplying the gap times the
change in the interest rate is called

A) basic duration analysis.

B) basic gap analysis.

C) interest-exposure analysis.

D) gap-exposure analysis.

35) Duration gap analysis

A) is a refinement of basic gap analysis that accounts for interest-rate changes over a multiyear period.

B) is a refinement of basic gap analysis that accounts for how long a gap will last.

C) is a complement to basic gap analysis that accounts for the effect of interest rate changes on market
value.

D) is a complement to basic gap analysis that accounts for the influence of partially rate sensitive assets.

36) If a decline in interest rates causes a bank’s market value of net worth to rise, then the bank must have
a

A) negative duration gap.

B) positive duration gap.

C) negative gap.

D) positive gap.

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SECTION 4 – Circle the correct answers

T F 41. A high positive GAP is more risky than a high negative GAP.

T F 42. Developing and maintaining long-term customer relationships help to

reduce banks’costs of screening and monitoring borrowers.

T F 43. Excess reserves may be used to meet liquidity needs.

T F 44. Credit rationing reduces adverse selection problems.

T F 45. Banks need liquidity for both deposit withdrawals and loan demand.

SECTION 5 – Answer the questions (Homework)

46. Explain why the credit risk associated with a loan portfolio is less than the sum of the credit risk
associated with each of the loans in the portfolio.

47. It is said that bankers are in the business of managing risk. Explain.

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e TOPIC 6: FINANCIAL MARKETS f

SECTION 1 - Match the terms with the explanations

Terms Explanations
1 Appreciation A The immediate exchange of bank deposits denominated
in different currencies.
2 Asset-backed B The interest rate charged on short-term funds bought or
commercial paper sold between large international banks.
3 Bearer instrument C Increase in a currency’s value
4 Book entry D The principle that if two or more countries produce an
identical good, the price of this good should be the same
no matter which country produces it.
5 Capital mobility E Competing in an auction against other potential buyers of
Treasury securities.
6 Competitive bidding F Restrictions on the quantity of foreign goods that can be
imported
7 Depreciation G A market in which securities can be bought and sold
quickly and with low transaction costs.
8 Discounting H The theory that exchange rates between any two
currencies will adjust to reflect changes in the price levels
of the two countries.
9 Deep market I The price of one currency in terms of another.
10 Liquid market K A situation in which foreigners can easily purchase a
country’s assets and the country’s residents can easily
purchase foreign assets.
11 LIBOR - London L Taxes on imported goods.
interbank offer rate
12 Exchange rate M Decrease in a currency’s value.
14 Forward transactions N Shortterm commercial paper secured by a bundle of
assets, usually mortgages
15 Foreign exchange O System of tracking securities ownership where no
market certificate is issued. Instead, the security issuer keeps
records, usually electronically, of who holds outstanding
securities.
16 Law of one price P Reduction in the value of a security at purchase such that
when it matures at full value, the investor receives a fair
return.
17 Tariffs Q An exchange rate transaction that involves the exchange
of bank deposits denominated in different currencies at
some specified future date.
18 Theory of purchasing R Markets where there are many participants and a great
power parity deal of activity, thus ensuring that securities can be
(PPP) rapidly sold at fair prices.
19 Quotas S The market in which exchange rates are determined.

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20 Spot transactions T A security payable to the holder when presented. No

proof of ownership is required.

SECTION 2 – Fill in the gaps

denominated currencies forecasts productivity traders

Eurodollars money market price levels low decisions
managers price needed maturity cost
high banker’s treasury bill negotiable commercial
acceptances returns certificates of paper
deposit

- (1)____________ securities are short-term instruments with an original (2)____________ of less than one
year. These securities include Treasury bills, (3)____________, federal funds, repurchase agreements,
negotiable certificates of deposit, banker’s acceptances, and (4)____________.
- Money market securities are used to “warehouse” funds until (5)____________. The returns earned on
these investments are low due to their (6)____________ risk and (7)____________ liquidity.
- (8)____________ are the lowest because they are virtually devoid of default risk. (9)____________ and
(10)____________ are next lowest because they are backed by the creditworthiness of large money center
banks.
- Foreign exchange rates are important because they affect the (11)____________ of domestically produced
goods sold abroad and the (12)____________ of foreign goods bought domestically.
- The theory of purchasing power parity suggests that long-run changes in the exchange rate between two
countries’ (13)____________ are determined by changes in the relative (14)____________ in the two
countries. Other factors that affect exchange rates in the long run are tariffs and quotas, import demand,
export demand, and (15)____________.
- (16)____________ of foreign exchange rates are very valuable to (17)____________ of financial
institutions because these rates influence (18)____________ about which assets (19)____________ in
foreign currencies the institutions should hold and what kinds of trades should be made by their
(20)____________ in the foreign exchange market.

SECTION 3 – Multiple Choice Questions

1) A financial market in which only short-term debt instruments are traded is called the ________ market.
A) bond
B) money
C) capital
D) stock

2) Because these securities are more liquid and generally have smaller price fluctuations, corporations and
banks use the ________ securities to earn interest on temporary surplus funds.
A) money market

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B) capital market
C) bond market
D) stock market

3) Prices of money market instruments undergo the least price fluctuations because of
A) the short terms to maturity for the securities.
B) the heavy regulations in the industry.
C) the price ceiling imposed by government regulators.
D) the lack of competition in the market.

4) U.S. Treasury bills pay no interest but are sold at a ________. That is, you will pay a lower purchase
price than the amount you receive at maturity.
A) premium
B) collateral
C) default
D) discount

5) A debt instrument sold by a bank to its depositors that pays annual interest of a given amount and at
maturity pays back the original purchase price is called
A) commercial paper.
B) a negotiable certificate of deposit.
C) a municipal bond.
D) federal funds.

6) A short-term debt instrument issued by well-known corporations is called

A) commercial paper.
B) corporate bonds.
C) municipal bonds.
D) commercial mortgages.

7) Federal funds are

A) funds raised by the federal government in the bond market.
B) loans made by the Federal Reserve System to banks.
C) loans made by banks to the Federal Reserve System.
D) loans made by banks to each other.

8) The British Banker's Association average of interbank rates for dollar deposits in the London market is
called the
A) Libor rate.
B) federal funds rate.
C) prime rate.
D) Treasury Bill rate.

9) Which of the following instruments are traded in a money market?

A) State and local government bonds
B) U.S. Treasury bills
C) Corporate bonds
D) U.S. government agency securities
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10) Which of the following instruments is not traded in a money market?

A) Residential mortgages
B) U.S. Treasury Bills
C) Negotiable bank certificates of deposit
D) Commercial paper

SECTION 4 – Answer the questions (Homework)

1. When the euro appreciates, are you more likely to drink California or French wine?

2. If the Indian government unexpectedly announces that it will be imposing higher tariffs on foreign
goods one year from now, what will happen to the value of the Indian rupee today?

3. “A country is always worse off when its currency is weak (falls in value).” Is this statement true, false,
or uncertain? Explain your answer.

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e TOPIC 7: FINANCIAL MARKETS f

SECTION 1 - Match the terms with the explanations

Terms Explanations
1 ask price A Stock on which a fixed dividend must be paid before
common dividends are distributed. It often does not
mature and usually does not give the holder voting rights
in the company.
2 bid price B Fund created by a provision in many bond contracts that
requires the issuer to set aside each year a portion of the
final maturity payment so that investors can be certain
that the funds will be available at maturity.
3 coupon rate C Securities that have their periodic interest payments
separated from the final maturity payment and the two
cash flows are sold to different investors.
4 credit default swap D A measure of how much the market is willing to pay for
(CDS) $1 of earnings from a firm.
5 current yield E The price market makers pay for the stocks.
6 discount F A transaction in which one party who wants to hedge
credit risk pays a fixed payment on a regular basis, in
return for a contingent payment that is triggered by a
credit event
7 interest-rate risk G The price market makers sell the stock for.
8 junk bonds H Periodic payments made by equities to shareholders
9 premium I Bonds for which the source of income that is used to pay
the interest and to retire the bonds is from a specific
source, such as a toll road or an electric plant.
10 registered bonds K Bonds requiring that their owners register with the
company to receive interest payments.
11 revenue bonds L An approximation of the yield to maturity that equals the
yearly coupon payment divided by the price of a coupon
bond.
12 dividends M The possible reduction in returns that is associated with
changes in interest rates.
13 Separate Trading of N The dollar amount of the yearly coupon payment
Registered Interest and expressed as a percentage of the face value of a coupon
Principal Securities bond.
(STRIPS)
14 NASDAQ O Bonds that are secured by the full faith and credit of the
issuer, which includes the taxing authority of
municipalities.
15 preferred stock P The amount paid for an option contract.
16 price earnings ratio Q Bonds rated lower than BBB by bond rating agencies.

17 sinking fund R A security that gives the holder an ownership interest in

the issuing firm. This ownership interest includes the
26


right to any residual cash flows and the right to vote on

major corporate issues.
18 general obligation S When the bond sells for less than the par value.
bonds
19 common stock T A computerized network that links dealers around the
country together and provides price quotes on over-the-
counter securities.

SECTION 2 – Fill in the gaps

long-term loans Corporations and the cash flows coupon rate only corporations
governments

the price pension the issuing firm mutual funds interest payments

maturity the dividends multiply price earnings ratio

1. The capital markets exist to provide financing for long-term capital assets. Households, often through
investments in (1) ___________ and (2)___________, are net investors in the capital markets.
2. The three main capital market instruments are bonds, stocks, and mortgages. Bonds represent borrowing
by (3)___________. Stock represents ownership in the issuing firm. Mortgages are (4)___________ secured
by real property. (5)___________ can issue stock. (6)___________ can issue bonds. In any given year, far
more funds are raised with bonds than with stock.
3. We compute the value of bonds by finding the present value of (7)___________, which consist of periodic
interest payments and a final principal payment.
4. The value of bonds fluctuates with current market prices. If a bond has an interest payment based on a
5% (8)___________, no investor will buy it at face value if new bonds are available for the same price with
(9)___________ based on 8% coupon interest. To sell the bond, the holder will have to discount
(10)___________ until the yield to the holder equals 8%. The amount of the discount is greater the longer
the term to (11) ___________.
5. Stocks are valued as the present value of (12)___________.
6. An alternative method for estimating a stock price is to (13)___________ the firm’s earnings per share
times the industry (14)___________.

SECTION 3 – Multiple Choice Questions

1. The bond markets are important because

A) they are easily the most widely followed financial markets in the United States.

B) they are the markets where interest rates are determined.

C) they are the markets where foreign exchange rates are determined.

27

D) all of the above.

2. When the price of bonds EXCEEDS the bond market equilibrium price level, then there is an bonds and
the price of bonds can be expected to .

A. excess demand for; rise

B. excess demand for; fall

C. excess supply of; fall

D. excess supply of; rise

3. (I) Debt markets are often referred to generically as the bond market.

(II) A bond is a security that is a claim on the earnings and assets of a corporation.

A) (I) is true, (II) false.

B) (I) is false, (II) true.

C) Both are true.

D) Both are false

4. (I) A bond is a debt security that promises to make payments periodically for a specified period of time.

(II) A stock is a security that is a claim on the earnings and assets of a corporation.

A) (I) is true, (II) false.

B) (I) is false, (II) true.

C) Both are true.

D) Both are false.

5. A declining stock market index due to lower share prices

A) reduces people's wealth and as a result may reduce their willingness to spend.

B) increases people's wealth and as a result may increase their willingness to spend.

C) decreases the amount of funds that business firms can raise by selling newly issued stock.

D) both A and C of the above.

6. Changes in stock prices

A) affect people's wealth and their willingness to spend.

28

B) affect firms' decisions to sell stock to finance investment spending.

C) are characterized by considerable fluctuations.

D) all of the above.

7. A stockholderʹs ownership of a companyʹs stock gives her the right to

A) vote and be the primary claimant of all cash flows.

B) vote and be the residual claimant of all cash flows.

C) manage and assume responsibility for all liabilities.

D) vote and assume responsibility for all liabilities.

8. Periodic payments of net earnings to shareholders are known as

A) capital gains.

B) dividends.

C) profits.

D) interest.

9. A stockʹs price will fall if there is

A) a decrease in perceived risk.

B) an increase in the required rate of return.

C) an increase in the future sales price.

D) current dividends are high.

10. A monetary expansion ________ stock prices due to a decrease in the ________ and an increase in the
________, everything else held constant.

A) reduces; future sales price; expected rate of return

B) reduces; current dividend; expected rate of return

C) increases; required rate of return; future sales price

D) increases; required rate of return; dividend growth rate

11. Dishonest corporate accounting procedures caused stock prices to

A) increase due to higher expected dividend growth and higher future sales price.

29

B) decrease due to lower expected dividend growth and lower required return.

C) decrease due to lower expected dividend growth and higher required return.

D) increase due to higher expected dividend growth and lower required return.

12. The price of one country's currency in terms of another's is called

A) the foreign exchange rate.

B) the interest rate.

C) the Dow Jones industrial average.

D) none of the above.

13. Bonds that are sold in a foreign country and are denominated in that country's currency are known as

A) foreign bonds.

B) Eurobonds.

C) Eurocurrencies.

D) Eurodollars.

14. Bonds that are sold in a foreign country and are denominated in a currency other than that of the
country in which they are sold are known as

A) foreign bonds.

B) Eurobonds.

C) Eurocurrencies.

D) Eurodollars.

SECTION 4 – Answer the questions (Homework): Explain why you would be more or less willing to
buy long-term bonds under the following circumstances: a. Trading in these bonds increases making them
easier to sell; b. Stock prices are expected to decline; c. Broker fees on stocks goes down; d. You expect
interest rates to rise; e. Broker fees on bonds goes down.

30

e TOPIC 8: FINANCIAL INSTRUMENTS f

SECTION 1: CHOOSE THE CORRECT ANSWER

1. A financial instrument is:

A) A type of contract

B) A type of asset

C) A type of liability

D) A type of asset or ability

2. Which of the following statements is true regarding a corporate bond?

A) A corporate callable bond gives the holder the right to exchange it for a specified number of the comp
any's common shares.

B) A corporate debenture is a secured bond.

C) A corporate indenture is a secured bond.

D) A corporate convertible bond gives the holder the right to exchange the bond for a specified number of
the company's common shares.

E) Holders of corporate bonds have voting rights in the company.

3. In the event of the firm's bankruptcy

A) The most shareholders can lose is their original investment in the firm's stock.

B) Common shareholders are the first in line to receive their claims on the firm's assets.

C) Bondholders have claim to what is left from the liquidation of the firm's assets after paying the
shareholders.

D) The claims of preferred shareholders are honored before those of the common shareholders.

E) A and D.

4. Which of the following is true regarding a firm's securities?

A) Common dividends are paid before preferred dividends.

B) Preferred stockholders have voting rights.

C) Preferred dividends are usually cumulative.

D) Preferred dividends are contractual obligations.

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E) Common dividends usually can be paid if preferred dividends have been skipped.

5. Deposits of commercial banks at the Federal Reserve Bank are called __________.

A) Bankers' acceptances

B) Repurchase agreements

C) Time deposits

D) Federal funds

E) Reserve requirements

6. Which of the following is not a characteristic of a money market instrument?

A) Liquidity

B) Marketability

C) Long maturity

D) Liquidity premium

E) C and D

7. Which one of the following is not a money market instrument?

A) A Treasury bill

B) A negotiable certificate of deposit

C) Commercial paper

D) A Treasury bond

E) A Eurodollar account

8. T-bills are financial instruments initially sold by ________ to raise funds.

A) Commercial banks

B) The government

C) State and local governments

D) Agencies of the federal government

E) B and D

9. Commercial paper is a short-term security issued by ________ to raise funds.

32

A) The Federal Reserve Bank

B) Commercial banks

C) Large, well-known companies

D) The New York Stock Exchange

E) State and local governments

10. Which one of the following terms best describes Eurodollars:

A) Dollar-denominated deposits in European banks.

B) Dollar-denominated deposits at branches of foreign banks in the U. S.

C) Dollar-denominated deposits at foreign banks and branches of American banks outside the U. S.

D) Dollar-denominated deposits at American banks in the U. S.

E) Dollars that have been exchanged for European currency.

SECTION 2: DECIDE IF THE FOLLOWING STATEMENTS ARE TRUE (T) OR FALSE (F)

Statements T F
1. All of stockholders have right to vote for directors and on certain issues.
2. Preferred stockholders recieve a fixed dividend that never changes, a share of
preferred stock is as much like a bond as it is like common stock.
3. The primary purpose of a stock market is to regulate the exchange of stocks,
as well as other financial assets.

SECTION 3: ANSWER THE QUESTIONS

1. Distinguish between the share instruments and debt instruments in the financial market. (characteristics,
maturities, the issuers, advantages and disadvantages, etc.)
2. How many types of financial instruments? What are they?

33