FIN 421 - Final Review

Factors that cause the demand curve for bonds to shift to the left include________

• an increase in the inflation rate.

• an increase in the liquidity of stocks.

• a decrease in the volatility of stock prices.

• all of these.

• none of these.

Answer explanation

Determinants of Asset Demand

- Wealth

- Expected Return

- Risk

- Liquidity

An increase in the liquidity of stocks means that the relative liquidity of bonds declines causing the demand curve for bonds to shift to the left.

A decrease in the volatility of stocks means that the relative volatility/risk of bonds rises causing the demand curve for bonds to shift to the left.

In the above figure, one possible explanation for the increase in the interest rate from i1 to i2 is a(n) ________ in ________.

• increase; the expected inflation rate

• decrease; the expected inflation rate

• increase; economic growth

• decrease; economic growth

Answer explanation

The liquidity premium theory of the term structure

• indicates that today's long-term interest rate equals the average of short-term interest rates that people expect to occur over the life of the long-term bond.

• assumes that bonds of different maturities are perfect substitutes.

• suggests that markets for bonds of different maturities are completely separate because people have different preferences.

• does none of these.

Answer explanation

Investors prefer short-term rather than long-term bonds. This implies that investors must be paid positive "liquidity premium," to hold long term bonds.

Of the four theories that explain how interest rates on bonds with different terms to maturity are related, the one that views long-term interest rates as equaling the average of future short-term rates expected to occur over the life of the bond is the

• pure expectations theory.

• segmented markets theory.

• liquidity premium theory.

• None of these.

Answer explanation

A bond with default risk will always have a ________ risk premium, and an increase in its default risk will raise the risk premium.

• positive

• negative

• unpredictable

• minimal

Answer explanation

Since yield curves are usually upward sloping, the ________ indicates that, on average, people tend to prefer holding short-term bonds to long-term bonds.

• (A) market segmentation theory

• (B) expectations theory

• (C) liquidity premium theory

• both A and B of the above

• both A and C of the above

Answer explanation

Liquidity Premium Theory

- Investors prefer short-term rather than long-term bonds

A loose money policy tends to ____ economic growth and ____ the inflation rate.

• stimulate; place downward pressure on

• ​stimulate; place upward pressure on

• ​dampen; place upward pressure on

• ​dampen; place downward pressure on

Answer explanation

Which of the following is NOT an effect of a stimulative monetary policy?

Hint: The spread between the interest rates on bonds with default risk and default-free bonds, both of the same maturity, called the risk premium or the credit risk premium.

• The risk-free rate and the credit risk premium increase.

• A firm's cost of debt decreases.

• A firm's cost of equity decreases.

• Depository institutions experience an increase in their supply of funds.

Answer explanation

When the Fed uses open market operations to sell some of its Treasury securities, there will be

• ​an outward shift in the supply curve of loanable funds.

• ​an inward shift in the supply curve of loanable funds.

• ​no shift in the supply curve of loanable funds.

• ​an outward shift in the demand curve for loanable funds.

Answer explanation

​A purchase of Treasury securities by the Fed leads to a(n) ____ in interest rates and a(n) ____ in the level of business investment.

• increase; decrease

• decrease; decrease

• increase; increase

• ​decrease; increase

Answer explanation

Effects of Restrictive Monetary Policy (Open Market Sale)

- Increasing risk-free interest rate increases corporate cost of financing (decreasing investment)

- As economic growth is slowed, inflationary pressure may be reduced