Deck 15: Financial Markets and Expectations

Question 1

Suppose the current one- year interest rate is 6%, and financial markets expect the one- year interest rate next year to be 7%, and expect the one- year rate to be 8% the year after that. Given this information, the yield to maturity on a three- year bond will be:

A) 22%.
B) 18%.
C) 10%.
D) 7%.
E) 12%.

Answer 1

7%.

Question 2

Equity finance is represented by which of the following?

A) When a firm sells bonds.
B) When a firm borrows money from banks.
C) When a firm draws down retained earnings.
D) When a firm sells shares of stock.
E) When a firm sells off part of its capital stock.

Answer 2

When a firm sells shares of stock.

Question 3

Which of the following represents a form of equity finance?

A) Stock.
B) Bonds.
C) Loans.
D) Both A and C.
E) Both B and C.

Answer 3

Stock.

Question 4

Suppose policy makers, as expected, cut the level of taxes. Which of the following will occur as a result of this expected tax cut?

A) An increase in stock prices.
B) No change in stock prices.
C) Stock prices decrease only if goods prices decrease.
D) A decrease in stock prices.
E) An ambiguous effect on stock prices.

Question 5

Assume that the current one- year rate is 5% and the two- year rate is 9%. Given this information, the one- year rate expected one year from now is:

A) 21%.
B) 13%.
C) 17%.
D) 3%.
E) 7%.

Question 6

Assume that the RBA is expected to respond to any event by keeping the interest rate constant (i.e., equal to its initial level). An unexpected tax cut will cause:

A) stock prices to fall.
B) stock prices to rise.
C) no change in stock prices.
D) an ambiguous effect on stock prices.
E) stock prices to rise only if goods prices rise.

Question 7

Suppose that financial market participants expect short- term rates to decrease in the future. Given this information, we would expect:

A) a downward shifting yield curve.
B) a downward sloping yield curve.
C) an upward sloping yield curve.
D) a horizontal yield curve.
E) an upward shifting yield curve.

Question 8

Suppose the current one- year interest rate is 8%, and financial markets expect the one- year interest rate next year to be 14%. Given this information, the yield to maturity on a two- year bond will be approximately:

A) 5%.
B) 3%.
C) 6%.
D) 11%.
E) 15%.

Question 9

Which of the following variables would not influence the present value price of a share of stock at time t?

A)
B)
C)
D)

E) None of the above.

Question 10

Suppose there is an increase in the short- term interest rate. Given this increase in the current short- term interest rate, which of the following will most likely occur?

A) The long- term interest rate will decrease.
B) The long- term interest rate will increase, but by less than the short- term rate.
C) The long- term interest rate will remain the same.
D) The long- term interest rate will increase by more than the short- term rate.
E) The long- term interest rate will increase by the same amount as the short- term rate.

Question 11

Which of the following represents a stock's fundamental value?

A) The present value of its expected future dividend payments.
B) The price the stock would sell at in the midst of a rational bubble.
C) The product of all future dividend payments multiplied together.
D) The simple sum of its future dividend payments.
E) The price the stock would sell at if the interest rates were zero.

Question 12

Suppose the central bank decreases the money supply as expected. Which of the following will occur as a result of this expected policy decision?

A) Stock prices decrease only if goods prices decrease.
B) A decrease in stock prices.
C) An increase in stock prices.
D) An ambiguous effect on stock prices.
E) No change in stock prices.

Question 13

Assume that the RBA is expected to respond to any event by keeping the interest rate constant (i.e., equal to its initial level). An unexpected tax increase will cause:

A) stock prices to fall.
B) stock prices to rise.
C) no change in stock prices.
D) an ambiguous effect on stock prices.
E) stock prices fall only if goods prices fall.

Question 14

Which of the following statements about indexed bonds is correct?

A) They have a nominal interest rate that rises when the inflation rate rises.
B) They are increasingly used in England to save for retirement.
C) They exist in Australia.
D) All of the above.
E) None of the above.

Question 15

Which of the following does not represent a form of debt finance?

A) Stock.
B) Bonds.
C) Loans.
D) Both A and B.
E) Both B and C.

Question 16

Suppose that financial market participants now expect a future tax cut and that the yield curve is initially upward sloping. Given this information, we would expect which of the following to occur?

A) The yield curve will become vertical.
B) The yield curve will become steeper.
C) The yield curve will become U- shaped.
D) The yield curve will become horizontal.
E) The yield curve will become flatter.

Question 17

Suppose households unexpectedly decrease consumption. Which of the following will occur as a result of this consumer pessimism?

A) No change in stock prices.
B) An increase in stock prices.
C) Stock prices decrease only if goods prices decrease.
D) A decrease in stock prices.
E) An ambiguous effect on stock prices.

Question 18

Suppose policy makers decrease government spending according to expectations. Which of the following will occur as a result of this policy measure?

A) An ambiguous effect on stock prices.
B) A decrease in stock prices.
C) No change in stock prices.
D) An increase in stock prices.
E) Stock prices decrease only if goods prices decrease.

Question 19

Why do investors demand an equity premium to hold stocks?

A) Investors perceive stocks to be more liquid than bonds.
B) Investors perceive stocks to be more risky than bonds.
C) Investors perceive stocks to yield higher returns than bonds.
D) Investors perceive stocks to be more popular than bonds.
E) Investors perceive stocks to be more credible than bonds.

Question 20

Assume that the central bank implements monetary expansion that is fully anticipated by financial markets. This fully anticipated monetary expansion will cause which of the following to occur?

A) Stock prices to fall.
B) Stock prices to rise.
C) Stock prices to fall and the interest rate to rise.
D) Stock prices to remain unchanged.
E) An ambiguous effect on stock prices.

Question 21

Suppose policy makers implement an unexpected monetary contraction. Which of the following will occur as a result?

A) A decrease in stock prices.
B) An increase in stock prices.
C) Stock prices decrease only if goods prices decrease.
D) An ambiguous effect on stock prices.
E) No change in stock prices.

Question 22

A share of stock will pay a dividend of $30 in one year, and will be sold for an expected price of $700 at that time. If the current one- year interest rate is 4.5%, the current price of the stock is approximately equal to:

A) $501.56.
B) $464.56.
C) $545.56.
D) $698.56.
E) $483.56.

Question 23

Assume that policy makers implement fiscal contraction unexpectedly. Further assume that there is no expected monetary policy response to this unexpected fiscal policy. Given this information, we would expect that this will:

A) always cause stock prices to fall.
B) cause no changes in stock prices.
C) tend to cause stock prices to fall if the LM curve is very steep.
D) tend to cause stock prices to fall if the LM curve is very flat.
E) always cause stock prices to rise.

Question 24

Assume that the central bank implements monetary contraction that is not fully anticipated by financial markets. This partially unexpected monetary contraction will cause which of the following to occur?

A) An ambiguous effect on stock prices.
B) Stock prices to rise.
C) Stock prices to remain unchanged.
D) Stock prices fall initially followed by increases.
E) Stock prices to fall.

Question 25

Which of the following describes the attribute of a risk neutral investor?

A) An investor that makes decisions based on the expected return and the degree of risk of assets.
B) An investor that makes decisions based on the credit rating of assets.
C) An investor that makes decisions based on the popularity of assets.
D) An investor that makes decisions based on the advice of financial planners.
E) An investor that makes decisions based on the expected return of assets.

Question 26

The length of time over which a bond promises to make payments to the holder is called which of the following?

A) The term structure of interest rates.
B) Maturity.
C) Yield duration.
D) Face value.
E) Yield to maturity.

Question 27

A "junk bond" is a bond with a:

A) value of zero.
B) very low maturity.
C) low yield to maturity.
D) low face value, but high coupon rate.
E) high default risk.

Question 28

For this question, assume that one- year and two- year bonds have the same risk; therefore, you can ignore risk here. Assume that there is arbitrage between one- year bonds and two- year bonds, we know that the expected rate of return on two- year bonds:

A) will be exactly half the rate of return on one- year bonds.
B) will equal the expected rate of return from holding a one- year bond for two years.
C) will equal the expected rate of return from holding a one- year bond for one year.
D) will be smaller than the expected rate of return from holding a one- year bond for one year.
E) will be larger than the expected rate of return from holding a one- year bond for one year.

Question 29

Suppose that financial market participants now expect a future tax increase in one year. Also assume that the yield curve is initially upward sloping. Given this information, we would expect which of the following to occur?

A) The yield curve will become steeper.
B) The yield curve will become vertical.
C) i2t will increase.
D) i2t will decrease.
E) The yield curve will become horizontal.

Question 30

Which of the following describes the attribute of a risk averse investor?

A) An investor that makes decisions based on the popularity of assets.
B) An investor that makes decisions based on the expected return of assets.
C) An investor that makes decisions based on the advice of financial planners.
D) An investor that makes decisions based on the expected return and the degree of risk of assets.
E) An investor that makes decisions based on the credit rating of assets.

Question 31

Suppose the yield curve is initially horizontal and the current one- year interest rate increases by 2% while the expected future one- year interest rate does not change. This event will tend to cause:

A) i2t to increase by 1%.
B) i2t to increase by less than 1%.
C) i2t to decrease by 2%.
D) i2t to increase by 2%.
E) i2t to decrease by 1%.

Question 32

As the LM curve becomes steeper, an unexpected increase in consumer confidence:

A) is more likely to cause stock prices to rise.
B) is more likely to keep stock prices constant.
C) will cause a relatively small increase in output and relatively small increase in the interest rate.
D) will cause a relatively large increase in output and relatively large increase in the interest rate.
E) is more likely to cause stock prices to fall.

Question 33

As the LM curve becomes flatter, an unexpected increase in consumer confidence:

A) will cause a relatively small increase in output and relatively small increase in the interest rate.
B) is more likely to cause stock prices to fall.
C) is more likely to keep stock prices constant.
D) is more likely to cause stock prices to rise.
E) will cause a relatively large increase in output and relatively large increase in the interest rate.

Question 34

The fundamental value of a share of stock is equal to which of the following?

A) The sum of coupon payments.
B) The present value of expected dividends.
C) The present value of coupon payments.
D) The present value of the expected yield.
E) The sum of expected dividends.

Question 35

Suppose that financial market participants expect that the central bank will pursue a monetary expansion in the future. Also assume that the yield curve is initially upward sloping. Given this information, we would expect which of the following to occur?

A) The yield curve will become steeper.
B) i2t will increase.
C) i2t will decrease.
D) The yield curve will become vertical.
E) The yield curve will become horizontal.

Question 36

Assume that the RBA is expected to respond to any event by keeping output constant (i.e., equal to its initial level). An unexpected increase in taxes will cause:

A) stock prices to fall.
B) stock prices to rise.
C) no change in stock prices.
D) an ambiguous effect on stock prices.
E) stock prices to rise only if goods prices rise.

Question 37

Suppose policy makers implement an unexpected monetary expansion. Which of the following will occur as a result?

A) A decrease in stock prices.
B) An ambiguous effect on stock prices.
C) An increase in stock prices.
D) Stock prices increase only if goods prices increase.
E) No change in stock prices.

Question 38

Suppose households unexpectedly increase consumption. Which of the following will occur as a result of this consumer optimism?

A) An ambiguous effect on stock prices.
B) An increase in stock prices.
C) A decrease in stock prices.
D) Stock prices increase only if goods prices increase.
E) No change in stock prices.

Question 39

Suppose a bond promises to make a single payment at maturity. These types of bond are called:

A) discount bonds.
B) corporate bonds.
C) indexed bonds.
D) junk bonds.
E) government bonds.

Question 40

A bond has a face value of $12,000, a price of $15,000, and coupon payments of $3000 for two years. The coupon rate of this bond is:

A) 15%.
B) 20%.
C) 10%.
D) 25%.
E) 30%.

Question 41

Deviations of prices from their fundamental value in the financial markets are known as:

A) fluctuations in prices.
B) rational speculation.
C) irrational exuberance.
D) bubbles and fads.
E) mispricing of the fundamentals.

Question 42

Among the following, which is the broadest measure of stock prices in Australia?

A) S&P ASX 200 index.
B) FTSE index.
C) Hang Seng index.
D) Dow Jones industrial index.
E) Nikkei index.

Question 43

Assume that the one- year interest rate is on the vertical axis of the IS- LM model and that the yield curve is initially upward sloping. If financial market participants now expect the central bank will pursue a monetary expansion in the future, we would expect which of the following to occur?

A) The yield curve will become vertical.
B) The yield curve will become steeper.
C) The yield curve will become horizontal.
D) The yield curve will become downward sloping.
E) The yield curve will become flatter.

Question 44

Suppose there are two types of bonds (one- year bonds and two- year bonds) and that the yield curve is initially upward sloping in period t. For this question assume that: (1) expected inflation is zero; and (2) the relevant interest rate on the vertical axis of the IS- LM model is the one- year interest rate. Based on our understanding of the IS- LM model, of the yield curve and of financial markets, we know with certainty that an announcement in period t of a partially unexpected future increase in taxes (to be implemented in period t + 1) will have which of the following effects?

A) Stock prices will fall in period t.
B) The yield curve will become steeper in period t.
C) Stock prices will increase in period t.
D) The yield curve will become flatter in period t.
E) Stock prices will not change in period t.

Question 45

Which of the following represents the house price fundamental value?

A) The simple sum of its future rental income.
B) The price a house would sell at if interest rates were zero.
C) The present value of its expected future rental income.
D) The price a house would sell at in the midst of a rational bubble.
E) The product of all future rental income payments multiplied together.

Question 46

Which of the following statements applies to a discount bond?

A) It is a bond offered at a special price for large investors only.
B) It is a bond with no face value.
C) It is a bond with no coupon payments.
D) It is a bond that pays no yield.
E) It is a bond that never matures.

Question 47

Assume that there is perfect arbitrage in the stock market. Given this information, economists believe that:

A) the rate of return on stocks will be equal to the rate of return on bonds.
B) most stocks diverge widely from their fundamental value.
C) movements in stock prices are largely unpredictable.
D) stocks will generally earn a lower rate of return than bonds.
E) movements in stock prices can be easily predicted.

Question 48

An upward- sloping yield curve suggests that financial market participants expect short- term interest rates will:

A) be equal to zero in the future.
B) not change in the future.
C) rise in the future.
D) be unstable in the future.
E) fall in the future.

Question 49

Suppose the central bank, as expected, increases the money supply as the result of a decision for monetary expansion. Which of the following will occur as a result?

A) Stock prices increase only if goods prices increase.
B) A decrease in stock prices.
C) No change in stock prices.
D) An increase in stock prices.
E) An ambiguous effect on stock prices.

Question 50

What are the factors that determine fundamental house prices? Explain the similarities and differences between these two asset prices.

Question 51

Assume policy makers implement fiscal expansion unexpectedly. Further assume that monetary policy is expected to keep interest rates constant in response to this unexpected fiscal policy. Given this information, we would expect that this will cause:

A) stock prices to rise.
B) stock prices to remain constant.
C) stock prices rise initially followed by decreases.
D) stock prices to fall.
E) an ambiguous effect on stock prices.

Question 52

A bond has a face value of $1,200, a price of $1,500, and coupon payments of $300 for two years. The "current yield" of this bond is:

A) 6%.
B) 24%.
C) 12%.
D) 16%.
E) 20%.

Question 53

Which of the following best explains why the long- term interest rate will generally change by less than 1% when the short- term interest changes by 1%?

A) The mathematical calculations are more difficult for analysts in the case of long- term bonds.
B) Financial market participants will not expect this increase in the short- term interest rate to persist fully in the future.
C) Long- term rates are always lower than short- term rates, so there is less room for them to change.
D) Financial markets are often swept up by bubbles and fads.
E) Financial markets assume that the central bank will be passive as interest rates rise or fall.

Question 54

Assume that the RBA is expected to respond to any event by keeping output constant (i.e., equal to its initial level). An unexpected increase in government spending will cause:

A) stock prices to fall.
B) stock prices to rise.
C) no change in stock prices.
D) an ambiguous effect on stock prices.
E) stock prices to fall only if goods prices fall.

Question 55

Suppose a cut in government spending occurs that is at least partially unexpected. Explain what effect this will have on stock prices.

Question 56

Suppose the RBA implements monetary contraction that is at least partially unexpected. Explain what effect this monetary policy move will have on stock prices.

Question 57

Which of the following represents the ratio of coupon payments to the face value of a bond?

A) The interest rate.
B) The discount rate.
C) The coupon rate.
D) The current yield.
E) The risk premium.

Question 58

Suppose the central bank implements monetary expansion in the current period and is not expected to continue this policy in the future. Explain what effect this policy will have on the shape of the yield curve (in terms of a one- year rate and a two- year rate) and stock prices in the current period.

Question 59

Which of the following bonds (of equal maturity) would have the largest risk premium?

A) Australian Treasury bonds.
B) The bonds of a financially stable corporation.
C) Junk bonds.
D) U.S. government bonds.
E) Bonds rated AAA by Moody's.

Question 60

The yield curve indicates that the two- year interest rate will be a function of what variables? Include in your answer an explanation of how changes in these variables will affect the two- year interest rate.

Question 61

When interpreting bond prices as present values, discuss what factors determine the price of a two- year discount bond. Include in your answer an explanation of how changes in each of these factors affect the price of a two- year discount bond.

Question 62

Suppose there is a report that the unemployment rate unexpectedly increased in the previous month. To what extent will the expected central bank response to this news affect how stock prices will respond to this report of a higher than expected unemployment rate? Explain.

Question 63

Explain what is meant by the fundamental value of a share of stock.

Question 64

Suppose the yield curve is upward- sloping. How should one interpret this particular yield curve?

Question 65

Explain what the term structure of interest rates represents.

Question 66

Suppose individuals expect an increase in future taxes. Explain what effect this expected increase in future taxes will have on the yield curve (in terms of a one- year rate and a two- year rate) and on stock prices in the current period.

Question 67

Give two explanations why stock prices might deviate from their fundamental values.