UNIVERSITY OF TORONTO

DEPARTMENT OF ECONOMICS
Money, Banking & Financial Markets
ECO349H5F (LEC0101)
MICHAEL HO
MID-TERM TEST SOLUTIONS
DURATION: 90 MINUTES
OCTOBER 16, 2013

IMPORTANT:

(i) This test should be answered in ballpoint pen and any part done in pencil will not be eligible for
re-assessment.
(ii) You must put all your answers to Part A in the table provided on page 2 or a 10-mark penalty
will be imposed.
(iii) Answer all Part B questions in point form and only in the designated pages. Answer every part
of all the questions and clearly label each part of your answer.
(iv) Please ensure your handwriting is legible.
(v) Only non-programmable calculators are allowed.
(vi) A 10-mark penalty will be imposed if any page is separated from this test.

Student Name (Print Clearly): Student ID#:

Part A Part B
Question A1 A25 B1 B2 Total
Marks 50 30 20 100
(a) 8
(b) 8
50 20
(c) 8 100
(d) 6

Score 50 30 20
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 PART A (50 Marks): Answer all twenty-five multiple-choice questions and write each answer only in
the table below or a 10-mark penalty will be imposed.

Part A Answers
A1 A2 A3 A4 A5 A6 A7 A8 A9 A10

A D D D B C A B B C

A11 A12 A13 A14 A15 A16 A17 A18 A19 A20

C A B B D A B D D A

A21 A22 A23 A24 A25

D A C B D

A1. High interest rates might ________ purchasing a house or car but at the same time high interest
rates might ________ saving.
(A) discourage; encourage
(B) discourage; discourage
(C) encourage; encourage
(D) encourage; discourage

A2. Evidence from business cycle fluctuations in Canada indicates that ________.
(A) a negative relationship between money growth and general economic activity exists
(B) recessions have been preceded by declines in share prices on the stock exchange
(C) recessions have been preceded by dollar depreciation
(D) recessions have been preceded by a decline in the growth rate of money

A3. Well-functioning financial markets ________.

(A) cause inflation
(B) eliminate the need for indirect finance
(C) cause financial crises
(D) produce an efficient allocation of capital

A4. Which of the following can be described as involving indirect finance?

(A) You make a loan to your neighbor.
(B) A corporation buys a share of common stock issued by another corporation in the primary
market.
(C) You buy a Canadian Treasury bill from the Bank of Canada.
(D) You make a deposit at a bank.

A5. An example of the problem of ________ is when a corporation uses the funds raised from selling
bonds to fund corporate expansion to pay for Caribbean cruises for all of its employees and their
families.
(A) adverse selection
(B) moral hazard
(C) risk sharing
(D) credit risk
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 A6. Which of the following is a true statement?
(A) The conversion of a barter economy to one that uses money increases efficiency by increasing
the cost of exchange.
(B) The conversion of a barter economy to one that uses money increases efficiency by increasing
the cost to those who wish to specialize.
(C) The conversion of a barter economy to one that uses money increases efficiency by reducing
transactions costs.
(D) The conversion of a barter economy to one that uses money does not increases efficiency.

A7. When compared to exchange systems that rely on money, disadvantages of the barter system
include ________.
(A) the requirement of a double coincidence of wants
(B) lowering the cost of exchanging goods over time
(C) lowering the cost of exchange to those who would specialize
(D) encouraging specialization and the division of labor

A8. Compared to an electronic payments system, a payments system based on cheques has the major
drawback that ________.
(A) cheques are less costly to process
(B) cheques take longer to process, meaning that it may take several days before the depositor can
get her cash
(C) fraud may be more difficult to commit when paper receipts are eliminated
(D) legal liability is more clearly defined

A9. The difference between money and income is that ________.

(A) money is a flow and income is a stock
(B) money is a stock and income is a flow
(C) there is no differencemoney and income are both stocks
(D) there is no differencemoney and income are both flows

A10. The evolution of the payments system from barter to precious metals, then to fiat money, then to
cheques can best be understood as a consequence of ________.
(A) government regulations designed to improve the efficiency of the payments system
(B) government regulations designed to promote the safety of the payments system
(C) innovations that reduced the costs of exchanging goods and services
(D) competition among firms to make it easier for customers to purchase their products

A11. The components of the M1+ monetary aggregate are chequable deposits plus ________.
(A) currency
(B) currency plus savings deposits
(C) currency outside banks
(D) currency plus money market deposits

A12. Which of the following is true for a coupon bond?

(A) When the coupon bond is priced at its face value, the yield to maturity equals the coupon rate.
(B) The price of a coupon bond and the yield to maturity are positively related.
(C) The yield to maturity is greater than the coupon rate when the bond price is above the par value.
(D) The yield is less than the coupon rate when the bond price is below the par value.

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 A13. The yield to maturity is ________ than the ________ rate when the bond price is ________ its
face value.
(A) greater; coupon; above
(B) greater; coupon; below
(C) greater; perpetuity; above
(D) less; perpetuity; below

A14. Which of the following is generally true of all bonds?

(A) The longer a bond's maturity, the greater is the rate of return that occurs as a result of the
increase in the interest rate.
(B) Even though a bond has a substantial initial interest rate, its return can turn out to be negative if
interest rates rise.
(C) Prices and returns for short-term bonds are more volatile than those for longer term bonds.
(D) A fall in interest rates results in capital losses for bonds whose terms to maturity are longer than
the holding period.

A15. To claim that a lottery winner who is to receive $1 million per year for twenty years has won $20
million ignores the process of ________.
(A) face value
(B) par value
(C) deflation
(D) discounting the future

A16. The yield to maturity for a one-year discount bond equals the increase in price over the year,
divided by the ________.
(A) initial price
(B) face value
(C) interest rate
(D) coupon rate

A17. When real income ________, the demand curve for money shifts to the ________ and the
interest rate ________, everything else held constant.
(A) falls; right; rises
(B) rises; right; rises
(C) falls; left; rises
(D) rises; left; rises

A18. Interest rates increased continuously during the 1970s. The most likely explanation is ________.
(A) banking failures that reduced the money supply
(B) a rise in the level of income
(C) the repeated bouts of recession and expansion
(D) increasing expected rates of inflation

A19. Everything else held constant, if the expected return on ABC stock rises from 5 to 10 percent and
the expected return on CBS stock is unchanged, then the expected return of holding CBS stock
________ relative to ABC stock and the demand for CBS stock ________.
(A) rises; rises
(B) rises; falls
(C) falls; rises
(D) falls; falls

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 A20. In a business cycle expansion, the ________ of bonds increases and the ________ curve shifts to
the ________ as business investments are expected to be more profitable.
(A) supply; supply; right
(B) supply; supply; left
(C) demand; demand; right
(D) demand; demand; left

A21. If the probability of a bond default increases because corporations begin to suffer large losses,
then the default risk on corporate bonds will ________ and the expected return on these bonds
will ________, everything else held constant.
(A) decrease; increase
(B) decrease; decrease
(C) increase; increase
(D) increase; decrease

A22. The spread between interest rates on low quality corporate bonds and Canada bonds ________.
(A) widens significantly during recessions
(B) narrows significantly during recessions
(C) narrows moderately during recessions
(D) does not change during recessions

A23. According to the segmented markets theory of the term structure ________.
(A) the interest rate on long-term bonds will equal an average of short-term interest rates that people
expect to occur over the life of the long-term bonds
(B) buyers of bonds do not prefer bonds of one maturity over another
(C) interest rates on bonds of different maturities do not move together over time
(D) buyers require an additional incentive to hold long-term bonds

A24. According to the liquidity premium theory of the term structure ________.
(A) because buyers of bonds may prefer bonds of one maturity over another, interest rates on bonds
of different maturities do not move together over time
(B) the interest rate on long-term bonds will equal an average of short-term interest rates that people
expect to occur over the life of the long-term bonds plus a term premium
(C) because of the positive term premium, the yield curve will not be observed to be downward
sloping
(D) the interest rate for each maturity bond is determined by supply and demand for that maturity
bond

A25. According to the expectations theory of the term structure ________.

(A) when the yield curve is steeply upward sloping, short-term interest rates are expected to remain
relatively stable in the future
(B) when the yield curve is downward sloping, short-term interest rates are expected to remain
relatively stable in the future
(C) investors have strong preferences for short-term relative to long-term bonds, explaining why
yield curves typically slope upward
(D) yield curves should be equally likely to slope downward as slope upward

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 B1. (a) Suppose an investor is considering whether he should invest $900 in a coupon bond with
2 years to maturity, but his plan is to hold the bond for only one year. One coupon
payment will be received at the end of each year. Use the information in the table below
to calculate the present value of expected profit (expected total discounted cash receipts
minus the amount of investment). Show your calculation or a zero will be given. (8
marks)

Face Value 1,000

Coupon Rate 8%
Current Interest Rate 8% Present Value of Total
Bond Price in Cash Receipts Weighted
New Interest Rate Probability (Discounted Yield)
Year 2 ( ) Outcome
5% 50% 1,028.6 1,026.5 513.2
11% 50% 973.0 975.0 487.5
Expected Total
1,000.7
Discounted Cash Receipts
Current Bond Price ( ) 900
Present Value of
100.7
Expected Profit

B1. (b) Assume there is a second investment alternative, he can purchase $900 worth of stock
that pays a fixed dividend at the end of each year to stock holders forever. Use the
information in the table below to calculate the present value of the expected profit
(expected total discounted cash receipts minus the amount of investment). Show your
calculation or a zero will be given. (8 marks)

Dividend per Year 72

Current Interest Rate 8% Present Value of Total
Stock Price in Cash Receipts Weighted
New Interest Rate Probability (Discounted Yield)
Year 2 ( ) Outcome
5% 50% 1,440.0 1,400.0 700.0
11% 50% 654.5 672.7 336.4
Expected Total
1,036.4
Discounted Cash Receipts
Current Stock Price ( ) 900
Present Value of
136.4
Expected Profit

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 B1. (c) If there is a third investment alternative that the investor can invest $900 in a discount
bond with 2 years to maturity, but his plan is to hold the discount bond for only one year.
Use the information in the table below to calculate the present value of expected profit
(expected total discounted cash receipts minus the amount of investment). Show your
calculation or a zero will be given. (8 marks)

Face Value 1,000

Current Interest Rate 8% Present Value of Total
Bond Price in Cash Receipts Weighted
New Interest Rate Probability (Discounted Yield)
Year 2 ( ) Outcome
5% 50% 952.4 881.8 440.9
11% 50% 900.9 834.2 417.1
Expected Total
858.0
Discounted Cash Receipts
Current Bond Price ( ) 900
Present Value of
-42.0
Expected Profit

B1. (d) Based on the present value of the expected profit of each investment alternative, which
one is the most attractive and which one is the least attractive? Why? Is there any
information that might imply this result? (6 marks)

Investing in the stock is the most attractive investment alternative because it yields the highest present
value of expected profit ($136.4) for the $900 investment. The investment in the discount bond is the
least attractive alternative because it has a present value of expected loss of $42. A discount bond does
not pay coupon payment and the return is determined by the difference between its market price and
face value. When the investor sells this discount bond next year, the expected bond price is $926.65 and
the present value of that is only $858, which results in an expected loss of $42. In other words, the
discounted bond is not discounted enough.

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 B2. Discuss the impacts of expected returns and expected inflation on demand for bonds. (20 marks)

Expected returns on bonds relative to alternative assets - for a one-year discount bond and a one-year
holding period, the expected return and the interest rate are identical, so nothing besides todays interest
rate affects the expected return. For bonds with maturities greater than one year, the expected return
may differ from the interest rate. If people began to think that interest rates will be higher next year than
they had originally anticipated, the expected return today on long-term bonds will fall, and the quantity
demanded will fall at each interest rate. Higher expected interest rates in the future lower the expected
return for long-term bonds, decrease the demand, and shift the demand curve to the left.

Changes in expected return on other assets can also shift the demand curve for bonds. If people
suddenly became more optimistic about the stock market and began to expect higher stock prices in the
future, both expected capital gains and expected returns on stocks would rise. With the expected return
on bonds held constant, the expected return on bonds today relative to stocks would fall, lowering the
demand for bonds and shifting the demand curve to the left (asset substitution).

A change in expected inflation is likely to alter expected returns on physical assets (houses), which
affect the demand for bonds. An increase in expected inflation will lead to higher prices on real assets in
the future and hence higher nominal capital gains. The resulting rise in the expected returns today on
these real assets will lead to a fall in the expected return on bonds (face value fixed regardless of
inflation) relative to the expected return on real assets today and thus cause the demand for bonds to fall.

Alternative, the rise in expected inflation will lower the real interest rate on bonds, and the resulting
decline in the relative expected return on bonds causes the demand for bonds to fall. An increase in the
expected rate of inflation lowers the expected return for bonds, causing their demand to decline and the
demand curve to shift to the left.

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