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Multiple Choice
Questions
1.
Over the past year you
earned a nominal rate of interest of 10 percent
on your money. The inflation rate was
5 percent over the same period.
The
exact actual growth rate of your purchasing power
was
Answer: D Difficulty: Moderate
Rationale: r = (1+R) / (1+I) - 1; % / %
- 1 = %.
A) %.
B) %.
C) %.
D) %.
E) %
2.
A year ago,
you invested $$1,000 in a savings account that pays
an annual
interest
rate
of
7%.
What
is
your
approximate
annual
real
rate
of
return
if the rate of
inflation was 3% over the year
Answer: A
Difficulty: Easy
Rationale: 7% - 3% =
4%.
A) 4%.
B) 10%.
C) 7%.
D) 3%.
E) none of the above.
3.
If
the
annual
real
rate
of
interest
is
5%
and
the
expected
inflation
rate
is
4%, the nominal rate of interest would be
approximately
Answer: B Difficulty: Easy
Rationale: 5% + 4% = 9%.
A) 1%.
B) 9%.
C) 20%.
D) 15%.
E) none
of the above.
4.
You purchased a share of
stock for $$20. One year later you received $$1
as
dividend
and
sold
the
share
for
$$29.
What
was
your
holding
period
return
Answer: B Difficulty:
Moderate
Rationale: ($$1 + $$29 - $$20)/$$20 = , or
50%.
A) 45%
B) 50%
C) 5%
D) 40%
E) none of the above
5.
Which of the following determine(s) the
level of real interest rates
I)
the supply of
savings by households and business
firms
II)
the demand for investment
funds
III)
the government's net supply and/or
demand for funds
Answer: D
Difficulty: Moderate
Rationale:
The
value
of
savings
by
households
is
the
major
supply
of
funds;
the
demand
for
investment
funds
is
a
portion
of
the
total
demand
for
funds;
the government's position can be one of
either net supplier, or net
A) I only
B) II only
C) I and II only
D) I, II, and III
E) none of the above
demander of funds. The above factors
constitute the total supply and
demand
for funds, which determine real interest
rates.
6.
Which of the following
statement(s) is (are)
true
I)
The real rate
of
interest is determined
by the supply and demand
for
funds.
II)
The real rate
of interest is determined by the expected rate of
inflation.
III)
The real
rate of interest can be affected by actions of the
Fed.
IV)
The real rate
of
interest is equal
to the
nominal interest rate
plus
the expected rate of inflation.
Answer: B Difficulty: Moderate
Rationale: The expected rate of
inflation is a determinant of nominal,
not real, interest rates. Real rates
are determined by the supply and
demand
for funds, which can be affected by the
Fed.
7.
Which of the following
statements is
true
A)
Inflation has no effect on the nominal rate of
interest.
B) The realized
nominal rate
of
interest is
always
greater
than the
real
rate of interest.
C) Certificates
of deposit offer a guaranteed real rate of
interest.
A) I and II only.
B) I and III only.
C) III and IV only.
D) II and III only.
E) I, II, III, and IV only
D) None of the above is true.
E) A, B and C
Answer: D Difficulty: Moderate
Rationale:
Expected
inflation
rates
are
a
determinant
of
nominal
interest
rates. The
realized nominal rate of interest would be
negative if the
difference between
actual and anticipated inflation rates exceeded
the
real rate. The realized nominal
rate of interest would be less than the
real rate if the unexpected inflation
were greater than the real rate of
interest.
Certificates
of
deposit
contain
a
real
rate
based
on
an
estimate
of inflation that is not
guaranteed.
8.
Other things equal, an
increase in the government budget deficit
Answer: B Difficulty: Moderate
Rationale: An increase in the
government budget deficit, other things
equal, causes the government to
increase its borrowing, which increases
the demand for funds and drives
interest rates up.
9.
Ceteris
paribus, a decrease in the demand for loanable
funds
A) drives the
interest rate down.
B)
drives the interest rate up.
C) might not have any effect on
interest rate.
D) results
from an increase in business prospects and a
decrease in the
level of savings.
Answer: A Difficulty: Moderate
Rationale:
A
decrease
in
demand,
ceteris
paribus,
always
drives
interest
rates down. An increase in business
prospects would increase the demand
for
funds. The savings level affects the supply of,
not the demand for,
funds.
E) none of the above.
A) drives the interest rate
down.
B) drives the
interest rate up.
C) might
not have any effect on interest rates.
D) increases business prospects.
E) none of the above.
10.
The holding period return (HPR) on a
share of stock is equal to
Answer: B Difficulty:
Moderate
Rationale: The HPR of any investment is
the sum of the capital gain and
the
cash flow over the period, which for common stock
is B.
A) the capital gain
yield during the period, plus the inflation rate.
B) the capital gain yield
during the period, plus the dividend yield.
C) the current yield, plus
the dividend yield.
D) the
dividend yield, plus the risk premium.
E) the change in stock price.
11.
Historical records regarding return on
stocks, Treasury bonds, and
Treasury
bills between 1926 and 2005 show that
Answer: A
Difficulty: Moderate
Rationale: The historical
data show that, as expected, stocks offer a
greater return and greater volatility
than the other investment
alternatives.
Inflation sometimes exceeded the T-bill
return.
12.
If the interest rate
paid by borrowers and the interest rate received
by
savers accurately reflects the
realized rate of inflation:
Answer: D
Difficulty: Moderate
Rationale: If the described
interest rate accurately reflects the rate
of inflation, both borrowers and
lenders are paying and receiving,
respectively, the real rate of
interest; thus, neither group gains.
A) borrowers gain and
savers lose.
B) savers gain
and borrowers lose.
C) both
borrowers and savers lose.
D) neither borrowers nor savers gain or
lose.
E) both borrowers and
savers gain.
A) stocks
offered
investors
greater
rates
of
return
than
bonds
and
bills.
B) stock returns were less volatile
than those of bonds and bills.
C) bonds
offered
investors
greater
rates
of
return
than
stocks
and
bills.
D) bills
outperformed stocks and bonds.
E) treasury
bills
always
offered
a
rate
of
return
greater
than
inflation.
Use
the following to answer questions
13-15:
You
have
been
given
this
probability
distribution
for
the
holding
period
return
for
KMP stock:
13.
What is the expected holding period
return for KMP stock
Answer: A Difficulty:
Moderate
Rationale: HPR = .30 (18%) + .50 (12%)
+ .20 (-5%) = %
A) %
B) %
C) %
D) %
E) %
14.
What is the expected standard deviation
for KMP stock
Answer: B Difficulty: Difficult
Rationale: s = [.30 (18 -
2
+ .50 (12 -
2
+ .20 (-5 -
2
]
1/2
= %
A) %
B) %
C) %
D) %
E) %
15.
What is the
expected variance for KMP stock
A) %
B) %
C) %
D) %
E) %
Answer: A Difficulty: Difficult
Rationale: s = [.30 (18 -
2
+ .50 (12 -
2
+ .20 (-5 -
2
] = %
16.
If the nominal return is constant, the
after-tax real rate of return
Answer: E
Difficulty: Moderate
Rationale:
Inflation
rates
have
an
inverse
effect
on
after-
tax
real
rates
of
return.
A) declines as the
inflation rate increases.
B) increases as the inflation rate
increases.
C) declines as
the inflation rate declines.
D) increases as the inflation rate
decreases.
E) A and D.
17.
The risk premium for common stocks
A) cannot be
zero, for investors would be unwilling to invest
in common
stocks.
Answer: D Difficulty:
Moderate
Rationale: If the risk premium for
common stocks were zero or negative,
investors
would
be
unwilling
to
accept
the
lower
returns
for
the
increased
risk.
18.
A risk-free intermediate or long-term
investment
A) is free of all types of
risk.
B) does not guarantee
the future purchasing power of its cash flows.
C) does guarantee the
future purchasing power of its cash flows as it is
insured by the U. S. Treasury.
Answer: B Difficulty: Moderate
Rationale: A risk-free U. S. Treasury
bond is a fixed income instrument,
and
thus
does
not
guarantee
the
future
purchasing
power
of
its
cash
flows.
As a
result, purchasing power risk is
present.
D) A
and B.
E) B and C.
B) must always be positive,
in theory.
C) is negative,
as common stocks are risky.
D) A and B.
E) A
and C.
19.
You purchase a share of Boeing stock
for $$90. One year later, after
receiving a dividend of $$3, you sell
the stock for $$92. What was your
holding period return
Answer: D
Difficulty: Moderate
Rationale: HPR = (92 - 90 +
3) / 90 = %
A) %
B) %
C) %
D) %
E) none of the above
20.
Toyota
stock
has
the
following
probability
distribution
of
expected
prices
one year from
now:
If
you
buy
Toyota
today
for
$$55
and
it
will
pay
a
dividend
during
the
year
of $$4
per share, what is your expected holding period
return on Toyota
A) %
B) %
C) %
D) %
E) None of the above
Answer: D Difficulty: Difficult
Rationale: E(P1) = .25 (54/55 - 1) +
.40 (64/55 - 1) + .35 (74/55 - 1)
=
%.
21.
Which
of
the
following
factors
would
not
be
expected
to
affect
the
nominal
interest rate
A)
the supply of loanable funds
B) the demand for loanable funds
C) the coupon rate on
previously issued government bonds
D) the expected rate of inflation
E) government spending and
borrowing
Answer: C
Difficulty: Easy
Rationale: The nominal
interest rate is affected by supply, demand,
government actions and inflation.
Coupon rates on previously issued
government
bonds
reflect
historical
interest
rates
but
should
not
affect
the current level of
interest rates.
22.
Your
Certificate
of
Deposit
will
mature
in
one
week
and
you
are
considering
how to invest the proceeds. If you
invest in a 30-day CD the bank will
pay
you
4%.
If
you
invest
in
a
2-year
CD
the
bank
will
pay
you
6%
interest.
Which option would you choose
A) the 30-day
CD, no matter what you expect interest rates to do
in the
future
B) the 2-year CD, no matter what you
expect interest rates to do in the
future
Answer: D Difficulty: Moderate
Rationale: You would prefer to lock in
the higher rate on the 2-year CD
rather
than subject yourself to reinvestment rate risk.
If you expected
interest
rates
to
rise
in
the
future
the
opposite
choice
would
be
better.
23.
In words,
the real rate of interest is approximately equal
to
Answer: A Difficulty: Easy
Rationale:
The
actual
relationship
is
(1
+
real
rate)
=
(1
+
nominal
rate)
A) the nominal rate
minus the inflation rate.
B) the inflation rate minus the nominal
rate.
C) the nominal rate
times the inflation rate.
D) the inflation rate divided by the
nominal rate.
E) the
nominal rate plus the inflation rate.
C) the
30-day
CD
if
you
expect
that
interest
rates
will
fall
in
the
future
D) the
2-year
CD
if
you
expect
that
interest
rates
will
fall
in
the
future
E) You would be indifferent between the
30-day and the 2-year CDs.
/ (1 + inflation rate). This can be
approximated by the equation: real
rate
= nominal rate - inflation rate.
24.
If the Federal Reserve lowers the
discount rate, ceteris paribus, the
equilibrium
levels
of
funds
lent
will
__________
and
the
equilibrium
level
of real interest rates will ___________
Answer: B Difficulty: Moderate
Rationale:
A
lower
discount
rate
would
encourage
banks
to
make
more
loans,
which would increase
the money supply. The supply curve would shift to
the right and the equilibrium level of
funds would increase while the
equilibrium interest rate would
fall.
A) increase; increase
B) increase; decrease
C) decrease; increase
D) decrease; decrease
E) reverse direction from
their previous trends
25.
What has
been the relationship between T-Bill rates and
inflation rates
since the 1980s
A) The
T-Bill
rate
was
sometimes
higher
than
and
sometimes
lower
than
the
inflation rate.
B) The T-Bill rate has equaled the
inflation rate plus a constant
percentage.
C) The inflation rate has equaled the
T-Bill rate plus a constant
percentage.
D) The T-Bill
rate has been higher than the inflation rate
almost the
entire period.
E) The
T-Bill
rate
has
been
lower
than
the
inflation
rate
almost
the
entire
period.
Answer: D Difficulty: Moderate
Rationale: The T-Bill rate was higher
than the inflation rate for over
two
decades.
26.
“Bracket Creep” happens
when
A) tax
liabilities are based on real income and there is
a negative
inflation rate.
B) tax liabilities are
based on real income and there is a positive
inflation rate.
C) tax liabilities are based on nominal
income and there is a negative
inflation rate.
D) tax liabilities are based on nominal
income and there is a positive
inflation rate.
Answer: D Difficulty:
Moderate
Rationale: A positive inflation rate
typically leads to higher nominal
income. Higher nominal income means
people will have higher tax
liabilities
and
in
some
cases
will
put
them
in
higher
tax
brackets.
This
can happen even when
real income has declined.
27.
The holding-
period return (HPR) for a stock is equal to
Answer: E Difficulty: Easy
Rationale:
HPR
consists
of
an
income
component
and
a
price
change
component.
The income component on a stock is the
dividend yield. The price change
component is the capital gains
yield.
A) the real yield
minus the inflation rate.
B) the nominal yield minus the real
yield.
C) the capital gains
yield minus the tax rate.
D) the capital gains yield minus the
dividend yield.
E) the
dividend yield plus the capital gains yield.
E) too many peculiar people
make
their way into
the highest tax bracket.
28.
The
historical
arithmetic
rate
of
return
on
small
stocks
over
the
1926-2005
period
has
been
_______.
The
standard
deviation
of
small
stocks'
returns
has been ________
than the standard deviation of large stocks'
returns.
Answer: D Difficulty: Moderate
Rationale: See Table 5-5.
A) %, lower
B)
%, lower
C) %, higher
D) %, higher
E) %, higher
Use the following to answer question
29:
You
have
been
given
this
probability
distribution
for
the
holding
period
return
for
Cheese, Inc stock:
29.
Assuming that the expected return on
Cheese's stock is %, what is the
standard deviation of these returns
A) %
B) %
C) %
D) %
E)
None of the above
Answer: D
Difficulty: Moderate
Rationale: Variance =
.20*
2
+
.45*
2
+
.35*
2
= . Standard
deviation = = .
30.
An investor
purchased a bond 45 days ago for $$985. He
received $$15 in
interest and sold the
bond for $$980. What is the holding period return
on his investment
Answer: E
Difficulty: Easy
Rationale: HPR =
($$15+980-985)/$$985 = .0 = approximately
%.
A) %
B) %
C) %
D) %
E) None of the above
31.
Over the past year you earned a nominal
rate of interest of 8 percent on
your
money. The inflation rate was percent over the
same period. The
exact actual growth
rate of your purchasing power was
Answer: B
Difficulty: Moderate
Rationale: r = (1+R) /
(1+I) - 1; / - 1 = %.
A)
%.
B) %.
C) %.
D) %.
E) %
32.
Over the past year you earned a nominal
rate of interest of 14 percent
on your
money. The inflation rate was 2 percent over the
same period.
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