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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
A)
%.
B)
%.
C)
%.
D)
%.
E)
%
Answer: D Difficulty:
Moderate
Rationale: r = (1+R) / (1+I) - 1; % / %
- 1 = %.
2.
A year ago, you invested $$1,000 in a
savings account that pays an annual interest rate
of
7%. What is your approximate annual
real rate of return if the rate of inflation was
3%
over the year?
A)
4%.
B)
10%.
C)
7%.
D)
3%.
E)
none of the above.
Answer: A Difficulty:
Easy
Rationale: 7% - 3% = 4%.
3.
If the annual
real rate of interest is 5% and the expected
inflation rate is 4%, the nominal
rate
of interest would be approximately
A)
1%.
B)
9%.
C)
20%.
D)
15%.
E)
none of the above.
Answer: B Difficulty:
Easy
Rationale: 5% + 4% = 9%.
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4.
You purchased a share of
stock for $$20. One year later you received $$1 as
dividend and
sold the share for $$29.
What was your holding period return?
A)
45%
B)
50%
C)
5%
D)
40%
E)
none of the above
Answer: B
Difficulty: Moderate
Rationale: ($$1 + $$29 - $$20)/$$20 = , or
50%.
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
A)
B)
C)
D)
E)
I only
II only
I and II only
I, II, and
III
none of the above
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 demander of funds.
The above factors
constitute the total
supply and demand for funds, which determine real
interest rates.
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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.
A)
B)
C)
D)
E)
I and II
only.
I and III only.
III
and IV only.
II and III only.
I, II, III, and IV only
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.
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.
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8.
Other things equal, an increase in the
government budget deficit
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.
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.
E)
none of the
above.
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.
10.
The holding
period return (HPR) on a share of stock is equal
to
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.
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.
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11.
Historical records regarding return on
stocks, Treasury bonds, and Treasury bills
between 1926 and 2005 show that
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.
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:
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.
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.
Use the following to answer
questions 13-15:
You have
been given this probability distribution for the
holding period return for KMP stock:
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13.
What is the expected holding period
return for KMP stock?
A)
%
B)
%
C)
%
D)
%
E)
%
Answer: A
Difficulty: Moderate
Rationale: HPR = .30 (18%) + .50 (12%)
+ .20 (-5%) = %
14.
What is the expected
standard deviation for KMP stock?
A)
%
B)
%
C)
%
D)
%
E)
%
Answer: B Difficulty: Difficult
Rationale: s =
[.30 (18 -
2
+ .50 (12 -
2
+ .20 (-5 -
2
]
1/2
= %
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
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.
Answer: E
Difficulty: Moderate
Rationale: Inflation rates have an
inverse effect on after-tax real rates of return.
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17.
The risk premium for common stocks
A)
cannot be
zero, for investors would be unwilling to invest
in common stocks.
B)
must always be positive, in theory.
C)
is negative,
as common stocks are risky.
D)
A and B.
E)
A and C.
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.
D)
A and B.
E)
B and C.
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.
19.
You purchase
a share of Boeing stock for $$90. One year later,
after receiving a dividend
of $$3, you
sell the stock for $$92. What was your holding
period return?
A)
%
B)
%
C)
%
D)
%
E)
none of the above
Answer: D Difficulty: Moderate
Rationale: HPR
= (92 - 90 + 3) / 90 = %
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20.
Toyota stock has the following
probability distribution of expected prices one
year from
now:
If
you buy Toyota today for $$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.
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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
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.
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
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.
Answer: A
Difficulty: Easy
Rationale: The actual relationship is
(1 + real rate) = (1 + nominal rate) / (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
___________
A)
increase;
increase
B)
increase; decrease
C)
decrease; increase
D)
decrease;
decrease
E)
reverse direction from their previous
trends
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.
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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.
E)
too many
peculiar people make their way into the highest
tax bracket.
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
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.
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.
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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.
A)
%, lower
B)
%, lower
C)
%, higher
D)
%, higher
E)
%, higher
Answer: D Difficulty: Moderate
Rationale: See
Table 5-5.
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 = = .
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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?
A)
%
B)
%
C)
%
D)
%
E)
None of the
above
Answer: E
Difficulty: Easy
Rationale: HPR = ($$15+980-985)/$$985 =
.0 = approximately %.
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
A)
%.
B)
%.
C)
%.
D)
%.
E)
%
Answer: B Difficulty:
Moderate
Rationale: r = (1+R) / (1+I) - 1; / -
1 = %.
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. The exact actual growth rate of
your purchasing power was
A)
%.
B)
%.
C)
%.
D)
%.
E)
none of the above.
Answer: A Difficulty:
Moderate
Rationale: r = (1+R) / (1+I) - 1; / -
1 = %.
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