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Financial Institutions and Markets

Assignment- Week 3
TYPE OF QUESTION: MCQ/MSQ
Number of questions: 20 Total mark: 20 X 1 = 20
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QUESTION 1:
________________ refers to the relationship between different rates when all the investment
characteristics (such as default risk, marketability and liquidity and tax status) except the length
of time to maturity of the financial claims are held constant
a. Theories of Level
b. Term Structure of Interest Rate
c. Saving and Investment Theory
d. Pure Expectation Theory
Correct Answer: b. Term Structure of Interest Rate
Detailed Solution:
Term Structure of Interest Rate refers to the relationship between different rates when all the
investment characteristics (such as default risk, marketability and liquidity and tax status) except
the length of time to maturity of the financial claims are held constant

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QUESTION 2:
According to _____________ theory, interest rate determination is considered as a purely
monetary phenomenon.

a. The Classical
b. The Loanable Funds
c. The Keynesian
d. The Pure Expectation
Correct Answer: c. The Keynesian

Detailed Solution:

According to Keynes, interest rate is a purely monetary phenomenon. This means that the rate of
interest, at least in the short-run, is determined by the monetary factors, i.e., it depends on the
actions of the monetary authorities (the Central Bank and the Government), and on the attitude of
economic units towards holding money as an alternative to holding bonds.
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QUESTION 3:
The term structure of interest rates shows
a. Security yields ranked by default risk structure
b. The relationship between maturity and yield for similar securities
c. How interest rates vary over time
d. The pattern of interest rates over the long-term business cycle

Correct Answer: b. The relationship between maturity and yield for similar securities

Detailed Solution:

The term structure of interest rates refers to the relationship between different rates when all the
investment characteristics (such as the default risk, marketability and liquidity and tax status)
except the length of time to maturity of the financial claims are held constant

QUESTION 4:
Which of the following is/are a determinant of supply of loanable funds?
a. Dis saving
b. Hoarding
c. Investments
d. Bank Money
Correct Answer: d. Bank Money
Detailed Solution:
Supply of Loanable Funds: Savings, Bank Money, Disinvestment, Dishoarding

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QUESTION 5:
The classical theory is a dynamic theory
a. True
b. False
Correct Answer: b. False
Detailed Solution:
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The Classical Theory is a static theory. The classical theory posits, the rate of interest is not
affected by the level of money and prices. Interest rates are not influenced by the behavior of
banks and other credit institutions

QUESTION 6:
Which of the following is determinant of the demand of loanable funs?
a. Wealth
b. Bank money
c. Rate of interest
d. Hoarding
Correct answer: d. Hoarding
Detailed solution:
Supply of loanable funds are determined by savings, bank money, disinvestment, and
dishoarding. Dissaving, hoarding and investments determines the demand for loanable funds.
Wealth and rate of interest are determinants of supply of funds.

QUESTION 7:
The practice of holding money to satisfy the desire of liquidity is called
a. Investments
b. Hoarding
c. Dissaving
d. Black Money
Correct Answer: b. Hoarding

Detailed Solution:

The practice of holding money to satisfy the desire of liquidity is called hoarding. The demand
for loanable funds for hoarding purpose is a decreasing function of the rate of interest. At low
rate of interest demand for loanable funds for hoarding will be more and vice-versa.

QUESTION 8:
_______________ theory discards the independence of the interest rate from the behaviour of
money and banks
a. Liquidity Premium Theory
b. Classical Theory
c. Loanable Funds Theory
d. Keynesian Theory
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Correct Answer: c. Loanable Funds Theory

Detailed Solution:

The loanable funds theory discards the independence of the interest rate from the behaviour of
money and banks

QUESTION 9:
Money demanded to meet unforeseen contingencies is called speculative demand for money
a. True

b. False

Correct Answer: b. False

Detailed Solution:

Money demanded to meet unforeseen contingencies is called the precautionary demand for
money. Factors affecting precautionary demand for money are: Nature of business, Access to
money market, Degree of conservatism, Degree of liquidity of the assets Income.

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QUESTION 10:
In the context of Total Demand for Money (TDM), which of the following is/are a function of
Income?

a. Transaction

b. Preventive

c. Speculative

d. Precautionary

Correct Answer: a,d

a. Transaction

d. Precautionary

Detailed Solution:

TMD = MT + MP + MSP
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MSP= f(r), MP = f(Y); MT = f (Y),

where, MSP= speculative demand for money, MP= Precautionary demand for money, MT=
Transactions demand for money, Y = Income, r = interest rate

As MP and MT are a function of Y we can combine MT and MP

TMD = f (Y) + f (r)

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QUESTION 11:
_______________ can be thought of as an extension of the Pure Expectations Theory.
a. The Classical Theory,
b. The Liquidity Premium Theory
c. The Loanable Funds Theory
d. The Keynesian Theory
Correct Answer: b. The Liquidity Premium Theory
Detailed Solution:
The Liquidity Premium Theory can be thought of as an extension of the Pure Expectations
Theory. The Liquidity Premium Theory (LPT), also referred to as the Risk Premium Theory
(RPT), posits that there is a liquidity premium for long-term bonds over short-term bonds
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QUESTION 12:
______________ is a necessary extension of the Market Segmentation Theory.
a. Pure Expectation Theory
b. Liquidity Premium Theory
c. Preferred Habitat Theory
d. Market Segmentation Theory

Correct Answer: c. Preferred Habitat Theory

Detailed Solution:
PHT is a necessary extension of the MST
______________________________________________________________________________
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QUESTION 13:
When interest rate declines, the interest elasticity of speculative demand for money _________.
a. Increases
b. Decreases
c. Does not change
d. Remains ambiguous

Correct Answer: a

Detailed Solution:

Interest elasticity of speculative demand for money increases as the interest rate declines. The
rate of interest at which the speculative demand for money becomes perfectly elastic is called
liquidity trap
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QUESTION 14:
The relationship between yield and term to maturity is called the yield curve
a. True
b. False
Correct Answer: a. True
Detailed Solution:
Term Structure examines the relationship between YTM and maturity, M. The plot of YTM
against M for bonds measures the yield curve.
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QUESTION 15:

______________ assumes that investors and borrowers will be induced to forego their perfect
hedges and shift out of their preferred maturity segments when supply and demand conditions in
different maturity markets do not match
a. Liquidity Premium Theory
b. Preferred Habitat Theory
c. Market Segmentation Theory
d. Classical Theory
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Correct Answer: b. Preferred Habitat Theory

Detailed Solution:
Preferred Habitat Theory, PHT, assumes that investors and borrowers are willing to give up their
desired maturity segment and assume market risk if rates are attractive. PHT asserts that
investors and borrowers will be induced to forego their perfect hedges and shift out of their
preferred maturity segments when supply and demand conditions in different maturity markets
do not match

QUESTION 16:
The actual shape of the yield curve depends on:
a. Economic conditions
b. Maturity preferences of investors and borrowers
c. Investors' and borrowers' expectations about future rates, inflation, and the state of
economy.
d. All of the above

Correct Answer: d. All of the above

Detailed Solution:

The actual shape of the yield curve depends on:

i. The types of bonds under consideration (e.g., AAA bond versus B bond)
ii. Economic conditions (e.g., economic growth or recession, tight monetary conditions,
etc.)
iii. The maturity preferences of investors and borrowers
iv. Investors' and borrowers' expectations about future rates, inflation, and the state of
economy
______________________________________________________________________________
QUESTION 17:
According to Keynes, interest rate is determined by the real factors

a. True
b. False

Correct Answer: b. False

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Detailed Solution:
According to Keynes, interest rate is a purely monetary phenomenon. This means that the rate of
interest, at least in the short-run, is determined by the monetary factors, i.e., it depends on the
actions of the monetary authorities (the Central Bank and the Government), and on the attitude of
economic units towards holding money as an alternative to holding bonds. In other words,
interest rate is determined by the interaction between the supply of money and demand for it in
the economic system

QUESTION 18:
According to the Pure Expectations Theory, the long-term interest rate is always equal to the
short-term interest rates

a. True
b. False

Correct Answer: b. False

Detailed Solution:

The long-term rate will be higher than the short- term rate (i.e., the yield curve will be upward
sloping) only if investors expect future short-term spot rates to be higher than the current short-
term spot rate. Similarly, the long-term rate will be lower than the short-term rate (the yield
curve will be downward sloping) when investors expect future short-term spot rates to fall below
the current short-term spot rate. If no changes in future short-term spot rates are expected, the
long and short rate will be equal to each other (the yield curve will be flat).
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QUESTION 19:
________ curve shows the relationship between interest rate and speculative demand for money

a. Money Demand
b. Liquidity Preference
c. Liquidity Trap
d. Aggregate Supply Curve

Correct Answer: b. Liquidity Preference

Detailed Solution:
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Relationship between interest rate and speculative demand for money is called the Liquidity
Preference Curve. The rate of interest at which the speculative demand for money becomes
perfectly elastic is called liquidity trap

QUESTION 20:
Consider the following information. Assuming Pure Expectations Theory, calculate the forward
rate for a three-year U.S. Treasury bond two years from April 20XX.

Term to Maturity (years) TYM April 20XX

1 8.05%
2 7.90%
5 7.70%
10 7.45%
15 7.30%
20 7.20%
25 7.10%

a. 8.75%
b. 7.88%
c. 7.57%
d. 7.01%
Correct Answer: c. 7.57%

Detailed Solution:

=[(1+tR5)5/ (1+tR2)2]1/3-1

= =7.566%

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