Chapter Nine

Interest Rate Risk II

Multiple-Choice

1. Which of the following is indicated by high numerical value of the duration of an asset?
a. Low sensitivity of an asset price to interest rate shocks.
b. High interest inelasticity of a bond.
c. High sensitivity of an asset price to interest rate shocks.
d. Lack of sensitivity of an asset price to interest rate shocks.
e. Smaller capital loss for a given change in interest rates.
Answer: C

2. For small change in interest rates, market prices of bonds move in an inversely proportional manner
according to the size of the
a. equity.
b. asset value.
c. liability value.
d. duration value.
e. Answers A and B only.
Answer: D

3. Which of the following statements about leverage adjusted duration gap is true?
a. It is equal to the duration of the assets minus the duration of the liabilities.
b. Larger the gap in absolute terms, the more exposed the FI is to interest rate shocks.
c. It reflects the degree of maturity mismatch in an FI’s balance sheet.
d. It indicates the dollar size of the potential net worth.
e. Its value is equal to duration divided by (1+R).
Answer: B

4. The larger the size of an FI, the larger the _________ from any given interest rate shock.
a. duration mismatch
b. immunization effect
c. net worth exposure
d. net interest income
e. risk of bankruptcy
Answer: C

5. Managers can achieve the results of duration matching by using these to hedge interest rate risk.
a. Rate sensitive assets.

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 b. Rate sensitive liabilities.
c. Coupon bonds.
d. Consol bonds.
e. Derivatives.
Answer: E

6. Immunizing the balance sheet to protect equity holders from the effects of interest rate risk occurs when
a. the maturity gap is zero.
b. the repricing gap is zero.
c. the duration gap is zero.
d. the effect of a change in the level of interest rates on the value of the assets of the FI is exactly
offset by the effect of the same change in interest rates on the liabilities of the FI.
e. after-the-fact analysis demonstrates that immunization coincidentally occurred.
Answer: D

7. The duration of a consol bond is

a. less than its maturity.
b. infinity.
c. 30 years.
d. more than its maturity.
e. given by the formula D=1/1-R.
Answer: A

8. Immunization of a portfolio implies that changes in _____ will not affect the value of the portfolio.
a. book value of assets
b. maturity
c. market prices
d. interest rates
e. duration
Answer: D

9. When does "duration" become a less accurate predictor of expected change in security prices?
a. As interest rate shocks increase in size.
b. As interest rate shocks decrease in size.
c. When maturity distributions of an FI’s assets and liabilities are considered.
d. As inflation decreases.
e. When the leverage adjustment is incorporated.
Answer: A

10. An FI has financial assets of $800 and equity of $50. If the duration of assets is 1.21 years and the

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 duration of all liabilities is 0.25 years, what is the leverage-adjusted duration gap?
a. 0.9000 years.
b. 0.9600 years.
c. 0.9756 years.
d. 0.8844 years.
e. Cannot be determined.
Answer: C

11. Calculate the duration of a two-year corporate bond paying 6 percent interest annually, selling at par.
Principal of $20,000,000 is due at the end of two years.
a. 2 years.
b. 1.91 years.
c. 1.94 years.
d. 1.49 years.
e. 1.75 years.
Answer: C

12. Which of the following statements is true?

a. The optimal duration gap is zero.
b. Duration gap measures the impact of changes in interest rates on the market value of equity.
c. The shorter the maturity of the FI's securities, the greater the FI's interest rate risk exposure.
d. The duration of all floating rate debt instruments is equal to the time to maturity.
e. The duration of equity is equal to the duration of assets minus the duration of liabilities.
Answer: B

13. A $1,000 six-year Eurobond has an 8 percent coupon, is selling at par, and contracts to make annual
payments of interest. The duration of this bond is 4.99 years. What will be the new price using the
duration model if interest rates increase to 8.5 percent?
a. $23.10.
b. $976.90.
c. $977.23.
d. $1,023.10.
e. -$23.10.
Answer: B

14. What is the duration of a 5-year par value zero coupon bond yielding 10 percent annually?
a. 0.50 years.
b. 2.00 years.
c. 4.40 years.

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 d. 5.00 years.
e. 4.05 years.
Answer: D

15. Calculating modified duration involves

a. dividing the value of duration by the change in the market interest rate.
b. dividing the value of duration by 1 plus the interest rate.
c. dividing the value of duration by discounted change in interest rates.
d. multiplying the value of duration by discounted change in interest rates.
e. dividing the value of duration by the curvature effect.
Answer: B

Use the following information to answer the next three (3) questions:
Consider a six-year maturity, $100,000 face value bond that pays a 5 percent fixed coupon annually.
16. What is the price of the bond if market interest rates are 4 percent?
a. $105,816.44.
b. $105,287.67.
c. $105,242.14.
d. $100,000.00.
e. $106,290.56.
Answer: C

17. What is the price of the bond if market interest rates are 6 percent?
a. $95,082.68.
b. $95,769.55.
c. $95,023.00.
d. $100,000.00.
e. $96,557.87.
Answer: A

18. What is the percentage price change for the bond if interest rates decline 50 basis points from the
original 5 percent?
a. -2.106 percent.
b. +2.579 percent.
c. +0.000 percent.
d. +3.739 percent.
e. +2.444 percent.
Answer: B

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Use the following information to answer the next two (2) questions:

Based on an 18-month, 8 percent (semiannual) coupon Treasury note selling at par.

19. What is the duration of this Treasury note?
a. 1.500 years.
b. 1.371 years.
c. 1.443 years.
d. 2.882 years.
e. 1.234 years.
Answer: C

20. If interest rates increase by 20 basis points (i.e., ∆R = 20 basis points), use the duration approximation
to determine the approximate price change.
a. $0.000.
b. $0.2775 per $100 face value.
c. $2.775 per $100 face value.
d. $0.2672 per $100 face value.
e. $2.672 per $100 face value.
Answer: B

5
 Chapter Eight
Interest Rate Risk I
Multiple-Choice

1. The net worth of a bank is the difference between the

a. value of retained earnings and the provision for loan losses.
b. market value of assets and the market value of liabilities.
c. book value of assets and book value of liabilities.
d. rate-sensitive assets and rate-sensitive liabilities.
e. None of the above.
Answer: B

2. Because of its simplicity, smaller depository institutions still use this model as their primary measure of
interest rate risk.
a. The repricing model.
b. The maturity model.
c. The duration model.
d. The convexity model.
e. The option pricing model.
Answer: A

3. The repricing gap approach calculates the gaps in each maturity bucket by subtracting the
a. current assets from the current liabilities.
b. long term liabilities from the fixed assets.
c. rate sensitive assets from the total assets.
d. rate sensitive liabilities from the rate sensitive assets.
e. current liabilities from tangible assets.
Answer: D

4. The repricing gap does not accurately measure FI interest rate risk exposure because
a. FIs cannot accurately predict the magnitude change in future interest rates.
b. FIs cannot accurately predict the direction of change in future interest rates.
c. accounting systems are not accurate enough to allow the calculation of precise gap measures.
d. it does not recognize timing differences in cash flows within the same maturity grouping.
e. equity is omitted.
Answer: D

5. A positive gap implies that an increase in interest rates will cause _______ in net interest income.
a. no change
b. a decrease

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 c. an increase
d. an unpredictable change
e. Either A or B.
Answer: C

6. If interest rates decrease 50 basis points (i.e., 0.5%) for an FI that has a gap of +$5 million, the
expected change in net interest income is
a. + $2,500.
b. + $25,000.
c. + $250,000.
d. - $250,000.
e. - $25,000.
Answer: E

7. If interest rates decrease 40 basis points (0.40 percent) for an FI that has a cumulative gap of -$25
million, the expected change in net interest income is
a. +$100,000.
b. -$100,000.
c. -$625,000.
d. -$625,000.
e. +$250,000.
Answer: A

8. The gap ratio expresses the reprice gap for a given time period as a percentage of
a. equity.
b. total liabilities.
c. current liabilities.
d. total assets.
e. current assets.
Answer: D

9. What is spread effect?

a. Periodic cash flow of interest and principal amortization payments on long-term assets that can be
reinvested at market rates.
b. The effect that a change in the spread between rates on RSAs and RSLs has on net interest income
as interest rates change.
c. The effect of mismatch of asset and liabilities within a maturity bucket.
d. The premium paid to compensate for the future uncertainty in a security’s value.
e. The value of an FI to its owners.
Answer: B

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10. If an FI's repricing gap is less than zero, then
a. it is deficient in its required reserves.
b. it is deficient in its capital ratio requirement.
c. its liability costs are more sensitive to changing market interest rates than are its asset yields.
d. its liability costs are less sensitive to changing market interest rates than are its asset yields.
e. the duration of the FI's liabilities exceeds the duration of FI's assets.
Answer: C

11. The repricing model measures the impact of unanticipated changes in interest rates on
a. the market value of equity.
b. net interest income.
c. both market value of equity and net interest income.
d. the FI's capital position.
e. the prices of assets and liabilities.
Answer: B

12. If the chosen maturity buckets have a time period that is too long, the repricing model may produce
inaccurate results because
a. as the time to maturity increases, the price volatility increases.
b. price changes will be overestimated.
c. there may be large differentials in the time to repricing for different securities within each maturity
bucket.
d. the FI will be unable to accurately measure the quantity of rate sensitive assets.
e. the FI will be unable to accurately measure the quantity of rate sensitive liabilities.

Answer: C

13. An increase in interest rates

a. increases the market value of the FI's financial assets and liabilities.
b. decreases the market value of the FI's financial assets and liabilities.
c. decreases the book value of the FI's financial assets and liabilities.
d. increases the book value of the FI's financial assets and liabilities.
e. has no impact on the market value of the FI's financial assets and liabilities.
Answer: B

14. The repricing model is based on an accounting world that reports asset and liability values at
a. their market value.
b. their book value.
c. their historic values or costs.

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 d. All of the above.
e. Answers B and C only.
Answer: E

15. Which of the following is a weakness of the repricing model to measure interest rate risk?
a. Potential for overaggregation of assets and liabilities within each maturity bucket.
b. It ignores how changes in interest rates affect the market value of assets and liabilities.
c. It ignores the reinvestment of loan interest and principal payments that are reinvested at
current market rates.
d. It fails to recognize off-balance-sheet activities that may be rate sensitive.
e. All of the above.
Answer: E

Use the following information to answer the next five (5) questions:
The balance sheet of XYZ Bank. All figures in millions of US Dollars.

Assets Liabilities
1 Short-term consumer $ 150 1 Equity capital (fixed) $ 120
loans (one-year maturity)
2 Long-term consumer 125 2 Demand deposits 40
loans (two-year maturity)
3 Three-month Treasury 130 3 Passbook savings 130
bills
4 Six-month Treasury notes 135 4 Three-month CDs 140
5 Three-year Treasury bond 170 5 Three-month bankers 120
acceptances

6 10-year, fixed-rate 120 6 Six-month 160

mortgages commercial paper
7 30-year, floating-rate 140 7 One-year time 120
mortgages (rate adjusted deposits
every nine months)
8 Two-year time 40
deposits
$970 $970

16. Total one-year rate-sensitive assets is

a. $540 million.
b. $580 million.
c. $555 million.
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 d. $415 million.
e. $720 million.
Answer: C =150+130+135+140=555

17. Total one-year rate-sensitive liabilities is

a. $540 million.
b. $580 million.
c. $555 million.
d. $415 million.
e. $720 million.
Answer: A =140+120+160+120=540

18. The cumulative one-year repricing gap (CGAP) for the bank is
a. $25 million.
b. $-140 million.
c. $15 million.
d. $-150 million.
e. $-15 million.
Answer: C = 555 -540 =15

19. The gap ratio is

a. .015.
b. -.015.
c. .025.
d. -.144.
e. .154.
Answer: A =15/970=0.015

20. Suppose that interest rates rise by 2 percent on both RSAs and RSLs. The expected annual change in
net interest income of the bank is
a. -$300,000.
b. $500,000.
c. -$2,800,000.
d. -$3,000,000.
e. $300,000.
Answer: E =$15 million * 0.02= $300,000

5
 Chapter Seven
Risks of Financial Institutions
Multiple-Choice

1. Holding corporate bonds with fixed interest rates involves

a. default risk only.
b. interest rate risk only.
c. liquidity risk and interest rate risk only.
d. default risk and interest rate risk.
e. default and liquidity risk only.
Answer: D

2. Regulation limits FI investment in non-investment grade bonds (rated below Baa or non-rated).What
kind of risk is this designed to limit?
a. Liquidity risk.
b. Interest rate risk.
c. Credit risk.
d. Foreign exchange rate risk.
e. Off-balance sheet risk.
Answer: C

3. What type of risk focuses upon mismatched asset and liability maturities and durations?
a. Liquidity risk.
b. Interest rate risk.
c. Credit risk.
d. Foreign exchange rate risk.
e. Off-balance sheet risk.
Answer: B

4. Which function of an FI involves buying primary securities and issuing secondary securities?
a. Brokerage.
b. Asset transformation.
c. Investment research.
d. Self-regulator.
e. Trading.
Answer: B

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5. What type of risk focuses upon mismatched currency positions?
a. Liquidity risk.
b. Interest rate risk.
c. Credit risk.
d. Foreign exchange rate risk.
e. Off-balance sheet risk.
Answer: D

6. What type of risk focuses upon future contingencies?

a. Liquidity risk.
b. Interest rate risk.
c. Credit risk.
d. Foreign exchange rate risk.
e. Off-balance sheet risk.
Answer: E

7. If the loans in the bank's portfolio are all negatively correlated, what will be the impact on the bank's
credit risk exposure?
a. The loans' negative correlations will decrease the bank's credit risk exposure because lower
than expected returns on some loans will be offset by higher than expected returns on other loans.
b. The loans' negative correlations will increase the bank's credit risk exposure because lower
than expected returns on some loans will be offset by higher than expected returns on other loans.
c. The loans' negative correlations will increase the bank's credit risk exposure because higher
returns on less risky loans will be offset by lower returns on riskier loans.
d. The loans' negative correlations will decrease the bank's credit risk exposure because higher
returns on less risky loans will be offset by lower returns on riskier loans.
e. There is no impact on the bank's credit risk exposure.
Answer: A

8. A small local bank failed because a housing market collapse following the departure of the areas largest
employer. What type of risk applies to the failure of the institution?
a. Firm-specific risk.
b. Technological risk.
c. Operational risk.
d. Sovereign risk.

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 e. Insolvency risk.
Answer: E

9. The risk that a German investor who purchases British bonds will lose money when trying to convert
bond interest payments made in pounds sterling into euros is called
a. liquidity risk.
b. interest rate risk.
c. credit risk.
d. foreign exchange rate risk.
e. off-balance-sheet risk.
Answer: D

10. An FI that finances long-term fixed rate mortgages with short-term deposits is exposed to
a. increases in net interest income and decreases in the market value of equity when interest rates
fall.
b. decreases in net interest income and decreases in the market value of equity when interest rates
fall.
c. decreases in net interest income and decreases in the market value of equity when interest rates
rise.
d. increases in net interest income and decreases in the market value of equity when interest rates
rise.
e. increases in net interest income and increases in the market value of equity when interest rates
rise.
Answer: C

11. The risk that an investor will be forced to place earnings from a loan or security into a lower yielding
investment is known as
a. liquidity risk.
b. reinvestment risk.
c. credit risk.
d. foreign exchange risk.
e. off-balance-sheet risk.
Answer: B

12. Matching the book is intended to protect the FI from

a. liquidity risk.

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 b. interest rate risk.
c. credit risk.
d. foreign exchange risk.
e. off-balance-sheet risk.
Answer: B

13. When the assets and liabilities of an FI are not equal in size, efficient hedging of interest rate risk can
be achieved by
a. increasing the duration of assets and increasing the duration of equity.
b. issuing more equity and reducing the amount of borrowed funds.
c. not exactly matching the maturities of assets and liabilities.
d. issuing more equity and investing the funds in higher-yielding assets.
e. efficient hedging cannot be achieved without the use of derivative securities.
Answer: C

14. The asymmetric return distribution on risky debt exposes the FI to

a. technology risk.
b. interest rate risk.
c. credit risk.
d. foreign exchange risk.
e. off-balance-sheet risk.
Answer: C

15. The risk that a debt security's price will fall, subjecting the investor to a potential capital loss is
a. credit risk.
b. political risk.
c. currency risk.
d. liquidity risk.
e. market risk.
Answer: E

16. The risk that interest income will increase at a slower rate than interest expense is
a. credit risk.
b. political risk.
c. currency risk.
d. liquidity risk.
e. interest rate risk.
Answer: E

17. The risk that borrowers are unable to repay their loans on time is

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 a. credit risk.
b. sovereign risk.
c. currency risk.
d. liquidity risk.
e. interest rate risk.
Answer: A

18. The risk that many borrowers in a particular country fail to repay their loans is
a. credit risk.
b. sovereign risk.
c. currency risk.
d. liquidity risk.
e. interest rate risk.
Answer: B

19. The risk that many depositors withdraw their funds at once is
a. credit risk.
b. sovereign risk.
c. currency risk.
d. liquidity risk.
e. interest rate risk.
Answer: D

20. An advantage FIs have over individual household investors is that they are able to diversify away credit
risk by holding a large portfolio of loans to different entities. This reduces
a. firm-specific credit risk.
b. systematic credit risk.
c. interest rate risk.
d. market risk.
e. political risk.
Answer: A

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 Chapter Two
Financial Services: Depository Institutions
Multiple-Choice

1. In 2010, which of the following FIs does not currently provide a payment function for their customers?
a. Depository institutions.
b. Insurance companies.
c. Finance companies.
d. Pension funds.
e. Mutual funds.
Answer: D

2. In 2010, a consumer lending function is performed by each of the following FIs EXCEPT
a. Securities firms.
b. Finance companies.
c. Mutual funds.
d. Depository institutions.
e. Insurance companies.
Answer: C

3. In 2010, which of the following FIs does not provide a business lending function?
a. Depository institutions.
b. Insurance companies.
c. Finance companies.
d. Pension funds.
e. Mutual funds.
Answer: E

4. The largest asset class on U.S. commercial banks' balance sheet as of year-end 2009 was
a. investment securities.
b. commercial and industrial loans.
c. real estate loans.
d. cash.
e. deposits.
Answer C

5. The future viability of the savings association industry in traditional mortgage lending has been
questioned because of
a. securitization practices of other FIs.
b. the additional risk exposure of long-term mortgage lending.
c. intense competition from other FIs.
d. the liquidity risks associated with mortgage lending.
 e. All of the above.
Answer E

6. National-chartered commercial banks are most likely to be regulated by

a. the FDIC only.
b. the FDIC and the Federal Reserve System.
c. the Federal Reserve System only.
d. the FDIC, the Federal Reserve System, and the Comptroller of the Currency.
e. the Federal Reserve System and the Comptroller of the Currency.
Answer D

7. State-chartered commercial banks may be regulated by

a. the FDIC only.
b. the FDIC and the Federal Reserve System.
c. the Federal Reserve System only.
d. the FDIC, the Federal Reserve System, and the Comptroller of the Currency.
e. the FDIC, the Federal Reserve System, the Comptroller of the Currency,
and state banking commissions.
Answer E

8. The strong performance of commercial banks during the decade before 2007 was due to
a. the stability of interest rates during this period.
b. the ability of banks to shift credit risk from their balance sheets to financial markets.
c. the contraction of the number of banks and thrifts.
d. the growth in the number of thrifts and credit unions.
e. All of the above.
Answer B

9. A large number of the savings institution failures during the in the 1980s was a result of
a. interest rate risk exposure.
b. excessively risky investments.
c. fraudulent behavior on the part of managers.
d. All of the above.
e. answers B and C only.
Answer D

10. One of the primary reasons that investment banks were allowed to convert to bank holding companies
during the recent financial crisis was recognition that
a. their operating activities were too risky and they needed the cushion of bank deposits to alleviate
funding risks.
b. the industry had acquired too much capital during the previous decade.
c. bank holding companies needed the ability to underwrite new issues of corporate securities.
 d. it was the only way an investment bank could qualify for federal bailout funds.
e. the Federal Reserve was unable to purchase troubled assets from investment banks, but they could
from bank holding companies.
Answer: A

11. Regulatory forbearance refers to a policy of

a. allowing insolvent banks to continue to operate.
b. foreclosing real estate properties in the event on non-payments of mortgages.
c. strict regulation of banks, closing them down as soon as they are insolvent.
d. rescheduling of all loans of a client in the event of non-payment.
e. Answers B and C only.
Answer A

12. Customer deposits are classified on a DI's balance sheet as

a. assets, because the DI uses deposit funds to earn profits.
b. liabilities, because the DI uses deposits as a source of funds.
c. assets, because customers view deposits as assets.
d. liabilities, because the DI must meet reserve requirements on customer deposits.
e. liabilities, because DIs are required to serve depositors.
Answer B

13. Holdings of U.S. Treasury securities are classified on a DI's balance sheet as
a. assets, because U.S. Treasury securities are default risk-free.
b. liabilities, because the DI must pay cash in order to acquire the securities.
c. assets, because securities holdings represent a use of funds for investment.
d. liabilities, because the Treasury securities must be pledged as collateral against discount window
borrowing.
e. assets, because the market for U.S. Treasury securities is the most liquid in the world.
Answer C

14. Customer loans are classified on a DI's balance sheet as

a. assets, because the DI's major asset is its client base.
b. liabilities, because the customer may default on the loan.
c. assets, because the DI earns servicing fees on the loan.
d. liabilities, because the DI must transfer funds to the borrower at the initiation of the loan.
e. assets, because DIs originate and monitor loan portfolios.
Answer E

15. This broad class of loans constitutes the highest percentage of total assets for all U.S. commercial banks
as of the end of 2009.
a. Commercial and industrial.
b. Commercial and residential real estate.
 c. Individual loans.
d. Credit card debt.
e. Less developed country loans.
Answer B

16. Which of the following currently manages the insurance funds for both commercial banks and savings
institutions?
a. FDIC.
b. FSLIC.
c. OCC.
d. FRS.
e. State authorities.
Answer A

17. What was the primary objective of the Bank Holding Company Act of 1956?
a. Permitted bank holding companies to acquire banks in other states.
b. Restricted the banking and nonbanking acquisition activities of multibank holding companies.
c. Regulated foreign bank branches and agencies in the United States.
d. Bank holding companies were permitted to convert out-of-state subsidiary banks into branches of
a single interstate bank.
e. Allowed for the creation of a financial services holding company.
Answer B

18. Which of the following is the most important source of funds for savings institutions?
a. Borrowings from the Federal Home Loan Bank.
b. Small time and savings deposits.
c. Repurchase agreements.
d. Direct federal fund borrowings.
e. Negotiable certificates of deposit.
Answer B

19. The primary regulators of savings institutions are

a. the Federal Reserve and the FDIC.
b. the Office of Thrift Supervision and the FDIC.
c. the FDIC and the Office of the Comptroller of the Currency.
d. the Office of Thrift Supervision and the Comptroller of the Currency.
e. the Federal Reserve and the Comptroller of the Currency.
Answer: B

20. The largest asset class on credit unions’ balance sheet as of year-end 2009 was
a. cash.
b. investment securities.
 c. home mortgages.
d. checkable deposits.
e. consumer credit.
Answer C

21. The largest liability on credit unions’ balance sheet as of year-end 2009 was
a. small time and savings deposits.
b. open-market paper.
c. repurchase agreements.
d. ownership shares.
e. share advances.
Answer A

22. Credit Unions were generally less affected than other depository institutions by the subprime financial
crisis because
a. they had more assets in consumer loans than residential mortgages.
b. they had more residential mortgages than consumer loans.
c. they hold more government securities, on average.
d. they hold less government securities, on average.
e. Answers A and C only.
Answer E

23. Which of the following observations concerning credit unions is NOT true?
a. They invest heavily in corporate securities.
b. Member loans constitute a majority of their total assets.
c. They tend to invest more of their assets in U.S. Treasuries than other DIs.
d. They engage in off-balance-sheet activities.
e. They focus more on providing services and less on profitability.
Answer A

24. Compared to banks and savings institutions, credit unions are able to pay a higher rate on the deposits
of members because
a. they intend to attract new members.
b. they do not issue common stock.
c. of their tax-exempt status.
d. Regulation Q still applies to the industry.
e. they are subject to the provisions of the Community Reinvestment Act.
Answer C
 Chapter One
Why Are Financial Institutions Special?
Multiple-Choice
1. Depository financial institutions include all of the following EXCEPT
a. commercial banks.
b. savings banks
c. investment banks.
d. credit unions.
e. all of the above are depository institutions.
Answer: C

2. Nondepository financial institutions are represented by all of the following EXCEPT

a. insurance companies.
b. mutual funds.
c. finance companies.
d. credit unions.
e. securities firms.
Answer: D

3. Which of the following statements is FALSE?

a. A financial intermediary specializes in the production of information.
b. A financial intermediary reduces its risk exposure by pooling its assets.
c. A financial intermediary benefits society by providing a mechanism for payments.
d. A financial intermediary may act as a broker to bring together funds deficit and funds surplus
units.
e. A financial intermediary acts as a lender of last resort.
Answer: E

4. Which function of an FI reduces transaction and information costs between a corporation and
individual which may encourage a higher rate of savings?
a. Brokerage services.
b. Asset transformation services.
c. Information production services.
d. Money supply management.
e. Administration of the payments mechanism.
Answer: A

5. In its role as a delegated monitor, an FI

a. keeps track of required interest and principal payments on loans it originates.
b. works with financially distressed borrowers in danger of defaulting on their loans.
c. holds portfolios of loans that they continue to service.
d. maintains contact with borrowers to ensure that loan proceeds are utilized for intended purposes.
 e. All of the above.
Answer: E

6. Which of the following is NOT a major function of financial intermediaries?

a. Brokerage services.
b. Asset transformation services.
c. Information production.
d. Management of the nation's money supply.
e. Administration of the payments mechanism.
Answer: D

7. Advantages of depositing funds into a typical bank account instead of directly buying corporate
securities include all of the following EXCEPT
a. monitoring done by the bank on your behalf.
b. increased liquidity if funds are needed quickly.
c. increased transactions costs.
d. less price risk when funds are needed.
e. better diversification of deposited funds.
Answer: C

8. Many households place funds with financial institutions because many FI accounts provide
a. lower denominations than other securities.
b. flexible maturities verses other interest-earning securities.
c. better liquidity than directly negotiated debt contracts.
d. less price risk if interest rates change.
e. All of the above.
Answer: E

9. Which of the following refers to the possibility that a firm’s owners or managers will take actions
contrary to the promises contained in the covenants of the securities the firm issues to raise funds?
a. Liquidity risk.
b. Price risk.
c. Credit risk.
d. Intermediation.
e. Agency costs.
Answer: E

10. Depository institutions (DIs) play an important role in the transmission of monetary policy from the
Federal Reserve to the rest of the economy primarily because
a. loans to corporations are part of the money supply.
b. bank loans are highly regulated.
c. savings institutions provide a large amount of credit to finance residential real estate.
 d. DI deposits are a major portion of the money supply.
e. U.S. DIs compete with foreign financial institutions.
Answer: D

11. Which of the following measures the difference between the private costs of regulations and the private
benefits of those regulations for the producers of financial services?
a. Capital adequacy.
b. Agency costs.
c. Net regulatory burden.
d. Charter value.
e. Liquidity risk.
Answer: C

12. Which of the following is the term used when a banker refuses to make loans to residents living within
certain geographic boundaries?
a. Credit allocation.
b. Redlining.
c. Intermediation.
d. Externalization.
e. Spinning.
Answer: B

13. Why is the failure of a large bank more detrimental to the economy than the failure of a large steel
manufacturer?
a. The bank failure usually leads to a government bailout.
b. There are fewer steel manufacturers than there are banks.
c. The large bank failure reduces credit availability throughout the economy.
d. Since the steel company's assets are tangible, they are more easily reallocated than the intangible
bank assets.
e. Everyone needs money, but not everyone needs steel.
Answer: C

14. Why do households prefer to use FIs as intermediaries to invest their surplus funds?
a. Transaction costs are low to the household since FIs are more efficient in monitoring and
gathering investment information.
b. To receive the benefits of diversification that households may not be able to achieve on their
own.
c. The FI has can benefit from combining funds and negotiating lower asset prices and
transactions costs.
d. The FI can provide insurance at relatively low cost that will protect funds under management.
e. All of the above.
Answer: E
15. Financial intermediaries are
a. funds surplus units, because they exist to make money.
b. funds deficit units, because they must pay heavy regulatory fees and taxes.
c. funds surplus units, because they hold large portfolios of financial securities.
d. funds deficit units, because they must comply with minimum capital requirements.
e. neither funds surplus nor deficit units.
Answer: E

16. Net regulatory burden for FIs is higher because regulators may require the FI to
a. to hold more capital than what would be held without regulation.
b. to produce less information than would be produced without regulation.
c. to hold more debt than what would be held without regulation.
d. hold fewer reserves than they would without regulation.
e. All of the above.
Answer: A

17. In a world without FIs, households will be less willing to invest in corporate securities because they
a. are not able to monitor the activities of the corporation more closely than FIs.
b. tend to prefer shorter, more liquid securities.
c. are subject to price risk when corporate securities are sold.
d. may not have enough funds to purchase corporate securities.
e. All of the above.
Answer: E

18. Which of the following is true of secondary securities?

a. They include equities, bonds, and other debt claims.
b. They are backed by the real assets of corporations issuing them.
c. They are securities that back primary securities.
d. They are securities issued by FIs.
e. They must be placed in a separate account on order for primary securities to be offered.
Answer: C

19. The following are protective mechanisms that have been developed by regulators to promote the safety
and soundness of the banking system EXCEPT
a. encouraging banks to rely more on deposits rather than debt or capital as a cushion against
failure.
b. encouraging banks to limit lending to a single customer to no more than 10% of capital.
c. the provision of deposit insurance.
d. the periodic monitoring of banks.
e. encouraging banks to produce timely accounting statements and reports.
Answer: A
20. Safety and soundness regulations include all of the following layers of protection EXCEPT
a. the provision of guaranty funds.
b. requirements encouraging diversification of assets.
c. the creation of money for those FIs in financial trouble.
d. requiring minimum levels of capital.
e. monitoring and surveillance.
Answer: C