Multiple Choice

11. Prepayment risk is:

A. the risk you will not receive the cash flows on a mortgage-backed security

B. the risk that you will receive the cash flows sooner than expected and be forced to invest at a lower rate.

C. the risk that you will receive the cash flows later than expected and not be able to invest at current, higher rates.

12. Based on the video Inside the Meltdown, it appeared that the main reason Lehman Brothers was allowed to fail was:

A. systemic risk.

B. moral hazard.

C. it was a smaller and less important bank than Bear Stearns

D. Ben Bernanke did not like the CEO of Lehman Brothers

13. Which of the following should have the highest yield?

A. 90 day Treasury bill

B. 30-year BB corporate bond.

C. 30-year Treasury bond

D. 10-year AA corporate bond.

14. A contract that acts like an insurance policy against bond defaults (and other credit events) is called a(n):

A. collateralized debt obligation.

B. mortgage-backed security

C. credit default swap

D. plain vanilla interest rate swap

15. Which of the following has happened this semester (since we started school in January)?

A. Bars and restaurants are closing around the country to help with social distancing.

B. The Dow Jones Industrial Average has dropped more than 5000 points.

C. The Federal Reserve has cut the Fed funds rate.

D. All of the above have happened this semester.

16. The ________________________is used to find the discount rate (i.e., a stocks required rate of return) on an equity security.

A. nominal risk free rate of interest plus a default risk premium.

B. capital asset pricing model (CAPM).

C. yield to maturity.

D. nominal risk free rate of interest minus expected inflation.

17. The value of a stock is negatively (meaning the stock price decreases as the variable increases) related to which of the following variables?

A. an increase in k (the discount rate).

B. an increase in the dividend.

C. an increase in g (the growth rate in dividends and earnings).

D. both A and B.

E. both B and C.

18. A call option is out-of-the-money when:

A. the strike price is greater than the market price of the underlying stock.

B. the strike price is less than the market price of the underlying stock.

C. the option premium is greater than $0.

D. the strike price is greater than the option premium.

19. What set of conditions would result in a bond with the greatest price volatility (for a given change in interest rates)?

A. high coupon bond with a short maturity

B. high coupon bond with a long maturity

C. low coupon bond with a short maturity

D. low coupon bond with a long maturity

20. There are several problems with the mortgage-backed securities market that contributed to the financial crisis. Which of the following is NOT a problem with mortgage-backed securities (MBS)?

A. The underlying collateral (i.e., mortgages) was damaged by sub-prime lending.

B. Fannie Mae and Freddie Mac were encouraged to buy mortgages so that more people could own homes. The investment banks started buying mortgages too.

C. There is less incentive to make good loans because banks sell mortgage loans after they make them.

D. Investors who engaged in credit default swaps felt safe in investing in higher risk MBSs because they had effectively transferred the default risk to companies like AIG.

E. All of the above are factors in the financial crisis.

21. Companies are more likely to call bonds when:

A. the company has a ratings downgrade

B. when interest rates rise

C. when they are about to violate the terms of the indenture (like violate a bond covenant)

D. when interest rates fall

22. You intend to value a stock using a relative valuation model. Which of the following is a relative valuation model?

A. D₁/(k g)

B. D₀/k

C. P/E x expected earnings

D. discount the expected dividends and the expected selling price of the stock back to time zero using your required rate of return.

23. The way the Federal Reserve and Congress ultimately bailed out the banking system in the 2007-2008 financial crisis was to:

A. buy the toxic assets from the banks.

B. create a company to sell the toxic assets.

C. make an equity investment in a number of large banks.

D. because of moral hazard, the Fed and Congress did not bail out the banks.

24. In a fixed-rate, amortizing loan such as a fixed-rate mortgage:

A. the loan is paid back with interest only payments each month and then all of the principal is paid in one balance at the end of the life of the loan.

B. the amount of interest paid to the bank increases each month.

C. the amount of principal repaid (to pay down the loan) increases each month.

D. the lender has the right to call the loan if rates rise above a certain threshold.

25. You intend to value a stock using a dividend discount model. Which of the following is a dividend discount valuation model?

A. D₁/(k g)

B. D₀/k

C. P/E x expected earnings

D. Both A and B

E. Both A and C