Question 1

Suppose the current one- year interest rate is 6%, and financial markets expect the one- year interest rate next year to be 7%, and expect the one- year rate to be 8% the year after that. Given this information, the yield to maturity on a three- year bond will be:

Accepted Answer

D

Question 2

Equity finance is represented by which of the following?

Accepted Answer

Equity finance refers to raising capital by selling shares of stock. This allows investors to become part-owners of the company and share in its profits and losses.

Question 3

Which of the following represents a form of equity finance?

Accepted Answer

Stock is a form of equity finance as it represents ownership in a company and holders of stock have a claim on the assets and profits of a company. Bonds and loans represent debt finance as they involve borrowing money that needs to be repaid with interest.

Question 4

Suppose policy makers, as expected, cut the level of taxes. Which of the following will occur as a result of this expected tax cut?

Accepted Answer

The answer of Suppose policy makers, as expected, cut the...

Question 5

Assume that the current one- year rate is 5% and the two- year rate is 9%. Given this information, the one- year rate expected one year from now is:

Accepted Answer

The expected one-year rate one year from now can be calculated using the formula for forward rates: (1 + two-year rate)^2 = (1 + current one-year rate) * (1 + expected one-year rate one year from now). Solving for the expected rate gives approximately 13%.

Question 6

Assume that the RBA is expected to respond to any event by keeping the interest rate constant (i.e., equal to its initial level). An unexpected tax cut will cause:

Accepted Answer

An unexpected tax cut will increase consumer disposable income and increase spending, which will lead to higher corporate earnings and thus higher stock prices. The RBA keeping interest rates constant will not affect this relationship.

Question 7

Suppose that financial market participants expect short- term rates to decrease in the future. Given this information, we would expect:

Accepted Answer

When market participants expect short-term rates to decrease in the future, it typically leads to a downward sloping yield curve. This is because the yields on longer-term securities are expected to be lower than the yields on shorter-term securities, reflecting the anticipated decline in rates.

Question 8

Suppose the current one- year interest rate is 8%, and financial markets expect the one- year interest rate next year to be 14%. Given this information, the yield to maturity on a two- year bond will be approximately:

Accepted Answer

The yield to maturity on a two-year bond, given the expectations theory, is the average of the current one-year interest rate and the expected one-year interest rate next year. Thus, (8% + 14%) / 2 = 11%.

Question 9

Which of the following variables would not influence the present value price of a share of stock at time t?

Accepted Answer

The answer of Which of the following variables would not...

Question 10

Suppose there is an increase in the short- term interest rate. Given this increase in the current short- term interest rate, which of the following will most likely occur?

Accepted Answer

An increase in the short-term interest rate may signal that inflation is on the rise, which could lead to an increase in the long-term interest rate as well. However, the increase in the long-term interest rate is likely to be less than the increase in the short-term interest rate because investors may still seek the security of longer-term investments even in the face of rising short-term rates.

Question 11

Which of the following represents a stock's fundamental value?

Accepted Answer

A stock's fundamental value is based on its future expected dividend payments. Therefore, the present value of its expected future dividend payments represents its fundamental value. The other options, such as being in the midst of a rational bubble or assuming all future dividend payments are multiplied or added together, do not necessarily reflect the true fundamental value of the stock.

Question 12

Suppose the central bank decreases the money supply as expected. Which of the following will occur as a result of this expected policy decision?

Accepted Answer

The answer of Suppose the central bank decreases the money...

Question 13

Assume that the RBA is expected to respond to any event by keeping the interest rate constant (i.e., equal to its initial level). An unexpected tax increase will cause:

Accepted Answer

An unexpected tax increase will reduce disposable income, which in turn will lower consumer spending on goods and services. This will lower the profits of firms, leading to a fall in stock prices. Since the RBA is expected to keep the interest rate constant, there will be no offsetting effect on stock prices.

Question 14

Which of the following statements about indexed bonds is correct?

Accepted Answer

Indexed bonds have interest rates that adjust with inflation, are used in various countries including England for retirement savings, and do exist in Australia.

Question 15

Which of the following does not represent a form of debt finance?

Accepted Answer

Stock represents equity finance, not debt finance.

Question 16

Suppose that financial market participants now expect a future tax cut and that the yield curve is initially upward sloping. Given this information, we would expect which of the following to occur?

Accepted Answer

If financial markets expect a future tax cut, this suggests an increase in economic growth and demand for credit, causing interest rates to rise. As a result, the yield curve will become steeper as the difference between short-term and long-term interest rates widens. This is consistent with the expectations theory of the yield curve. Choice A is incorrect because a vertical yield curve would suggest that there is no difference between short-term and long-term interest rates, which is unlikely. Choice C is incorrect because a U-shaped yield curve is associated with an inverted yield curve, which typically occurs during economic recessions. Choice D is incorrect because a horizontal yield curve would imply that interest rates remain constant across all maturities, which is also unlikely. Choice E is incorrect because a flatter yield curve would suggest that the difference between short-term and long-term interest rates is decreasing, which goes against the expectations theory.

Question 17

Suppose households unexpectedly decrease consumption. Which of the following will occur as a result of this consumer pessimism?

Accepted Answer

The answer of Suppose households unexpectedly decrease consumption. Which of...

Question 18

Suppose policy makers decrease government spending according to expectations. Which of the following will occur as a result of this policy measure?

Accepted Answer

The answer of Suppose policy makers decrease government spending according...

Question 19

Why do investors demand an equity premium to hold stocks?

Accepted Answer

Investors demand an equity premium to hold stocks because they perceive stocks to be riskier than bonds. Stocks are subject to large price fluctuations due to various factors such as economic and political developments, company performance, and market sentiments. This uncertainty and volatility make stocks more risky than bonds, which typically offer a fixed income stream and lower default risk. Therefore, investors demand an equity premium to compensate for the added risk they bear by holding stocks.

Question 20

Assume that the central bank implements monetary expansion that is fully anticipated by financial markets. This fully anticipated monetary expansion will cause which of the following to occur?

Accepted Answer

When monetary expansion is fully anticipated, it is already priced into the stock market, so stock prices remain unchanged.

Quiz 15: Financial Markets and Expectations