Question 1

Small and illiquid assets that are unable to be sold individually can be pooled together into financial instruments in order to reduce risk and to be sold to general investors. This strategy is called:
A)Diversification.
B)Securitization.
C)Investment.
D)Due diligence.

Accepted Answer

The method of pooling small and illiquid assets into financial instruments to reduce risk and then sell them to general investors is called securitization. Because each security will represent a fraction of the total value of the diverse pool of these assets, the risk of investing in the assets is reduced.
Key Takeaway: Securities that have their value and income payments derived from and backed by this specified pool of assets are asset-backed securities.

Question 2

What is the primary responsibility of the U.S. Securities and Exchange Commission (SEC)?
A)Regulating the securities industry, stocks, and options exchanges.
B)Enforcing the federal securities laws.
C)Regulating electronic securities markets.
D)All of the above.

Accepted Answer

The SEC is an independent agency of the U.S. government which holds primary responsibility for:
1. Regulating the securities industry, the nation's stock exchanges, and option exchanges.
2. Enforcing the federal securities laws.
3. Regulating other electronic securities markets.
Key Takeaway: The SEC requires that public companies and their managers submit quarterly and annual financial reports that outline the previous year's operations and next year's plans. It will bring about information transparency for investors in order to make rational decisions.

Question 3

NASDAQ, the National Association of Securities Dealers Automated Quotations, is an American stock exchange. It is the largest electronic screen-based securities trading market in the United States. What is the authority that oversees NASDAQ operations and regulations?
A)NASCAR
B)NASD
C)NASB
D)NASA

Accepted Answer

NASD, or the National Association of Securities Dealers, is the self-regulatory organization of the securities industry responsible for the operations and regulations of NASDAQ, the stock market, and over-the-counter markets. It also administers exams for investment professionals.
Key Takeaway: With approximately 3,800 companies and corporations, NASDAQ has more trading volume per hour than any other stock exchange in the world. Hence, the role played by NASD is extremely important in regulating NASDAQ. In 2007, NASD merged with the New York Stock Exchange's regulation committee to form the Financial Industry Regulatory Authority, or FINRA in order to perform their responsibilities better.

Question 4

The Sarbanes-Oxley Act of 2002 is a federal law enacted in reaction to which of the following events?
A)The Madoff's Ponzi scheme.
B)The Enron debacle.
C)The WorldCom collapse.
D)All of the above.

Accepted Answer

The Sarbanes-Oxley Act of 2002 is a federal law enacted to respond to major corporate and accounting scandals, including the Madoff's Ponzi scheme, the Enron debacle, and the WorldCom collapse. The act oversees, regulates, inspects, and disciplines accounting firms; and covers issues such as auditor independence, corporate governance, and enhanced financial disclosure.
Key Takeaway: The enactment of the Sarbanes-Oxley Act shows the effort of the government to prevent financial losses and maintain public confidence in the national securities market.

Question 5

Long-Term Capital Management (LTCM) was a U.S. hedge fund which used trading strategies combined with high leverage. Despite initial enormous profits, it failed spectacularly in 1998. What most likely led to this failure? Select all that apply.
A)The uncontrolled use of high leverage.
B)The Asian Financial crisis in 1997.
C)The Russian Financial crisis in 1998.
D)The incompetent board of directors.

Accepted Answer

Uncontrolled use of high leverage and the Russian Financial crisis in 1998 are two reasons that led to the collapse of LTCM in 1998. The uncontrolled use of high leverage brought about huge returns to LTCM, which then allowed many banks to extend credit to LTCM at very low interest rates. However, the Russian debt crisis widened spreads between government debt and risky debt unexpectedly in almost all the LTCM trades. LTCM lost 90% of its value and experienced a severe liquidity crisis, which led to its financial collapse.
Key Takeaway: This case illustrates the prominent example of risk potential in the hedge fund industry. When LTMC faced liquidity crisis, it could not sell billions in illiquid assets at fair prices, nor could it find more capital to maintain its position until volatility decreased and interest rate credit spreads returned to normal

Question 6

A liquidity trap is...
A)A strategy that an investor would use to gain his competitor's liquid assets.
B)A situation where the liquidity in the market created by low interest rates does not stimulate the economy to full employment.
C)A strategy that banks use to trap house owners to pay their mortgages.
D)A situation when liquid assets become illiquid because they are unable to be sold or bought.

Accepted Answer

A liquidity trap describes the situation where the liquidity in the market created by low interest rates does not stimulate the economy to full employment.
Key Takeaway: The nominal interest rate cannot drop below zero. Any further injection of liquidity will not further lower the nominal interest rate.

Question 7

A bank run is...
A)A portable bank service that is convenient for customers to deposit or withdraw their money.
B)A situation when a bank lends out a lot to customers.
C)A situation when a large number of customers withdraw their deposits because they believe the bank might be or is insolvent.
D)A situation when a big bank splits into different smaller banks.

Accepted Answer

A bank run is an initial phase for bankruptcy if it is not prevented. As more people withdraw their deposits, the likelihood of default increases and this encourages further withdrawals. This can destabilize the bank to the point where it faces bankruptcy. If many banks suffer runs at the same time, it leads to the financial crisis of bank panic.

Question 8

WePro Ltd. is considered to be highly leveraged. What does "highly leveraged" refer to in the company situation?
A)WePro Ltd. has significantly more debt than its equity.
B)WePro Ltd. Breaks even in sales.
C)WePro Ltd. has made huge profit.
D)WePro Ltd. is facing bankruptcy.

Accepted Answer

WePro Ltd. is considered to be highly leveraged, which means that it has significantly more debt than its equity.
Key Takeaway: Leverage refers to the use of debt to supplement investment. WePro Ltd. can leverage to increase returns to stock, as this practice can maximize gains. However, it has to be careful not to become highly leveraged.

Question 9

A hedge fund is...
A)A fund that can be transferred among investors.
B)An investment fund open to a limited range of investors permitted to undertake a wider range of investment and trading activities.
C)An unlimited fund that the Federal Reserve Bank assigns for only limited corporations.
D)An unconditional fund for the development of venture companies.

Accepted Answer

A hedge fund is an investment fund available to a limited range of investors that is permitted by regulators to undertake a wider range of investment and trading activities than other investment funds. A hedge fund has to pay a performance fee to its investment manager.
Key Takeaway: Hedge funds are normally for the super rich and sophisticated investors, who possess great investment knowledge. By law, these investors must earn a minimum amount of money every year. Their net worth must be more than S1 million in order to become members of a hedge fund.

Question 10

Which of the following is considered a "hedge fund"? Select all that apply.
A)A venture capital fund.
B)A private equity fund.
C)A real estate partnership.
D)None of the above.

Accepted Answer

A venture capital fund, a private equity fund, a commodity pool, and real estate partnership are not considered "hedge funds." The reason is that by definition, hedge funds generally take leveraged positions in publicly traded equity, debt, foreign exchange, and derivatives. Therefore, those funds above do not match the definition of hedge funds.
Key takeaway: Hedge funds are normally for the super rich and sophisticated investors, who possess great investment knowledge. By law, these investors must earn a minimum amount of money every year, and their net worth must be more than S1 million in order to become members of a hedge fund.

Question 11

The Mississippi Scheme was formulated by John Law for the colonization and commercial exploitation of the Mississippi Valley and other French colonial areas. The main reason for its financial collapse in October 1720 was
A)The failure to launch a plan to exploit gold in the Mississippi, since there was no gold to be found.
B)The colonization and commercial exploitation of the Mississippi valley and other French colonial areas faced a strong opposition from the tribal people.
C)The speculation about the richness of the area.
D)Decline in investment from other overseas companies.

Accepted Answer

The main reason for the Mississippi Scheme to collapse is the speculation about the richness of the area, plus the overexpansion of John Law's activities, and the haste with which he proceeded with the plan.
Key Takeaway: The Mississippi Scheme is a case of a speculative bubble, which happens when there is frenzied maniac optimism about the value of an asset. The price of the asset then increases rapidly, resulting in more buyers than sellers. However, if there is no one who wants to buy the asset, its value gradually decreases. This in turn causes collapse in asset prices, intense pessimism, and financial distress.

Question 12

On June 30, 2009, Bernard Madoff was sentenced to 150 years for his fraudulent financial activities. He defrauded thousands of investors out of $65 billion. What fraudulent scheme did he use?
A)A Ponzi scheme.
B)A Black-Scholes scheme.
C)An advance fee scheme.
D)A bucket shop scheme.

Accepted Answer

Bernard Madoff was convicted of operating a Ponzi scheme, which pays the first people in the scheme with the money from later people. This scheme usually offers very high and short term returns in order to attract new investors. This scheme takes advantage of investors' ignorance about the financial system. If the earnings are less than the payments, however, the system will collapse.
The Ponzi scheme takes advantage of peoples' false expectations about high returns from attractive-sounding investments. Madoff, who was then a non-executive Chairman of NASDAQ, used his reputation to deceive thousands of investors in the fraud.
Key Takeaway: Due diligence is the key to avoiding financial scams. If something seems too good to be true, it probably is.

Question 13

What is Fannie Mae?
A)A well known wholesale chain in America.
B)The Federal National Mortgage Association (FNMA).
C)The name of a brand for electronic fans.
D)The Federal Home Loan Mortgage Corporation.
E)All of the above.

Accepted Answer

Fannie Mae is the Federal National Mortgage Association (FNMA). It buys mortgages and securitizes them to make sure that funds are always available for institutions to lend money to home buyers.
Key Takeaway: By late 2007, Fannie Mae lost more than 90% of its share value and had to be bailed out by the federal government.

Question 14

As an investor, Tom is obliged to perform due diligence. What is "due diligence"?
A)Education on market regulations.
B)The paperwork required to make an investment.
C)The responsibility to gather necessary information on actual or potential risks involved in an investment.
D)Commitment to be diligent all the time for investment projects in order to prevent actual or potential risks.
E)None of the above.

Accepted Answer

Due diligence is the act of gathering information on actual or potential risks involved in an investment.
Key Takeaway: As there are many actual and potential risks involved in an investment, an investor should be extremely careful in gathering all necessary information. Without this due diligence, there can be mistakes or miscalculations which lead to huge losses in investments.

Question 15

Bankruptcy refers to a situation when a court judges that a debtor (or a borrower) is unable to make the payments owed to a creditor (or a lender). America's bankruptcy code for corporate entities can be found in
A)Chapter 8.
B)Chapter 9.
C)Chapter 10.
D)Chapter 11.

Accepted Answer

Chapter 11 is a chapter of American's bankruptcy code which permits reorganization of corporate entities under the bankruptcy laws in America. This chapter protects firms from their creditors. It is particularly friendly to troubled borrowers, allowing them to borrow more money and giving them time to work out their problems.
Key Takeaway: In 2001, Enron, the giant American energy corporation, filed for bankruptcy protection. It tried to repay its debts by selling off any asset it had.

Question 16

Insolvency refers to:
A)Having illiquid assets.
B)Bankruptcy.
C)Having negative net assets as liabilities exceed assets.
D)The inability to pay debts when they fall due.

Accepted Answer

Insolvency refers to having negative net assets and the inability to pay debts as they fall due.
Key Takeaway: Bankruptcy is a determination of insolvency. In July 2002, WorldCom filed for bankruptcy protection, in what was considered the largest corporate insolvency ever at the time.

Question 17

Income elasticity of demand is a measure of how demand for a good changes with people's income.

Accepted Answer

Income elasticity of demand measures how the quantity demanded changes when income increases. Luxury goods are highly income elastic, while staples such as basic food and clothing are less income elastic.
Key Takeaway: Understanding how a good is treated by consumers in a dynamic economy is essential to understanding how a company will fare as people's income rises and falls with economic ups and downs.

Quiz 6: Terms and Concepts

Small and illiquid assets that are unable to be sold individually can be pooled together into financial instruments in order to reduce risk and to be sold to general investors. This strategy is called:

What is the primary responsibility of the U.S. Securities and Exchange Commission (SEC) ?

NASDAQ, the National Association of Securities Dealers Automated Quotations, is an American stock exchange. It is the largest electronic screen-based securities trading market in the United States. What is the authority that oversees NASDAQ operations and regulations?

The Sarbanes-Oxley Act of 2002 is a federal law enacted in reaction to which of the following events?

Long-Term Capital Management (LTCM) was a U.S. hedge fund which used trading strategies combined with high leverage. Despite initial enormous profits, it failed spectacularly in 1998. What most likely led to this failure? Select all that apply.

A liquidity trap is...

A bank run is...

WePro Ltd. is considered to be highly leveraged. What does "highly leveraged" refer to in the company situation?

A hedge fund is...

Which of the following is considered a "hedge fund"? Select all that apply.

The Mississippi Scheme was formulated by John Law for the colonization and commercial exploitation of the Mississippi Valley and other French colonial areas. The main reason for its financial collapse in October 1720 was

On June 30, 2009, Bernard Madoff was sentenced to 150 years for his fraudulent financial activities. He defrauded thousands of investors out of $65 billion. What fraudulent scheme did he use?

What is Fannie Mae?

As an investor, Tom is obliged to perform due diligence. What is "due diligence"?

Bankruptcy refers to a situation when a court judges that a debtor (or a borrower) is unable to make the payments owed to a creditor (or a lender) . America's bankruptcy code for corporate entities can be found in

Insolvency refers to:

Income elasticity of demand is a measure of how demand for a good changes with people's income.