fin exam 1

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Slippery Rock University of Pennsylvania *

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320

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Finance

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Jan 9, 2024

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pdf

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FIN 323: FINANCIAL MARKETS AND INSTITUTIONS QUIZ 1: Chapters 1 and 2 (100 points) NAME Instructions: Part 1: True/False (10 points each *8 = 80 points) Indicate whether the following statement is true or false. Provide at least five sentences of explanation to support your answer. Even if the answer is true, students need to elaborate to earn full credit 1. The required return to implement a given business project will be lower if interest rates are lower. This implies that businesses will demand a lower quantity of loanable funds when interest rates are lower because projects are more likely to yield negative NPV at the lower discount rate. a True b. False Explanation The statement above is false, business will want a higher quantity of loanable funds when interest rates are lower. This is because there is an inverse relationship between interest rates and the quantity of loanable funds demanded. When interest rates are lower the cost of borrowing is lower. This makes it more attractive for business to borrow funds. Lower interest rates can reduce the discount rate that is used to calculate NPV but this doesn't mean that this will yield a negative NPV. Lower interest rates can make business projects more feasible because there is a lower cost of financing them. 2. As a result of more favorable economic conditions, there is a(n) increase demand for loanable funds, causing an outward shift in the demand curve and a rise in interest rate. a. True b. False Explanation The statement above is true. This is because when there are favorable economic conditions, businesses often have a boost in confidence which can lead to increased demand to take on investment projects and business expansions. These projects require financing which induces a demand for loanable funds. This increase in demand causes and outward shift in the demand

curve. Because of this increase in demand lenders could raise interest rates to help reach an equilibrium in regard to the supply and demand of loanable funds. 3. For a given set of foreign interest rates, the quantity of U.S. loanable funds demanded by foreign governments or firms will be positively related to U.S. interest rates. a. True b. False Explanation The above statement is false because the quantity of U.S. loanable funds demanded by foreign governments or firms is typically inversely related to U.S. interest rates. This is because as U.S. interest rates increase the quantity of U.S. loanable funds demanded by foreign entities decrease. Generally, a country's demand for foreign funds will depend on the interest differential between the domestic interest rate and the United States. In simpler terms U.S funds would be wanted by foreign governments and firms when their domestic rates are higher when compared to the United States. So as we can see when higher U.S interest rates are presents this can offer foreign governments and firms better returns when compared to their own markets. 4. A higher federal government deficit increases the quantity of loanable funds demanded at any prevailing interest rate, causing an outward shift in the demand schedule. a. True b. False Explanation The above statement is true. This is because a high government deficit results in an increase of loanable funds demanded at any prevailing interest rate. This is due to the government needing to borrow money to cover its deficit. This can lead to the “crowding-out effect” which is when the government's demand contends with the private demand for funds. This will result in the supply curve shifting outward because the government spending can result in the creation of more jobs.

5. Assume that foreign investors who have invested in U.S. securities decide to decrease their holdings of U.S. securities and instead increase their holdings of securities in their own countries. This should cause the supply of loanable funds in the United States to increase and should place upward pressure on U.S. interest rates. a. True b. False Explanation The above statement is true. If foreign investors decrease, their holdings and increase their holdings of securities in their own countries, this will result in a decrease in demand for U.S. securities. Which would result in an increase of supply in loanable funds in the U.S. The supply of U.S loanable funds is influenced by U.S Fiscal Policy, Monetary Policy, and the supply of funds provided by foreign investors. The increase in the amount of loanable funds places upward pressure on U.S interest rates. 6. Money market securities such as stocks and bonds generally have high liquidity. Capital market securities such as Treasury bill and commercial papers are typically expected to have a high annualized return. a. True b. False Explanation The above statement is false. It is true money market security's generally have high liquidity, due to them having a maturity of one year or less. But they also have a low expected rate of return and offer a low risk. While capital market securities have a maturity of more than one year and offer higher annualized returns. Capital markets have more risk than money market securities and are less liquid but offer higher annualized returns due to their higher risk. 7. If markets are perfect, securities buyers and sellers will have full access to information and can always break down securities to the precise size they desire without the need of financial institutions. true false Explanation: The above statement is true. In a perfect market it is hypothesized securities buyers and sellers have full access to information and can break down securities to the size they desire. This is immensely theoretical, but because the buyers and sellers have full access to the information,

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they are able to make informed decisions. Because of this they can do this without the need of a financial institution to facilitate things. Also, in the scenario of a perfect market the securities can be broken down to precise size desired by the buyers and sellers. 8. Credit union and commercial banks and savings institutions are the same except credit union are much larger and only provides loan to members. a. True b. False Explanation The above statement is false. Credit unions are nonprofit entities, which means they operate in the best interest of their members. While commercial banks and savings institutions operate as for-profit entities. Credit unions also limit their business to the members that belong to the credit union. Credit unions also tend to be much smaller than commercial banks and savings institutions. PartI1 1. Explain the following economic force that affects the interest rate (20 points) 1.1 Increase in Economic Expansion Demand of loanable funds=> Increases / Decreases/Remains the same (Choose one answer) Explanation The reason the demand for loanable funds will increase when there is an increase in economic expansion is because business will be more optimistic about their future investments. Meaning when there are lower interest rates business are more willing to take on projects and be more willing to borrow funds. This causes an outward shift within the demand schedule. But with the increase an important thing to note is that the supply of the loanable funds is uncertain. Because the supply is influenced by several factors the direction of the shift in the supply curve is uncertain. Supply of loanable funds=> Increases/Decreases/Remains the Same (Choose one answer) Explanation The supply of loanable funds is uncertain but under certain conditions it can increase. Some factors that can play into it increasing is the suppliers of the loanable funds are willing to supply more if interest rates are higher. The supply of loanable funds is also influenced by the Federal reserve's monetary policy changes. When there are changes in interest rates this can affect the borrwoing and spending of businesses and households, which can influence the supply of funds.

Interest Rate=> Increases/Decreases/Remains the same (Choose one answer) Explanation Their interest rate changes because more businesses and households want to borrow money but the funds available to lend don't increase. Because of this shift in the demand curve the interest rates will increase. Because of the increase in demand for loans, lenders often increase interest rates to manage the increase in demand. The federal reserve's monetary policy also plays a factor in the increase of interest rates to provide price stability as well as to help combat inflation. Plot the graphs of original and new demand and supply curve of loanable funds and show the new equilibrium interest rate. Interest S1&S2 l \ ' Interest 2 : nterest\ / " Quantity of Loanable Funds D1 T —