Finance Final Exam Practice Questions

What is the general relationship between mortgage rates and long-term government security rates?

The general relationship between mortgage rates and long-term government security rates (like the U.S. 10-year Treasury note) is that they tend to move in the same direction. Mortgage rates are influenced by the yields on these government securities because they represent a benchmark for the cost of borrowing in the economy.

Explain how mortgage lenders can be affected by interest rate movements. Also explain how they can insulate themselves against interest rate movements.

Mortgage lenders are significantly affected by interest rate movements. If a lender holds loans (instead of selling them), and interest rates rise, the market value of those fixed-rate loans drops, leading to losses. Lenders insulate themselves against interest rate movements by selling loans quickly, mixing fixed and adjustable rate mortgages, implement forward sales agreements, and interest rate swaps.

Why is the 15-year mortgage attractive to homeowners?

The 15-year mortgage is attractive to homeowners primarily because it offers lower total interest costs.

Is the interest rate risk to the financial institution higher for a 15-year mortgage or a 30-year mortgage? Why?

The interest rate risk to a financial institution is higher for a 30-year mortgage than for a 15-year mortgage. A 30-year mortgage has a longer duration, meaning the lender's funds are tied up for a much longer time. Borrowers are more likely to refinance or prepay 30-year mortgages when interest rates fall, leading to prepayment risk. In a 30-year mortgage, the lender receives a slower return of principal, delaying reinvestment opportunities and locking the lender into older, potentially less favorable interest rates for a longer period.

Describe the shared-appreciation mortgage.

A shared-appreciation mortgage (SAM) is a type of home loan in which the borrower agrees to share a portion of the property's future appreciation in value with the lender, in exchange for favorable loan terms, such as a lower interest rate or reduced monthly payments.

Explain the rights of common stockholders that are not available to other individuals.

They have voting rights (electing board of directors and approving major corporate actions).

If the company declares dividends, common shareholders are entitled to them after preferred shareholders are paid.

Common stockholders can buy and sell shares freely on public exchanges (for publicly traded companies), giving them liquidity.

Explain why the stock price of a firm may rise when the firm announces that it is repurchasing its shares.

A firm's stock price may rise when it announces a share repurchase (buyback) because the market often interprets this as a positive signal about the company's financial health, future prospects, and management’s confidence. A buyback signals that management believes the stock is undervalued.

Create a balance sheet for a typical bank, showing its main liabilities (sources of funds) and assets (uses of funds).

Assets (Uses of Funds) - Mortgages, personal loans, business loans and Government bonds, municipal bonds, MBS

Liabilities - Bonds or other long-term debt instruments and Short-term borrowing from other banks

What are four major sources of funds for banks?

Customer Deposits (checking accounts, savings accounts, certificates of deposits), Borrowing from other financial institutions ( interlock loans, repurchase agreements, borrowing central banks), Issuance of debt securities (bonds or notes), Shareholders equity ( common stock, preferred stock, and retained earnings).

Which alternatives does a bank have if it needs temporary funds?

Borrowing from other banks, repurchase agreements, Borrowing from the central bank, selling Liquid Assets, Issuing commercial paper.

What is the most common reason that banks issue bonds?

The most common reason that banks issue bonds is to raise long-term funding to support their lending activities and general operations, especially when they need a stable, predictable source of capital beyond short-term deposits.

Explain how the federal funds market facilitates bank operations.

The federal funds market facilitates bank operations by allowing banks to lend and borrow short-term funds (usually overnight) to meet their reserve requirements and manage liquidity efficiently.

Explain why mutual funds are attractive to small investors.

Mutual funds are attractive to small investors because they offer diversification, professional management, ease of investment, and liquidity—key advantages that would be difficult for an individual investor to achieve on their own with limited capital.

How can mutual funds generate returns to their shareholders?

Capital Gains - When the price of securities held by the fund increases, and the fund sells them at a profit, this creates capital gains.

Dividend Income - If the fund holds dividend-paying stocks or interest-bearing bonds, it earns income from these investments.

Increase in NAV - The NAV per share of a mutual fund may rise over time as the value of its underlying assets grows. Investors realize this return when they sell their mutual fund shares for more than they paid.

Like mutual funds, commercial banks and stock-owned savings institutions sell shares, but the proceeds received by mutual funds are used in a different way. Explain.

Mutual Funds -

Use of proceeds: The money from selling mutual fund shares goes directly into buying financial assets on behalf of the fund’s shareholders.

Commercial Banks and Stock-Owned Savings Institutions -

• Use of proceeds: The funds are used to support the bank’s operations—such as:

  • Making loans

  • Meeting capital requirements

  • Expanding services or facilities

Describe the ideal mutual fund for investors who wish to generate tax-free income but also maintain a low degree of interest rate risk.

Short-Term Municipal Bond Fund

1. Tax-Free Income

• The interest they pay is exempt from federal income tax.

📉 2. Low Interest Rate Risk

• A short-term bond fund holds bonds with maturities typically under 3 years. Shorter maturities make the fund’s value less sensitive to changes in interest rates.

Explain why diversification across different types of mutual funds is highly recommended.

Diversification across different types of mutual funds is highly recommended because it helps investors reduce risk, smooth returns, and adapt to changing market conditions, ultimately creating a more stable and resilient investment portfolio.

Explain the role of the SEC, FINRA, and the stock exchanges in regulating the securities industry.

SEC (Securities and Exchange Commission)

• Mission: To protect investors, maintain fair and efficient markets, and facilitate capital formation.

• Responsibilities:

  • Enforces Securities Laws: The SEC enforces major securities laws.

  • Registration and Disclosure: Requires companies to disclose material financial information to the public through filing.

FINRA (Financial Industry Regulatory Authority)

Role: FINRA is a self-regulatory organization (SRO) that regulates broker-dealers and markets. It works under the oversight of the SEC to ensure the fairness and integrity of broker-dealer activities and investment professionals.

• Responsibilities:

  • Licensing and Registration: FINRA oversees the licensing of individuals and firms that sell securities, ensuring they meet professional standards.

  • Regulating Broker-Dealer Activities: FINRA sets rules and regulations for brokers and dealers, such as suitability rules.

Stock Exchanges (e.g., NYSE, NASDAQ)

Role: Stock exchanges like the New York Stock Exchange (NYSE) and NASDAQ provide a regulated marketplace where securities are bought and sold. While they are private entities, they are subject to SEC oversight and must comply with federal regulations.

• Responsibilities:

• Listing Standards: Stock exchanges set the criteria for listing companies' shares.

• Market Surveillance: They monitor trading activity to ensure there is no market manipulation, insider trading, or other forms of unfair trading.

• Regulatory Compliance: Enforce their own rules in accordance with SEC regulations, ensuring transparency and fair play in transactions.

Describe the origination process for corporations that are about to issue new stock.

• Develop a Prospectus (S-1 Registration): The company files a detailed document with the SEC, which includes financial statements, risk factors, and other relevant information about the company.

• Road Shows: The company’s management meets with institutional investors to generate interest in the IPO, discuss the company’s potential, and get feedback to help finalize pricing.

• Book Building: Underwriters gather indications of interest from institutional investors to determine the offering price of the IPO based on demand.

• Lock-Up Period: After the IPO, insiders (company executives, employees, etc.) are prohibited from selling their shares for a set period (usually 90 to 180 days) to avoid market instability.

What is a best-efforts agreement?

A best-efforts agreement is a type of arrangement used in securities offerings, where the underwriters (usually investment banks) agree to sell as many shares as possible to the public, but do not guarantee the sale of the entire offering.