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DSST Money and Banking study materials
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DSST Money and Banking practice questions

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Question 1Money and the Financial System

In the United States, which institution is responsible for conducting monetary policy by setting a target range for the federal funds rate?

  1. The Federal Open Market Committee Correct answer.
  2. The Office of the Comptroller of the Currency
  3. The Federal Deposit Insurance Corporation
  4. The Securities and Exchange Commission

Explanation

The Federal Open Market Committee (FOMC) is the monetary policy body within the Federal Reserve System; it sets the target range for the federal funds rate and directs open market operations. The other agencies listed are regulators or insurers rather than monetary policymakers.

Question 2Money and the Financial System

Which function of money allows a person to compare the prices of a used car and a laptop without needing to trade goods directly?

  1. Medium of exchange
  2. Store of value
  3. Standard of deferred payment
  4. Unit of account Correct answer.

Explanation

Money as a unit of account provides a common measure in which prices are quoted, which makes relative price comparison possible. A medium of exchange concerns the act of payment, a store of value concerns holding purchasing power over time, and a standard of deferred payment concerns settling debts later.

Question 3Money and the Financial System

A monetary aggregate that includes currency in circulation plus checkable deposits held by the public is best described as which measure?

  1. The monetary base
  2. Reserves held at the central bank
  3. M2
  4. M1 Correct answer.

Explanation

M1 consists of the most liquid forms of money: currency held by the nonbank public plus transaction deposits such as checkable deposits. M2 adds savings-type and time deposits, while the monetary base and reserves are central bank liabilities rather than measures of money held by the public.

Question 4Money and the Financial System

When the Federal Reserve buys government securities in the open market, the immediate effect on the banking system is that:

  1. Required reserve ratios rise
  2. Currency in circulation expands immediately
  3. Bank reserves increase Correct answer.
  4. The discount rate automatically rises

Explanation

An open market purchase credits the accounts that banks hold at the Federal Reserve, so reserves rise directly and the monetary base expands. Reserve requirements and the discount rate are policy tools adjusted by separate decisions, and currency in circulation changes only when the public withdraws cash.

Question 5Money and the Financial System

If the required reserve ratio is 10 percent and a bank receives a new deposit of $5,000 with no excess reserves held beforehand, the maximum additional loans the banking system can create under the simple deposit multiplier is:

  1. $500
  2. $50,000
  3. $5,000
  4. $45,000 Correct answer.

Explanation

The simple deposit multiplier equals 1 divided by the reserve ratio, which is 10 here. The new deposit of $5,000 can support total deposits of $50,000, so the additional lending beyond the original deposit is $50,000 minus $5,000, or $45,000.

Question 6Money and the Financial System

The interest rate at which one bank lends reserves overnight to another bank, using funds held at the Federal Reserve, is called the:

  1. Prime rate
  2. Discount rate
  3. Treasury bill rate
  4. Federal funds rate Correct answer.

Explanation

The federal funds rate is the rate on unsecured overnight lending of reserve balances between depository institutions. The discount rate applies to Fed lending to banks, the prime rate is a benchmark for commercial loans to creditworthy customers, and the Treasury bill rate is the return on short-term government debt.

Question 7Money and the Financial System

A saver who holds cash during a period of rapid inflation experiences a loss of purchasing power. This best illustrates which cost of inflation?

  1. Menu cost
  2. Shoe-leather cost
  3. Reduced real value of money holdings Correct answer.
  4. Tax distortion

Explanation

Inflation erodes the real value of nominal money balances, so people who hold cash lose purchasing power. Shoe-leather costs refer to the extra effort of holding less cash, menu costs refer to the expense of changing prices, and tax distortions arise when nominal gains are taxed.

Question 8Money and the Financial System

Which of the following is counted as part of the monetary base but not part of M1?

  1. Vault cash held by banks Correct answer.
  2. Currency held by the public
  3. Checkable deposits held by households
  4. Traveler's checks held by the public

Explanation

The monetary base equals currency in circulation plus reserves held by banks, and vault cash is a component of bank reserves. M1 counts currency and checkable deposits held by the nonbank public, so vault cash inside banks is excluded from M1 but included in the base.

Question 9Money and the Financial System

The primary purpose of deposit insurance in the financial system is to:

  1. Guarantee that banks earn a profit on loans
  2. Prevent bank runs by protecting depositors against loss Correct answer.
  3. Set the interest rate paid on savings accounts
  4. Ensure that all banks hold identical portfolios

Explanation

Deposit insurance reassures depositors that their funds are safe up to a limit, which reduces the incentive to withdraw funds in a panic and thereby limits runs. It does not set prices, guarantee profits, or standardize bank portfolios.

Question 10Money and the Financial System

A bond with a face value of $1,000 pays a fixed annual coupon of $60. If the market price of the bond falls to $800, the current yield is approximately:

  1. 6.0 percent
  2. 7.5 percent Correct answer.
  3. 60 percent
  4. 8.0 percent

Explanation

Current yield equals the annual coupon divided by the market price, so $60 divided by $800 equals 7.5 percent. The 6.0 percent figure reflects the coupon rate at face value, which is not the current yield once the price changes.

Question 11Money and the Financial System

When market interest rates rise, the price of an existing fixed-coupon bond typically:

  1. Remains unchanged
  2. Rises
  3. Becomes equal to its face value
  4. Falls Correct answer.

Explanation

Bond prices and market interest rates move in opposite directions because new bonds issued at higher rates make older lower-coupon bonds less attractive, so their prices must decline to offer competitive yields. The price equals face value only when the coupon rate matches the market yield.

Question 12Money and the Financial System

The risk that a borrower will fail to make promised payments on a bond is known as:

  1. Purchasing power risk
  2. Interest rate risk
  3. Liquidity risk
  4. Default risk Correct answer.

Explanation

Default risk, also called credit risk, is the chance that an issuer misses scheduled interest or principal payments. Liquidity risk concerns the ability to sell quickly at a fair price, interest rate risk concerns price changes from rate moves, and purchasing power risk concerns inflation.

Question 13Money and the Financial System

According to the quantity theory of money, if velocity and real output are constant, a 5 percent increase in the money supply will lead to approximately:

  1. A 5 percent decline in nominal output
  2. A 5 percent decline in velocity
  3. No change in the price level
  4. A 5 percent rise in the price level Correct answer.

Explanation

The equation of exchange, MV = PY, implies that with velocity V and real output Y fixed, the money supply M and price level P move proportionally. A 5 percent rise in M therefore produces roughly a 5 percent rise in P.

Question 14Money and the Financial System

The three traditional tools of monetary policy available to the Federal Reserve are open market operations, the discount rate, and:

  1. Reserve requirements Correct answer.
  2. Capital gains taxes
  3. Margin requirements
  4. Deposit insurance premiums

Explanation

The Fed's traditional toolkit consists of open market operations, the discount rate, and reserve requirements. Margin requirements and deposit insurance premiums are regulatory tools used by other agencies or for other purposes.

Question 15Money and the Financial System

A financial intermediary that accepts deposits from savers and makes loans to households and firms is performing which function?

  1. Reducing transaction costs through pooling Correct answer.
  2. Issuing the national currency
  3. Conducting open market operations
  4. Setting fiscal policy

Explanation

Banks pool many small deposits into larger loans, which lowers the cost of matching savers and borrowers and reduces transaction costs. Fiscal policy, currency issuance, and open market operations are government or central bank functions.

Question 16Money and the Financial System

Which of the following best describes the role of the secondary market for securities?

  1. It is where the government auctions new Treasury bills
  2. It guarantees issuers a minimum price for new shares
  3. It allows investors to trade previously issued securities among themselves Correct answer.
  4. It sets the coupon rate on new bond issues

Explanation

A secondary market provides liquidity by letting investors buy and sell securities that were already issued, without the issuer receiving new funds. New issues are sold in the primary market, and coupon rates and auction prices are determined there.

Question 17Money and the Financial System

If the public decides to hold more currency relative to deposits, the money multiplier in the banking system will generally:

  1. Stay the same
  2. Become infinite
  3. Increase
  4. Decrease Correct answer.

Explanation

When the public shifts from deposits into currency, fewer deposits remain in banks to support lending, and the currency drain reduces the money multiplier. The multiplier falls rather than rises, and it cannot become infinite because reserves and currency holdings constrain expansion.

Question 18Money and the Financial System

The real interest rate is best defined as:

  1. The interest rate paid on Treasury securities
  2. The nominal interest rate minus the expected inflation rate Correct answer.
  3. The interest rate after taxes are deducted
  4. The nominal interest rate plus the expected inflation rate

Explanation

The Fisher relationship defines the real interest rate as the nominal rate minus expected inflation, reflecting the return in terms of purchasing power. Adding inflation would overstate the real return, and the other options describe specific rates or after-tax returns.

Question 19Money and the Financial System

The term structure of interest rates that states long-term rates reflect expected future short-term rates plus a term premium is the:

  1. Liquidity premium theory Correct answer.
  2. Pure expectations theory
  3. Default premium theory
  4. Segmented markets theory

Explanation

The liquidity premium theory combines expectations of future short rates with a premium that compensates investors for holding longer-term bonds. The pure expectations theory omits the term premium, and segmented markets theory treats each maturity as determined separately.

Question 20Money and the Financial System

A bank that holds mostly long-term fixed-rate mortgages funded by short-term deposits faces primarily which risk?

  1. Interest rate risk Correct answer.
  2. Currency risk
  3. Operational risk
  4. Sovereign risk

Explanation

Mismatched maturities mean that if short-term deposit rates rise, funding costs increase while mortgage returns stay fixed, compressing the bank's margin. Currency, operational, and sovereign risks concern foreign exchange, internal processes, and government default respectively.

Question 21Money and the Financial System

A central bank that raises its policy interest rate in response to rising inflation is primarily attempting to:

  1. Encourage more bank lending
  2. Increase government spending
  3. Reduce aggregate demand and slow price increases Correct answer.
  4. Weaken the currency to boost exports

Explanation

Higher policy rates raise borrowing costs, which tends to dampen consumption and investment and thereby ease inflationary pressure. Government spending is fiscal policy, and higher rates usually support the currency and discourage rather than encourage lending.

Question 22Money and the Financial System

Which of the following financial instruments is a claim on the earnings and assets of a corporation and represents ownership rather than debt?

  1. Commercial paper
  2. Common stock Correct answer.
  3. Corporate bond
  4. Treasury note

Explanation

Common stock is an equity claim that gives shareholders ownership rights and a residual claim on earnings and assets. Bonds, Treasury notes, and commercial paper are debt instruments that promise fixed payments.

Question 23Money and the Financial System

The liquidity of an asset refers to:

  1. The maturity date on which it must be redeemed
  2. The ease and speed with which it can be converted into cash without significant loss of value Correct answer.
  3. The credit rating assigned by a rating agency
  4. The total return it earns over a year

Explanation

Liquidity describes how quickly an asset can be turned into cash at or near its fair value. Return, credit rating, and maturity are separate attributes that do not by themselves define liquidity.

Question 24Money and the Financial System

A bank with $100 million in assets and $90 million in liabilities has equity capital of $10 million. If the bank's assets lose 15 percent of their value, the bank's equity becomes:

  1. $5 million positive
  2. $10 million positive
  3. $15 million positive
  4. $5 million negative Correct answer.

Explanation

A 15 percent loss on $100 million of assets is $15 million, which exceeds the $10 million of equity. Assets fall to $85 million while liabilities stay at $90 million, leaving equity of negative $5 million and rendering the bank insolvent.

Question 25Money and the Financial System

The main reason households and firms hold money rather than interest-bearing assets, according to Keynesian liquidity preference, includes the transactions motive, the precautionary motive, and the:

  1. Tax motive
  2. Speculative motive Correct answer.
  3. Export motive
  4. Inflation motive

Explanation

Keynes identified three motives for holding money: transactions, precautionary, and speculative. The speculative motive reflects uncertainty about future interest rates and bond prices, while the other options are not part of the liquidity preference framework.

Question 26Money and the Financial System

A credit union pools the small deposits of many members and uses the funds to originate automobile loans for other members. In the flow of funds through the financial system, this activity is best described as:

  1. Disintermediation, because savers bypass the banking system entirely
  2. Direct finance, because borrowers and lenders negotiate a loan without any institution in between
  3. Indirect finance, because a financial intermediary stands between ultimate savers and ultimate borrowers Correct answer.
  4. Deficit spending, because the credit union spends more than it collects

Explanation

Indirect finance occurs when an intermediary such as a bank or credit union issues its own liabilities (deposits) to savers and uses the proceeds to acquire the liabilities of borrowers (loans). The intermediary's balance sheet separates the saver from the borrower, which is precisely what distinguishes indirect from direct finance.

Question 27Money and the Financial System

Which function of money is being performed when a merchant posts a price of $45 for a pair of shoes?

  1. Unit of account Correct answer.
  2. Standard of deferred payment
  3. Medium of exchange
  4. Store of value

Explanation

Money serves as a unit of account when it is used as the common yardstick in which prices and debts are quoted, allowing goods to be compared. Pricing the shoes at $45 expresses value in money terms without any transaction necessarily taking place.

Question 28Money and the Financial System

An economy has currency held by the public of $300 billion, checkable deposits of $700 billion, and no other components of the money supply. Using M1, the value of M1 and the currency-to-deposit ratio are, respectively:

  1. $1,000 billion and 0.30
  2. $300 billion and 3.00
  3. $1,000 billion and 0.43 Correct answer.
  4. $700 billion and 2.33

Explanation

M1 equals currency in circulation plus checkable deposits, so $300 billion plus $700 billion gives $1,000 billion. The currency-to-deposit ratio is currency divided by deposits, or 300/700, which is approximately 0.43.

Question 29Money and the Financial System

A government sells a large volume of Treasury securities to the public to finance a budget deficit. In the loanable funds framework, this action is most likely to:

  1. Leave the equilibrium interest rate unchanged because government borrowing is not part of the loanable funds market
  2. Shift the supply of loanable funds rightward and lower the equilibrium interest rate
  3. Shift the supply of loanable funds leftward and lower the equilibrium interest rate
  4. Shift the demand for loanable funds rightward and raise the equilibrium interest rate Correct answer.

Explanation

Government deficit financing creates additional demand for loanable funds, shifting the demand curve to the right along an upward-sloping supply curve. The result is a higher equilibrium interest rate and a larger quantity of funds lent, an effect often called crowding out of private borrowing.

Question 30Money and the Financial System

A financial system with a well-developed secondary market for corporate bonds is most likely to benefit primary-market issuance because:

  1. Secondary trading guarantees that bond issuers will earn a profit on their operations
  2. Secondary trading lets investors resell holdings before maturity, making them more willing to buy new issues at a lower required yield Correct answer.
  3. Secondary trading raises the coupon rate that issuers must promise to pay investors
  4. Secondary trading removes all default risk from the bonds that are traded

Explanation

Liquidity in the secondary market lowers the liquidity premium investors demand, since they know they can sell before maturity without large price concessions. Cheaper liquidity therefore reduces the yield issuers must offer in the primary market and broadens the pool of willing buyers.

Question 31Financial Markets and Instruments

A Treasury bill with a face value of $10,000 and 90 days to maturity is quoted at a bank discount yield of 4%. What is the dollar discount from face value?

  1. $1,000
  2. $100 Correct answer.
  3. $98.63
  4. $400

Explanation

Bank discount yield is computed on a 360-day year applied to face value, so the dollar discount equals face value times the quoted rate times days divided by 360: $10,000 x 0.04 x 90/360 = $100. The investor pays $9,900 and receives $10,000 at maturity.

Question 32Financial Markets and Instruments

Which characteristic distinguishes a money market instrument from a capital market instrument?

  1. Money market instruments have original maturities of one year or less. Correct answer.
  2. Money market instruments trade only on organized exchanges.
  3. Money market instruments are issued only by governments.
  4. Money market instruments always pay fixed coupons.

Explanation

The money market is defined by short maturity, conventionally one year or less, which makes these instruments highly liquid and low in price risk. Capital market instruments such as notes and bonds have longer original maturities.

Question 33Financial Markets and Instruments

An investor buys a share of a mutual fund at its net asset value of $25.00 and the fund charges a 5% front-end load. How much does the investor actually pay per share?

  1. $26.25
  2. $26.32 Correct answer.
  3. $23.75
  4. $25.00

Explanation

With an offering price quoted inclusive of the load, the public offering price equals NAV divided by one minus the load: $25.00 / 0.95 = $26.32. The $1.32 difference is the sales charge.

Question 34Financial Markets and Instruments

A bond has a coupon rate of 6%, a par value of $1,000, and is currently priced at $950. What is its current yield?

  1. 6.00%
  2. 6.32% Correct answer.
  3. 6.67%
  4. 5.70%

Explanation

Current yield equals the annual coupon payment divided by the market price: $60 / $950 = 6.32%. Because the bond trades at a discount, the current yield exceeds the coupon rate.

Question 35Financial Markets and Instruments

When market interest rates rise above a bond's coupon rate, the bond's price will:

  1. rise above par value
  2. rise only if the bond is callable
  3. fall below par value Correct answer.
  4. remain at par value

Explanation

Bond prices and market yields move inversely. If prevailing yields exceed the coupon, investors will pay less than par so that the total return matches the market, producing a discount bond.

Question 36Financial Markets and Instruments

Which agency rates the creditworthiness of corporate and municipal bonds?

  1. The Securities and Exchange Commission
  2. The Federal Reserve Board
  3. The Federal Deposit Insurance Corporation
  4. Moody's Investors Service Correct answer.

Explanation

Moody's, along with S&P Global and Fitch, is a private credit rating agency that assigns letter ratings reflecting default risk. The Fed, SEC, and FDIC are regulators, not rating agencies.

Question 37Financial Markets and Instruments

The yield curve plots the relationship between:

  1. inflation and unemployment
  2. coupon rate and bond duration
  3. yield to maturity and time to maturity Correct answer.
  4. bond prices and credit ratings

Explanation

A yield curve shows yields on bonds of equal credit quality plotted against their terms to maturity. Its shape reflects expectations about future rates, liquidity, and term premiums.

Question 38Financial Markets and Instruments

According to the expectations theory of the term structure, an upward-sloping yield curve implies that:

  1. investors expect future short-term rates to rise Correct answer.
  2. inflation has been negative for several years
  3. investors demand a large liquidity premium
  4. the issuer's credit quality is deteriorating

Explanation

Under pure expectations theory, long rates are geometric averages of expected future short rates, so an upward slope signals expected increases in short-term rates. The theory assumes no term premium.

Question 39Financial Markets and Instruments

A company issues commercial paper with a face value of $1,000,000 maturing in 180 days, sold at a discount so the investor earns a 5% discount yield. What proceeds does the issuer receive?

  1. $1,025,000
  2. $975,000 Correct answer.
  3. $950,000
  4. $987,500

Explanation

The discount is $1,000,000 x 0.05 x 180/360 = $25,000, so the issuer receives $1,000,000 - $25,000 = $975,000. Commercial paper is quoted on a discount basis using a 360-day year.

Question 40Financial Markets and Instruments

Which statement best describes the role of an underwriter in a new securities issue?

  1. The underwriter sets the coupon rate on behalf of the central bank.
  2. The underwriter insures the issue against default.
  3. The underwriter purchases the issue from the issuer and resells it to the public. Correct answer.
  4. The underwriter guarantees a secondary market for the security.

Explanation

In a firm-commitment underwriting, the investment bank buys the securities from the issuer at a negotiated price and bears the risk of reselling them to investors. The spread between purchase and offering price is its compensation.

Question 41Financial Markets and Instruments

An investor holds a 10-year bond with a modified duration of 7. If interest rates fall by 50 basis points, the bond's price is expected to:

  1. rise by about 7%
  2. fall by about 0.5%
  3. fall by about 3.5%
  4. rise by about 3.5% Correct answer.

Explanation

Price change is approximately negative duration times the change in yield: -7 x (-0.005) = +0.035, or a 3.5% increase. Duration measures sensitivity to small parallel yield shifts.

Question 42Financial Markets and Instruments

A put option gives its holder the:

  1. right to buy the underlying asset at a set price
  2. right to sell the underlying asset at a set price Correct answer.
  3. obligation to sell the underlying asset at a set price
  4. obligation to buy the underlying asset at a set price

Explanation

A put conveys the right, but not the obligation, to sell the underlying at the strike price before expiration. The writer of the put takes on the corresponding obligation.

Question 43Financial Markets and Instruments

An investor wants to hedge against falling stock prices using index futures. Which position accomplishes this?

  1. Buying the underlying index stocks on margin
  2. A short position in the index futures contract Correct answer.
  3. Buying a call option on the index
  4. A long position in the index futures contract

Explanation

A short futures position gains value when the index declines, offsetting losses on the existing portfolio. This is the standard hedging use of stock index futures.

Question 44Financial Markets and Instruments

Which of the following is a primary function of a securities exchange such as the New York Stock Exchange?

  1. Issuing new shares on behalf of listed companies
  2. Insuring investors against losses on securities
  3. Setting the interest rates paid on corporate bonds
  4. Providing a centralized marketplace that facilitates price discovery and liquidity Correct answer.

Explanation

Exchanges bring buyers and sellers together, which promotes price discovery, liquidity, and fair execution in the secondary market. They do not insure investors or issue securities themselves.

Question 45Financial Markets and Instruments

A bond is callable at par in three years and currently trades at a premium. For the investor, the most relevant yield measure is the:

  1. coupon rate
  2. yield to maturity
  3. current yield
  4. yield to call Correct answer.

Explanation

When a premium bond is likely to be called, yield to call better reflects the return the investor will actually earn because the bond may be redeemed before maturity. Yield to call is typically lower than yield to maturity for such bonds.

Question 46Financial Markets and Instruments

The federal funds rate is best described as the interest rate:

  1. the Federal Reserve charges on discount window loans
  2. the Treasury pays on newly issued bills
  3. banks charge their most creditworthy customers
  4. banks charge each other on overnight reserve loans Correct answer.

Explanation

The federal funds rate is the market rate for overnight loans of reserve balances between depository institutions. The Fed influences it through open market operations but does not set it directly.

Question 47Financial Markets and Instruments

An investor purchases a Treasury bond with a 4% coupon at a price of 102. What is the approximate current yield?

  1. 4.00%
  2. 4.08%
  3. 3.92% Correct answer.
  4. 2.04%

Explanation

A price of 102 means $1,020 per $1,000 par. Current yield equals $40 / $1,020 = 3.92%, which is below the coupon rate because the bond trades at a premium.

Question 48Financial Markets and Instruments

Which market participant typically acts as a dealer in the over-the-counter bond market?

  1. A pension fund seeking long-term income
  2. A commercial bank issuing demand deposits
  3. A securities firm quoting bid and ask prices Correct answer.
  4. A household purchasing Treasury bills at auction

Explanation

Dealers stand ready to buy and sell securities at quoted bid and ask prices, providing liquidity and earning the spread. Pension funds and households are typically investors, not dealers.

Question 49Financial Markets and Instruments

A firm issues a bond with a sinking fund provision. What is the effect of this feature for bondholders?

  1. It increases the coupon rate by extending the bond's maturity.
  2. It reduces default risk by requiring periodic retirement of principal. Correct answer.
  3. It guarantees the bond will trade at par value.
  4. It allows the issuer to convert the bond into common stock.

Explanation

A sinking fund requires the issuer to set aside money or retire a portion of the issue each year, reducing the outstanding principal and lowering default risk. Investors generally accept a slightly lower yield as a result.

Question 50Financial Markets and Instruments

An investor buys 100 shares of stock on 50% margin at $40 per share. If the maintenance margin is 25%, at what price would the investor first receive a margin call?

  1. $30.00
  2. $26.67 Correct answer.
  3. $33.33
  4. $20.00

Explanation

The margin call price equals the initial loan per share divided by one minus the maintenance margin: $20 / (1 - 0.25) = $26.67. Below this price, equity falls under 25% of the position value.