Deck 1: Basic Concepts

Question 1

Which of the following statements is are) true?

A)A risk-preferring individual always prefers the riskier of two gambles that involve different expected value.
B)A risk neutral individual is indifferent between receiving with certainty the expected value of a gamble and the uncertainty of the gamble itself.
C)A risk neutral individual has a utility function which is linear in wealth.
D)Both a and b.
E)Both b and c.

Answer 1

E

Question 2

If the role of financial intermediaries is to produce and process information, then they are least needed when

A)the capital market is weak-form efficient.
B)the capital market is semi strong-form efficient.
C)the capital market is strong-form efficient.
D)information is costly for individuals to obtain and process.
E)none of the above.

Answer 2

C

Question 3

In order for a signal to be informative,

A)it has to be costly for the sender
B)the cost of signal should be positively related to quality
C)the first-best outcome must be attainable
D)all of the above
E)none of the above

Answer 3

E

Question 4

Use the following information for questions
There are three types of cars, the good G, the bad B, and the ugly U.A G car is worth $30, a B car is worth $15, and a U car is worth $0.A buyer cannot distinguish the quality of cars offered for sale, but the seller does.If there is equal probability of a car being G, B, or U,

-Suppose the type G seller offers a warranty of $g and the type B seller offers $b.If the probability of failure is 0.1, 0.5, and 1 for types G, B, and U, respectively, what is the warranty offered by type G and B sellers to ensure incentive compatibility?

A)$20, $15
B)$25, $15
C)$30, $30
D)$37.5, $30
E)$37.5, $37.5

Question 5

In a market with asymmetric information,

A)market failure may occur and therefore regulation may be needed
B)individuals are unable to prevent market failure
C)first-best outcome can always be achieved
D)both a and c
E)both b and c

Question 6

There are two assets, A and B, with a standard deviation of 10 and 15, respectively.If the correlation coefficient between the two assets is 0.5, then a portfolio that consists of 0.4 of A and 0.6 of B has a standard deviation of

A)11.53
B)13.00
C)15.00
D)18.02
E)20.00

Question 7

Which of the following statements is are) false?

A)A risk-averse individual demands a premium for bearing risk.
B)A risk-averse individual prefers a certain amount to a gamble with the same expected value.
C)A risk-averse individual has a convex utility function.
D)All of the above.
E)None of the above.

Question 8

Use the following information for questions .
There are two possible states of nature, s = 1, and s = 2, over the next period.There are two securities i and j) whose current prices are $10 and $15, respectively.Security i has a payoff of $10 in state s = 1, and $16 in state s = 2, while security j provides $25 in state s = 1 and $8 in state s = 2.

-What are the prices of the Arrow-Debreu securities in the two states?

A)0.25 in state s = 1 and 0.675 in state s = 2.
B)0.3 in state s = 1 and 0.6 in state s = 2.
C)0.4 in state s = 1 and 0.75 in state s = 2.
D)0.5 in state s = 1 and 0.3125 in state s = 2.
E)insufficient information.

Question 9

Suppose there are two risky assets, X and Y, and a riskless bond, B.There are two possible states H and L of the economy over the next period.X provides a payoff of $0 in state H and $50 in state L, while Y provides a payoff of $50 in state H and $0 in state L.B provides a payoff of $50 regardless of the states.X, Y, and B are currently selling for $30, $30, and $25, respectively.A possible riskless arbitrage opportunity is to...

A)buy one unit each of X and Y and sell one unit of B to get a riskless profit of $35
B)buy one unit of B and sell one unit each of X and Y to get a riskless profit of $35
C)buy one unit each of X and B and sell one unit of Y to get a riskless profit of $25
D)buy one unit each of Y and B and sell one unit of X to get a riskless profit of $25
E)there is no riskless arbitrage opportunity.

Question 10

An incentive compatibility condition is one where

A)an agent must be offered at least his reservation utility in order to agree to a contract with the principal
B)an agent must offer the principal at least her reservation utility in order to induce her to write a mutually beneficial contract
C)an agent with a certain type does not have an incentive to mimic the action of another agent of different type
D)both a and b
E)both a and c

Question 11

Use the following information for questions .
There are two possible states of nature, s = 1, and s = 2, over the next period.There are two securities i and j) whose current prices are $10 and $15, respectively.Security i has a payoff of $10 in state s = 1, and $16 in state s = 2, while security j provides $25 in state s = 1 and $8 in state s = 2.

-A third security is introduced.It generates a payoff of $16 in state s = 1 and $24 in state s = 2.How many units of this new security can you buy if your initial wealth is $3,100?

A)200 units
B)162 units
C)154 units
D)127 units
E)More information is needed

Question 12

Use the following information for questions .
There are two possible states of nature, s = 1, and s = 2, over the next period.There are two securities i and j) whose current prices are $10 and $15, respectively.Security i has a payoff of $10 in state s = 1, and $16 in state s = 2, while security j provides $25 in state s = 1 and $8 in state s = 2.

-If you want to get a payoff of $16 in state s = 1 and $12.8 in state s = 2, how would you allocate your wealth between the two securities i and j?

A)10% in I and 80% in J
B)10% in J and 90% in J
C)80% in I and 20% in J
D)70% in I and 20% in J
E)60% in I and 40% in J

Question 13

With diversification, an investor can

A)reduce risk and increase his return from holding risky assets.
B)reduce risk due to imperfect correlation of returns among risky assets in his portfolio.
C)reduce the market risk associated with holding a portfolio of risky assets.
D)Both a and c.
E)Both b and c.

Question 14

Which of the following statements is are) false about options?

A)A call option is more valuable when the value of the underlying security is more volatile.
B)An American option can never be worth less than a European option.
C)An option buyer has the right, not the obligation, to buy or sell an asset at a predetermined price over a fixed time interval.
D)A put option is more valuable when the value of the underlying security is less volatile.
E)All of the above is false.

Question 15

The efficient market hypothesis implies that

A)investors have perfect forecasting ability.
B)prices do not fluctuate.
C)the market is irrational.
D)competition among investors is such that one can earn only a normal return.
E)all of the above.

Question 16

When a market is incomplete,

A)subject to his budget constraint, an individual can achieve any desired distribution of income b.an individual has a limited ability to manage uncertainty
C)the introduction of new securities generally make individuals better off
D)both a and c
E)both b and c.

Question 17

In problem 4, if the correlation coefficient is -1 and you want to completely eliminate the risk of the portfolio, then you will invest

A)0.3 in A and 0.7 in B
B)0.4 in A and 0.6 in B
C)0.6 in A and 0.4 in B
D)0.8 in A and 0.2 in B
E)any combination will eliminate the risk completely since the correlation coefficient is -1

Question 18

Adverse selection is a situation where

A)a party of a transaction undertakes an unobservable action at the detriment of the second party after contracting takes place
B)a party of a transaction possesses an unobservable attribute which is unknown to the second party prior to contracting
C)the informed party must send a costless signal to prevent market break down
D)both a and c
E)both b and c

Question 19

Use the following information for questions
There are three types of cars, the good G, the bad B, and the ugly U.A G car is worth $30, a B car is worth $15, and a U car is worth $0.A buyer cannot distinguish the quality of cars offered for sale, but the seller does.If there is equal probability of a car being G, B, or U,

-which car is offered for sale in equilibrium and at what price?

A)B and U, at a price = $15.
B)U only, at a price = $15.
C)U only, at a price = $0.
D)All cars will be offered for sale, at a price = $30.
E)No cars will be offered for sale.

Question 20

A market is considered complete if

A)there are more number of states of nature than there are securities b.there are fewer number of states of nature than there are securities
C)there are as many securities as there are states of nature
D)it is frictionless
E)both b and d.

Question 21

A time-consistent policy is one where

A)the parties to a contract are free to renegotiate the contract at a later date
B)the agent has no incentive to take an action to the detriment of the principal once the contract is agreed upon
C)the principal can contract directly on the effort level chosen by the agent
D)the parties to a contract has no incentive to renegotiate it at a later date
E)both b and c

Question 22

Consider a firm with risky debt outstanding which requires a repayment one period hence.There are no taxes and the firm has a risky project that can be financed using retained earnings.Assume that the firm's manager acts in the best interest of the shareholders.In this scenario, moral hazard exists if

A)the project has a positive net present value and is undertaken so as to maximize the firm's total value
B)the project has a positive net present value and is undertaken to maximize the shareholders' wealth
C)the project has a negative net present value and is undertaken to maximize the shareholders' wealth
D)the project has a zero net present value and is undertaken
E)moral hazard never exists

Question 23

Consider a game involving two players 1 and 2.Both players have two choices of actions, Left Lor Right R.If both players choose L, the payoff to both players is 5.If both choose R, they each get a payoff of 2.If player 1 chooses L and player 2 chooses R, the payoff is 2 for player 1 and 0 for player 2.If player 1 chooses R and player 2 chooses L, the payoff is 0 for player 1 and 2 for player 2.What is a Nash Equilibrium of this game?

A)Both players choose L
B)Player 1 chooses L and player 2 chooses R
C)Player 1 chooses R and player 2 chooses L
D)All of the above
E)None of the above

Question 24

Use the following information for questions
There are three types of cars, the good G), the bad B), and the ugly U).A G car is worth
$40, a B car is worth $20, and a U car is worth $15.The seller knows the precise quality of his car, but the buyer cannot distinguish the difference in the quality of a car offered for sale.There is an equal probability of a car being G, B, or U.
In equilibrium, which car is offered for sale and at what price?

A)B and U, at a price = $25
B)U only, at a price = $17.5
C)U only, at a price = $15
D)U only, at a price = $0
E)No car will be offered for sale since the rational expectations price is $0

Question 25

In a two-players 1 and 2 non-cooperative game, a strategy constitutes a Nash equilibrium when

A)holding fixed the strategy of player 2, player 1 is better off choosing other strategies other than his equilibrium strategy
B)holding fixed the strategy of player 1, player 2 is better off choosing other strategies other than his equilibrium strategy
C)holding fixed the strategy of player 2, player 1 is better off with his equilibrium strategy than with other strategies
D)holding fixed the strategy of player 1, player 2 is better off with his equilibrium strategy than with other strategies
E)both c and d

Question 26

A moral hazard problem can exist between

A)a firm's shareholders and bondholders who hold riskless debt claim
B)a firm's shareholders and managers
C)a bank and a potential borrower who is applying for a loan
D)all of the above
E)none of the above

Question 27

Moral hazard is a situation where

A)a self-interested agent has an attribute that is unknown to the principal prior to contracting
B)the principal undertakes an action at the expense of the agent
C)a self-interested agent undertakes an unobservable action at the expense of the principal and the outcome of that action contains some noise
D)both a and b
E)both b and c

Question 28

Use the following information for questions
There are three types of cars, the good G, the bad B, and the ugly U.A G car is worth $40, a B car is worth $20, and a U car is worth $15.The seller knows the precise quality of his car, but the buyer cannot distinguish the difference in the quality of a car offered for sale.There is an equal probability of a car being G, B, or U.

-A possible warranty scheme that can ensure incentive compatibility in question 20 is $g, $b, $u

A)$50, $45, $5
B)$45, $15, $0
C)$45, $35, $0
D)$50, $5, $0
E)$25, $12.5, $0

Question 29

Use the following information for questions
Suppose you are a bank lending officer and you are trying to determine if it is worthwhile giving a loan to a potential borrower.You have a prior belief that a borrower is good or bad with equal probability.By gathering information you can determine, albeit imperfectly, whether an applicant is good or bad.If the applicant is good, there is a probability of 0.7 0.3 that your signal reveals that he is good bad.If the applicant is bad, there is a 0.4 0.6 probability that your signal reveals that he is good bad.

-What is your posterior belief that an applicant is good when your signal tell you that he is good?

A)0.36
B)0.55
C)0.64
D)0.70
E)Insufficient information

Question 30

Use the following information for questions
Consider a firm with $100 retained earnings.It has risky debt outstanding which requires a payment of $100 one period hence.The firm has a risky project which requires an investment of $50 today.If the project is undertaken, the shareholders get a liquidating dividend of $50 today.The state of nature one period hence is either High H or Low L with equal probability.If no investment is made today, the firm has a total value of $120 in state H or $80 in state L.If the investment is made, the firm's total value is $250 in state H or $10 in state L.Assume a discount rate of zero.

-The firm's expected total value with the investment is

A)$250
B)$200
C)$180
D)$110
E)$100

Question 31

Use the following information for questions
Suppose you are a bank lending officer and you are trying to determine if it is worthwhile giving a loan to a potential borrower.You have a prior belief that a borrower is good or bad with equal probability.By gathering information you can determine, albeit imperfectly, whether an applicant is good or bad.If the applicant is good, there is a probability of 0.7 0.3 that your signal reveals that he is good bad.If the applicant is bad, there is a 0.4 0.6 probability that your signal reveals that he is good bad.

-What is your posterior belief that an applicant is bad when your signal tells you that he is goof?

A)0.15
B)0.22
C)0.30
D)0.33
E)0.45

Question 32

Use the following information for questions
Consider a firm with $100 retained earnings.It has risky debt outstanding which requires a payment of $100 one period hence.The firm has a risky project which requires an investment of $50 today.If the project is undertaken, the shareholders get a liquidating dividend of $50 today.The state of nature one period hence is either High H or Low L with equal probability.If no investment is made today, the firm has a total value of $120 in state H or $80 in state L.If the investment is made, the firm's total value is $250 in state H or $10 in state L.Assume a discount rate of zero.

-To maximize the shareholders' wealth, the firm should

A)Reject the project since it has a value = -$40 to the shareholders
B)Reject the project since it has a value = -$15 to the shareholders
C)Accept the project since it has a value = $110 to the shareholders
D)Accept the project since it has a value = $125 to the shareholders
E)Indifferent since the project has a zero net present value

Question 33

When there is moral hazard between a firm's shareholders and bondholders, the cost of moral hazard is borne by ______in equilibrium.

A)the bondholders
B)the firm's manager
C)the government
D)the shareholders
E)both a and b

Question 34

Use the following information for questions
Consider a firm with $100 retained earnings.It has risky debt outstanding which requires a payment of $100 one period hence.The firm has a risky project which requires an investment of $50 today.If the project is undertaken, the shareholders get a liquidating dividend of $50 today.The state of nature one period hence is either High H or Low L with equal probability.If no investment is made today, the firm has a total value of $120 in state H or $80 in state L.If the investment is made, the firm's total value is $250 in state H or $10 in state L.Assume a discount rate of zero.

-What is the expected payoff to the bondholders if the project is ndertaken?

A)$85
B)$55
C)$30
D)-$30
E)-$55

Question 35

Use the following information for questions
There are three types of cars, the good G), the bad B), and the ugly U).A G car is worth
$40, a B car is worth $20, and a U car is worth $15.The seller knows the precise quality of his car, but the buyer cannot distinguish the difference in the quality of a car offered for sale.There is an equal probability of a car being G, B, or U.
Suppose the seller of type G offers a warranty of $g, the type B seller offers $b, and the type U seller offers $u if the car fails.The probability of failure is 0.1, 0.6, and 0.9 for the G, B, and U types, respectively.An incentive compatibility condition is

A)$40 - 0.4$g) ≤ $20 and $20 - 0.6$b) ≤ $15
B)$40 - 0.5$b) ≤ $20 and $20 - 0.6$u) ≤ $15
C)$40 - 0.5$g) ≤ $20 and $20 - $u ≤ $15
D)$40 - 0.6$g) ≤ $20 and $20 - 0.9$b) ≤ $15
E)$40 - 0.5$g) ≤ $20 and $20 - 0.3$b) ≤ $15

Question 36

With a dissipative signal,

A)there is no social deadweight loss in the aggregate
B)the receiver compensates the sender for the cost of the signal
C)the incentive compatibility condition will always be restored
D)the sender absorbs some of the cost of signaling
E)all of the above