Question 1

Rory receives, from an insurance company, a payment of $5,000 each year, and he will continue to receive these payments until he dies. This series of payments is called a(n)
A)portfolio.
B)bond.
C)dividend.
D)annuity.

Accepted Answer

The series of payments that Rory receives from the insurance company is a form of annuity.

Question 2

The last $2,000 of Rolanda's wealth adds less to her utility than the previous $2,000. Based on this information, Rolanda has
A)increasing marginal utility of wealth and is risk averse.
B)increasing marginal utility of wealth and is not risk averse.
C)decreasing marginal utility of wealth and is risk averse.
D)decreasing marginal utility of wealth and is not risk averse.

Accepted Answer

According to the question, the last $2,000 of Rolanda's wealth adds less to her utility than the previous $2,000. This implies that the marginal utility of wealth is decreasing. This is consistent with the concept of diminishing marginal utility. Moreover, since Rolanda values the last $2,000 less than the previous $2,000, she is risk averse, meaning she is willing to give up some expected utility to avoid risk. Thus, the correct answer is C - decreasing marginal utility of wealth and is risk averse.

Question 3

Which of the following best illustrates moral hazard?
A)After a person obtains life insurance, she takes up skydiving.
B)A person obtains insurance knowing he is in poor health.
C)A person holds stock only in very risky corporations.
D)A person holds stocks from only a few corporations.

Accepted Answer

Moral hazard is the risk that a party to a transaction has not entered into the agreement in good faith or has an incentive to behave inappropriately once the agreement is made. In this case, the person takes up a dangerous activity knowing that they have life insurance, which puts the insurance company at risk of having to pay out a claim. It is an example of moral hazard because the insured party has an incentive to behave in a way that increases the likelihood of an insurance claim.

Question 4

Given that Tamar is a risk-averse person, she might accept a bet with a 50 percent chance of losing $100 today if she had a 50 percent
A)chance of winning $120 in two years and the interest rate was 11%.
B)chance of winning $114 in two years and the interest rate was 7%.
C)chance of winning $110 in two years and the interest rate was 3%.
D)None of the above are correct; a risk averse person would not accept any of the above bets.

Accepted Answer

Tamar is risk-averse and is willing to accept a bet with a 50% chance of losing $100 today only if the expected return on investment is greater than the risk of losing money. The expected return on investment can be calculated as follows: 
Expected return = (probability of winning x amount won) - (probability of losing x amount lost) 
For option A, the expected return would be (0.5 x $120) - (0.5 x $100) = $10, but this amount will be received two years later, which can be considered a risk for a risk-averse person. 
For option B, the expected return would be (0.5 x $114) - (0.5 x $100) = $7, but this amount will also be received two years later. 
For option C, the expected return would be (0.5 x $110) - (0.5 x $100) = $5, but this amount will still be received two years later. 
Therefore, option C would be the best choice for Tamar since it offers the highest expected return over the period given, and the risk involved is relatively low.

Question 5

You may be unwilling to buy a used car because you suspect the last owner found out the car was a lemon. You may treat a car you rented with a little less care than you would use on your own car.
A)Both examples primarily illustrate adverse selection.
B)Both examples primarily illustrate moral hazard.
C)The first example primarily illustrates adverse selection; the second primarily illustrates moral hazard.
D)The first example primarily illustrates moral hazard; the second primarily illustrates adverse selection.

Accepted Answer

The first example primarily illustrates adverse selection because the buyer is hesitant to buy a used car due to information asymmetry - the seller may know more about the car's condition than the buyer does, leading to a potentially inefficient transaction. The second example primarily illustrates moral hazard because the renter may not take as much care with the car since they are not ultimately responsible for any damages or repairs, leading to higher risk for the rental car company.

Question 6

Which of the following is adverse selection?
A)the risk associated with selecting stocks in only a few specific companies
B)the risk that a person will become overconfident in his ability to select stocks
C)a high-risk person being more likely to apply for insurance
D)after obtaining insurance a person having less incentive to be careful

Accepted Answer

Adverse selection is the tendency for high-risk individuals to be more likely to apply for insurance, thereby increasing the insurer’s risk of paying out claims.

Question 7

Recently, Lisa's wealth increased by $500. If her wealth were to increase by another $500 in the near future, then her utility would increase, but not by as much as it increased with the recent increase to her wealth. Based on this information, Lisa's utility function
A)and marginal utility function are both upward sloping.
B)and marginal utility function are both downward sloping.
C)is upward sloping and her marginal utility function is downward sloping.
D)is downward sloping and her marginal utility function is upward sloping.

Accepted Answer

Lisa's utility function must be upward sloping since her overall utility increased with the first increase in wealth. However, the fact that her utility will not increase as much with a second increase in wealth indicates that her marginal utility is decreasing. Therefore, her utility function is upward sloping while her marginal utility function is downward sloping. Choice C is the only option that reflects this pattern.

Question 8

Suppose that Thom experiences a greater loss in utility if he loses $50 than he would gain in utility if he wins $50. This implies that Thom's
A)marginal utility diminishes as wealth rises, so he must be risk averse.
B)marginal utility diminishes as wealth rises, but we can't tell from this if he is risk averse.
C)marginal utility increases as wealth rises, so he must be risk averse.
D)marginal utility increases as wealth rises, but we can't tell from this if he is risk averse.

Accepted Answer

The fact that Thom experiences a greater loss in utility if he loses $50 than he would gain in utility if he wins $50 indicates that he is risk averse. This is because he is more sensitive to losses than gains, which is a characteristic of risk aversion. Additionally, the statement implies that his marginal utility of wealth diminishes as his wealth increases, which is another characteristic of risk aversion. Therefore, option A is the correct answer.

Question 9

When you rent a car, you might treat it with less care than you would if it were your own. This is an example of
A)market risk.
B)moral hazard.
C)adverse selection.
D)risk aversion.

Accepted Answer

Moral hazard refers to the risk that someone will behave differently once they are insured or protected, taking more risks or acting with less caution than they would if exposed to the full consequences of their actions. Renting a car provides a measure of protection, as the driver is not responsible for the full value of the vehicle. Therefore, they may treat it with less care than they would if they owned it, which is an example of moral hazard.

Question 10

Which of the following actions best illustrates moral hazard?
A)A person adds risky stock to his portfolio.
B)A person who has narrowly avoided many accidents applies for automobile insurance.
C)A person is unwilling to buy a stock when she believes its price has an equal chance of rising or falling $10.
D)A person purchases homeowners insurance and then checks his smoke detector batteries less frequently.

Accepted Answer

Moral hazard refers to the tendency of people to take more risks or act more recklessly when they are protected from the consequences of their actions. This is often a result of insurance or other types of protection. In this case, the person who purchases homeowners insurance may be less conscientious about maintaining their smoke detectors because they feel protected from the consequences of a fire. This is an example of moral hazard.

Question 11

Financial intermediaries typically require mortgage borrowers to have homeowner's insurance and do credit checks before making the loan.
A)The insurance requirement and the credit check are both designed primarily to reduce adverse selection.
B)The insurance requirement and the credit check are both designed primarily to reduce the risk of moral hazard.
C)The insurance requirement is designed primarily to reduce adverse selection; the credit check is designed primarily to reduce the risk of moral hazard.
D)The insurance requirement is designed primarily to reduce the risk of moral hazard; the credit check is designed primarily to reduce adverse selection.

Accepted Answer

The insurance requirement helps to reduce the risk of moral hazard by ensuring that the borrower has a financial stake in the property and will therefore take steps to maintain and protect it. The credit check helps to reduce adverse selection by ensuring that the borrower has a good credit history and is less likely to default on the loan.

Question 12

Over the past two centuries, the average annual rates of return were about
A)5 percent for stocks and about 1.5 percent for short-term government bonds.
B)6 percent for stocks and about 2.5 percent for short-term government bonds.
C)8 percent for stocks and about 3 percent for short-term government bonds.
D)None of the above is correct.

Accepted Answer

According to historical data, the average annual rate of return for stocks over the past 200 years has been about 8%, while the average annual rate of return for short-term government bonds has been around 3%. This makes choice C the most accurate option.

Question 13

In effect, an annuity provides insurance
A)against the risk of dying and leaving one's family without a regular income.
B)against the risk of living too long.
C)to people who are not risk-averse.
D)to people whose utility functions do not display the usual properties.

Accepted Answer

An annuity provides insurance against the risk of living too long by providing a guaranteed income stream for life, ensuring that individuals do not run out of money in retirement. It does not provide insurance against the risk of dying and leaving one's family without a regular income, as this is typically addressed through life insurance policies. The other choices (C and D) are not accurate as annuities can be beneficial for risk-averse individuals and those whose utility functions display typical properties.

Question 14

Which of the following actions best illustrates adverse selection?
A)A person adds risky stock to his portfolio.
B)A person who has narrowly avoided many accidents applies for automobile insurance.
C)A person is unwilling to buy a stock when she believes its price has an equal chance of rising or falling $10.
D)A person purchases homeowners insurance and then checks his smoke detector batteries less frequently.

Accepted Answer

Adverse selection refers to a situation where one party has more information than the other party in a transaction, leading to a potential problem. In this scenario, the person who narrowly avoided many accidents may be aware of their higher risk for accidents, but the insurance company is not aware of this information. Therefore, the person's application for automobile insurance represents adverse selection. The other choices do not represent adverse selection. A person's decision to add risky stock to their portfolio is more related to their risk appetite. The decision to buy or not buy a stock is related to personal preferences and beliefs about stock prices. Finally, the decision to check smoke detector batteries less frequently after purchasing homeowners insurance is not related to adverse selection but rather to moral hazard, which occurs when an insured party takes less precautionary action because they are protected by insurance.

Question 15

If a person is risk averse, then as wealth increases, total utility of wealth
A)increases at an increasing rate.
B)increases at a decreasing rate.
C)decreases at an increasing rate.
D)decreases at a decreasing rate.

Accepted Answer

A risk-averse person values additional wealth less as their total wealth increases, meaning the marginal utility of wealth decreases. Therefore, the total utility of wealth increases at a decreasing rate.

Question 16

Which of the following defines an annuity?
A)For a fee, an insurance company provides you with regular income until you die.
B)A surcharge is added to life-insurance premiums paid by persons in dangerous occupations.
C)Annuity is another name for stock funds managed by mutual fund managers.
D)Annuity is another name for any diversified portfolio.

Accepted Answer

An annuity is a financial product sold by insurance companies that provides a regular income stream to the holder in exchange for a lump sum or a series of payments. This income stream typically lasts for the lifetime of the holder, hence the insurance component of the product.

Question 17

Risk
A)can be reduced by placing a large number of small bets rather than a small number of large bets.
B)can be reduced by increasing the number of stocks in a portfolio.
C)Both A and B are correct.
D)Neither A nor B are correct.

Accepted Answer

Both options A and B are correct ways to reduce risk. By placing a large number of small bets or increasing the number of stocks in a portfolio, an investor can diversify their risk and minimize the impact of any one negative outcome. Therefore, the best choice is C as both options are correct.

Question 18

Tami knows that people in her family die young, and so she buys life insurance. Preston knows he is a reckless driver and so he applies for automobile insurance.
A)These are both examples of adverse selection.
B)These are both examples of moral hazard.
C)The first example illustrates adverse selection, and the second illustrates moral hazard.
D)The first example illustrates moral hazard, and the second illustrates adverse selection.

Accepted Answer

The answer of Tami knows that people in her family...

Question 19

Abby buys health insurance because she knows that she has health risks that wouldn't be obvious to an insurance company. Brad buys home owners insurance and then is less careful to make sure he's put out his cigarettes. The example with Abby
A)and the example with Brad illustrate adverse selection.
B)and the example with Brad illustrate moral hazard.
C)illustrates adverse selection; the example with Brad illustrates moral hazard.
D)illustrates moral hazard; the example with Brad illustrates adverse selection.

Accepted Answer

Abby's decision to buy health insurance despite her higher risks is an example of adverse selection, where individuals with higher risks are more likely to seek out and purchase insurance. Brad's decision to be less careful after purchasing home owners insurance is an example of moral hazard, where having insurance can lead to riskier behavior.

Question 20

Risk-averse people will choose different asset portfolios than people who are not risk averse. Over a long period of time, we would expect that
A)every risk-averse person will earn a higher rate of return than every non-risk-averse person.
B)every risk-averse person will earn a lower rate of return than every non-risk-averse person.
C)the average risk-averse person will earn a higher rate of return than the average non-risk-averse person.
D)the average risk-averse person will earn a lower rate of return than the average non-risk-averse person.

Accepted Answer

Risk-averse people tend to choose lower-risk portfolios, which may produce lower returns over the long term. Therefore, on average, we would expect risk-averse people to earn a lower rate of return than non-risk-averse people. However, this is not a universal rule, and there may be individual cases where a risk-averse person earns a higher rate of return than a non-risk-averse person.

Quiz 27: Tools of Finance

Rory receives, from an insurance company, a payment of $5,000 each year, and he will continue to receive these payments until he dies. This series of payments is called a(n)

The last $2,000 of Rolanda's wealth adds less to her utility than the previous $2,000. Based on this information, Rolanda has

Which of the following best illustrates moral hazard?

Given that Tamar is a risk-averse person, she might accept a bet with a 50 percent chance of losing $100 today if she had a 50 percent

You may be unwilling to buy a used car because you suspect the last owner found out the car was a lemon. You may treat a car you rented with a little less care than you would use on your own car.

Which of the following is adverse selection?

Recently, Lisa's wealth increased by $500. If her wealth were to increase by another $500 in the near future, then her utility would increase, but not by as much as it increased with the recent increase to her wealth. Based on this information, Lisa's utility function

Suppose that Thom experiences a greater loss in utility if he loses $50 than he would gain in utility if he wins $50. This implies that Thom's

When you rent a car, you might treat it with less care than you would if it were your own. This is an example of

Which of the following actions best illustrates moral hazard?

Financial intermediaries typically require mortgage borrowers to have homeowner's insurance and do credit checks before making the loan.

Over the past two centuries, the average annual rates of return were about

In effect, an annuity provides insurance

Which of the following actions best illustrates adverse selection?

If a person is risk averse, then as wealth increases, total utility of wealth

Which of the following defines an annuity?

Risk

Tami knows that people in her family die young, and so she buys life insurance. Preston knows he is a reckless driver and so he applies for automobile insurance.

Abby buys health insurance because she knows that she has health risks that wouldn't be obvious to an insurance company. Brad buys home owners insurance and then is less careful to make sure he's put out his cigarettes. The example with Abby

Risk-averse people will choose different asset portfolios than people who are not risk averse. Over a long period of time, we would expect that