Question 1

If an asset has a 0.7 probability of yielding 10 percent and a 0.3 probability of yielding 20 percent, the expected yield of the asset is

Accepted Answer

The expected yield can be calculated as follows:
Expected yield = (0.7 x 10%) + (0.3 x 20%)
Expected yield = 7% + 6%
Expected yield = 13%

Question 2

If asset A is a 30-year U.S. Treasury bond yielding 9 percent and asset B is a 30-year corporate bond issued by General Motors that also yields 9 percent, risk averse investors would

Accepted Answer

Risk averse investors would prefer asset A because it is a U.S Treasury bond, which is considered a safer investment compared to a corporate bond from General Motors. This is due to the fact that the U.S Treasury is backed by the government and is considered less risky than a private corporation like General Motors. Therefore, investors would prefer to invest in the safer asset to minimize their risk.

Question 3

If a person prefers a gamble with an expected value of $100 to a sure $100 that person is

Accepted Answer

A person who prefers a gamble with an expected value of $100 to a sure $100 is a risk lover. They are willing to take on the uncertainty and potential for loss in order to potentially gain more than the guaranteed amount. This does not necessarily make them irrational, nonsystematic or managing a portfolio.

Question 4

In a world of certainty, the key decisions influenced by the riskless interest rate are

Accepted Answer

The riskless interest rate is a key factor in influencing an individual's consumption versus saving decisions. A higher interest rate would incentivize saving as it increases the return on savings. Conversely, a lower interest rate would incentivize spending as it reduces the return on savings. In a world of certainty, risk premiums demanded by investors, portfolio decisions, and diversification decisions are not affected by changes in the riskless interest rate.

Question 5

Assume that a security has two possible outcomes. There is a 50 percent chance that the yield will equal 12 percent and a 50 percent chance that the yield will equal 4 percent. The expected yield for this security is

Accepted Answer

The expected yield is calculated as the average of the two possible outcomes, weighted by their probabilities: (0.5 * 12%) + (0.5 * 4%) = 6% + 2% = 8%.

Question 6

A potential drawback of using the standard deviation to measure risk is that

Accepted Answer

Standard deviation includes both positive and negative deviations from the mean, which means it treats all deviations as equal in terms of risk, even though only negative deviations might be considered risky in some contexts.

Question 7

The current price of a government bond is $920. The bond pays $90 in interest this year. At the end of the current year, the bond matures, and the principal of $1,000 is repaid. What is the return to the holder of this bond?

Accepted Answer

The return is calculated by adding the interest received ($90) to the principal repayment ($1,000), which totals $1,090. This amount is then compared to the initial investment of $920. The return is ($1,090 - $920) / $920 = $170 / $920 = 0.1848, or 18.48%, which is closest to 17 percent when rounded to the nearest whole number.

Question 8

Assume that the yield on a security has two possible outcomes. There is a 60 percent chance it will yield 10 percent and a 40 percent chance it will yield 5 percent. The expected yield for this security is

Accepted Answer

The expected yield is calculated by multiplying each possible outcome by its probability and then summing these products. Thus, (0.60 * 10%) + (0.40 * 5%) = 6% + 2% = 8%.

Question 9

Assume that a security has equally possible outcomes of yielding 8 percent and 4 percent. The standard deviation of the probability distribution of returns for this security is

Accepted Answer

The standard deviation is calculated as the square root of the variance. The variance is the average of the squared deviations from the mean. Here, the mean return is (8% + 4%) / 2 = 6%. The squared deviations are (8% - 6%)^2 = 4 and (4% - 6%)^2 = 4. The average of these squared deviations is (4 + 4) / 2 = 4. The standard deviation is the square root of 4, which is 2%.

Question 10

The most fundamental proposition of modern portfolio theory is that

Accepted Answer

Modern portfolio theory states that by diversifying and combining assets in a portfolio, the overall risk can be reduced. This is because the risk of each individual asset is not perfectly correlated with each other, so when combined, the portfolio's risk can be reduced, potentially even to zero. Therefore, option C correctly explains the fundamental proposition of modern portfolio theory. Options A, B, and D are not accurate descriptions of the theory.

Question 11

If the interest rate on a security consists only of the riskless rate, then

Accepted Answer

If the interest rate on a security consists only of the riskless rate, then there is no uncertainty. This is because the riskless rate is a guaranteed rate of return, meaning there is no risk involved in investing in such a security. Therefore, investors can be certain about the return they will receive, and there is no uncertainty involved.

Question 12

Modern portfolio analysis assumes that individuals

Accepted Answer

Modern portfolio analysis assumes that individuals are risk-averse, meaning they prefer less risk over more risk for the same level of return. This is why portfolio analysis focuses on constructing portfolios that provide the highest return for a given level of risk.

Question 13

Most people are

Accepted Answer

Research shows that most people have a tendency to be risk-averse, meaning they prefer to avoid risk and uncertainty whenever possible. This is especially true when it comes to financial decisions, such as investments or purchasing insurance. However, it's important to note that individual risk preferences can vary based on factors such as personality traits, past experiences, and the context of the decision being made.

Question 14

In a world of certainty, the interest rate reflects

Accepted Answer

In a world of certainty, there would be no risk, economic growth rates would be constant, and borrowers would have the same qualifications. Therefore, the only remaining factor influencing interest rates would be the differing time patterns of individuals' consumption preferences, which would affect the demand for and supply of credit.

Question 15

The expected yield on an asset with two possible outcomes is equal to the

Accepted Answer

The expected yield on an asset is calculated by taking the sum of the possible outcomes multiplied by their respective probabilities. This is commonly known as the weighted average of the possible outcomes.

Question 16

The standard deviation around an expected value is a useful measure of

Accepted Answer

The standard deviation measures the degree of variability or dispersion of a set of values. In finance, it is often used to measure the risk of an asset by calculating the deviation of its actual returns from its expected returns, reflecting the potential losses an investor may experience due to market fluctuations. Therefore, option D is the best choice as it correctly describes the standard deviation's relevance to measuring an asset's risk.

Question 17

Risk aversion implies that

Accepted Answer

Risk aversion refers to an individual's preference to avoid risk. In the context of investing, risk-averse investors need to be compensated for the risk they take on, which means they require a higher expected return for investments that involve higher risk. Therefore, option C is the correct answer. Option A is incorrect because risk aversion does not mean that individuals will not take on risk at all. Option B is incorrect as the statement that investors need to be compensated for about half of the risk they take on is not accurate. Option D is incorrect because one of the options is correct, making it not "none of the above."

Question 18

If asset A is a risky asset yielding 10 percent and asset B is a riskless asset with the same maturity with a yield of 8 percent, investors would

Accepted Answer

The answer of If asset A is a risky asset...

Question 19

Evidence that most investors are risk averse is that they

Accepted Answer

Buying a diversified portfolio is a strategy used by investors to spread their risk across different assets and reduce the impact of individual asset performance on their overall portfolio. This shows that most investors are risk averse and prefer to not put all their eggs in one basket. Option B is not a clear indicator of risk aversion as buying different bonds with the same yield and maturity is a common strategy for fixed income investors seeking to create a bond ladder. Option C is not a common behavior among most investors as it exposes them to high concentration risk. Option D is also not an indicator of risk aversion as gambling is a high-risk activity that most investors would typically avoid.

Question 20

Assume an asset has a 50 percent probability of yielding 10 percent and an equal probability of yielding 6 percent. The standard deviation for this asset is

Accepted Answer

The standard deviation is calculated using the formula for the standard deviation of a two-outcome asset, which is sqrt[p(1-p)(x1-x2)^2], where p is the probability of one outcome, x1 and x2 are the outcomes, and sqrt is the square root. Here, p=0.5, x1=10%, x2=6%, so the calculation is sqrt[0.5*0.5*(0.10-0.06)^2] = sqrt[0.5*0.5*0.0016] = sqrt[0.0004] = 0.02 or 2%.

Quiz 7: The Pricing of Risky Financial Assets