Question 1

In the end of 2008, We Pro Ltd., a corporation, earned a profit. The profit was then reinvested into the corporation or was paid out to shareholders as dividends. The amount of dividends a shareholder would receive is tied to:

Accepted Answer

Dividend is proportional to the number of shares that investors hold.
Key Takeaway: Dividends normally take the form of cash or shares in the company, depending on the company's structure.

Question 2

Which of the following types of information provide a likely opportunity to earn abnormal profits on the market?

Accepted Answer

C and E are both examples of advanced information. However, it is likely that it would be illegal to act on E, as it is insider information.
Key Takeaway: In order to make abnormal profit, information should not be available to the public. If the information is publicized, everyone can react to make profits from this information; and there will not be abnormal profit. In answers A, B, and D, this is all information that an efficient market will be aware of.

Question 3

Britney has the following utility function:U(w)=w2. Given that the second derivative is positive, what is her attitude to risk?

Accepted Answer

Britney is a risk loving person, since the second derivative of her utility function is positive. Utility function in finance is a function that specifies the satisfaction of an investor for her wealth levels. It represents both his welfare and his preferences.
Key Takeaway: If there is a lottery and Britney prefers the expected value of the lottery to the lottery itself, she is risk averse. If she is indifferent between the expected value of the lottery and the lottery itself, then she is risk neutral. And if she prefers the lottery itself to the expected value of the lottery, then she is a risk lover.

Question 4

Tom has the following curve that represents his utility function. What is his attitude to risk?

Accepted Answer

Tom is risk averse. If there is a lottery, Tom prefers the expected value of the lottery to the lottery itself. His utility function reflects his satisfaction for his wealth level and represents his welfare and preferences. Concave utility function shows that each increase in wealth conveys progressively smaller increase to utility.
Key Takeaway: Tom has his utility function concave to the origin because he is risk averse. For a risk neutral investor, his utility function is convex to the origin. For a risk lover, his utility function is a straight line.

Question 5

What is the meaning of standard deviation? Select all that apply.

Accepted Answer

The standard deviation provides a rough measure of risk by measuring the degree of spread from the mean. It is also the square root of the variance.
Key Takeaway: When a portfolio has low standard deviation, it means that it is less risky. When the portfolio has high standard deviation, it is more risky. Standard deviation is a measure of "volatility."

Question 6

Mike is a gambler. He's been offered a fair gamble. How will he likely behave?

Accepted Answer

Mike will roll the dice. A gambler tends to accept fair gambles, while a risk-averse person would refuse it.
Key Takeaway: While this is the terminology, remember that the distribution of outcomes is typically a far more important determinant. Mike might like to gamble when the chances of winning are 50/50, but if the gamble is $1 billion versus certain death, he might be less of a gambler.

Question 7

Jenny is a gambler who has a utility function that is "more concave" or "curvier" than Tom's utility function. Who is more risk averse?

Accepted Answer

Jenny is more risk averse than Tom because her utility function is curvier. As she is more risk averse than Tom, she loses more than Tom when risk is introduced.
Key Takeaway: Both Jenny and Tom are risk averse investors who, when faced with two investments with the same expected return but two different risks, prefer the one with the lower risk.

Question 8

A risk has two components: uncertainty and exposure. Interest rate risk is therefore a risk to the earnings or market value of a portfolio due to

Accepted Answer

Interest rate risk is a risk to the earnings or market value of a portfolio due to uncertain future interest rates. Future interest rates are uncertain and unpredictable. Therefore, an exposure to interest rates leads to a risk.
Key Takeaway: If future interest rates can be forecast and anticipated, then the level of risk can be reduced.

Question 9

You are a U.S. investor and you have stocks in France. The return that you will get is affected by both the change in the price of the stocks and the change of the Euro against the U.S. dollar. What kind of risk does this refer to?

Accepted Answer

This is a case of foreign exchange risk, also known as currency risk. It is a form of risk that arises from the change in the price of one currency against another. This risk usually affects businesses that export and/or import and investors who makes international investments.
Key Takeaway: Whenever you have assets or business operations across national borders, you face currency risk if your positions are not hedged. Currency hedging (also known as Foreign Exchange Risk hedging) is used to reduce the risks encountered when investing abroad.

Question 10

What is inflation risk?

Accepted Answer

Inflation risk is the possibility that the value of assets or income will decrease as inflation reduces the purchasing power of the currency. Inflation happens when the overall general price of goods and services in an economy moves upward. It is usually measured by the Consumer Price Index and the Producer Price Index in the US. Severe inflation causes loss of confidence, less investment, and economic instability because the purchasing power of the currency erodes as prices increase. Therefore, inflation involves the risk that the value of assets or incomes will decrease. The higher the inflation rate, the more risk it involves.
Key Takeaway: Zimbabwe's rate of inflation surged to 3,732% in 2008. Hope you weren't holding Zimbabwe dollars.

Question 11

In 2009, Deutsche Bank warned that the UAE might face deflation, which is a general decline in overall prices. Which of the following is the result of deflation?

Accepted Answer

Deflation, which is a general decrease in price, leads to shrinking employment, decrease in income, and defaults on loans. Ultimately, it leads to economic recession.
Key Takeaway: Deflation prevents monetary policy from stabilizing the economy because of a mechanism called the liquidity trap, which means any further increase in the money supply will not stimulate the economy any further. Some people think inflation is bad, but deflation is way worse. Think of it this way--if prices were going down, wouldn't you wait to buy? Deflation can bring a capitalist economy to a grinding halt.

Question 12

A systemic risk is a risk that affects an entire financial market or system--not just a specific section. It is possible to avoid the systemic risk through diversification.

Accepted Answer

It is not possible to avoid the systemic risk through diversification because the systemic risk affects the whole financial system, not just a particular section. Thus, the risk cannot be diversified away.
Key Takeaway: The power of diversification means that when an investor diversifies his portfolio into different assets (i.e. investing in different assets at the same time), he reduces the risk dramatically. However, since systemic risk does affect the whole system, it's impossible to diversify the risk.

Quiz 5: Dividend, Profit, and Risk