Question 1

From the standpoint of the economy as a whole,the role of
A)the interest rate is to make sure that the price of bonds increases over time.
B)diversification is to eliminate market risk.
C)insurance is to reduce the risks inherent in life.
D)insurance is to spread risks around more efficiently.

Accepted Answer

Insurance helps to spread risks around more efficiently, reducing the potential impact of losses on any single individual or business. This can have a positive effect on the economy as a whole by promoting stability and reducing the likelihood of systemic shocks. A and B are incorrect because neither the interest rate nor diversification are primarily responsible for the benefits mentioned in the question. C is only partially correct, as insurance does reduce risks, but it does so by spreading them around more effectively rather than eliminating them outright.

Question 2

A bank might make mortgages to people in different regions of the country.By doing so
A)the bank reduces the risk it faces from falling house prices in its region and falling prices in all regions.
B)the bank reduces the risk it faces of falling house prices in its region but not from falling prices in all regions.
C)the bank reduces the risk it faces of falling house prices in all regions,but not the risk it faces from falling house prices in its regions.
D)the bank reduces neither the risk it faces from falling house prices in its region nor falling prices in all regions.

Accepted Answer

By making mortgages in different regions of the country, the bank is diversifying its portfolio and reducing the risk it faces from falling house prices in its own region. However, it may still face the risk of falling prices in other regions due to economic factors that affect the housing market as a whole. Therefore, option B is the most accurate statement.

Question 3

Suppose interest of 5% for two years can be earned on $1,000 saved today with no risk.What is the least amount a person would need to have a 50% chance of winning to be willing to face a 50% chance of losing $1,000 today and be considered risk averse?
A)$907.03 to be paid in two years
B)$1,000.01 to be paid in two years
C)$1,100.01 to be paid in two years
D)$1,102.51 to be paid in two years

Accepted Answer

To solve this problem, we need to find the expected value of the amount the person would win if they took the risk.

If they win, they would receive the amount they risked plus the interest earned on that amount over two years:

$1,000 + ($1,000 * 0.05 * 2) = $1,100

If they lose, they would receive nothing:

$0

So the expected value of their winnings is:

(0.5 * $1,000) + (0.5 * $1,100) = $1,050

Therefore, the least amount the person would need to have a 50% chance of winning to be willing to face a 50% chance of losing $1,000 today is $1,050. This amount will be received in two years, so we need to discount it back to present value using the 5% interest rate:

PV = FV / (1 + r)^n

PV = $1,050 / (1 + 0.05)^2

PV = $907.03

Therefore, the best choice is (D) $1,102.51 to be paid in two years, because it is the closest option to the expected value of $1,050.

Question 4

Consider the following two situations.Irene accepts a job where she will be driving in dangerous traffic,so she seeks auto insurance.After Victor buys health insurance,he visits the gym less frequently.Which of these person's actions illustrates moral hazard?
A)both Irene's and Victor's
B)Irene's but not Victor's
C)Victor's but not Irene's
D)neither Victor's nor Irene's

Accepted Answer

Victor's action illustrates moral hazard because he now has insurance to cover his healthcare costs, so he is less motivated to engage in healthy behaviors, such as exercising. Irene's action of seeking auto insurance is not an example of moral hazard because she is taking measures to protect herself and her property from potential damages while driving in dangerous traffic.

Question 5

John has been a sky diver for many years.When the company John works for offers its employees the option to purchase a life insurance policy,John purchases a policy.This illustrates the problem of
A)moral hazard.
B)adverse selection.
C)risk-return tradeoff.
D)diversification.

Accepted Answer

John's decision to purchase a life insurance policy when it is offered implies that he may be a higher risk individual than others in the company. This is an example of adverse selection, where those individuals who are at a higher risk are more likely to purchase insurance, leading to an imbalance in the risk pool. Moral hazard refers to the situation where individuals change their behavior because of the presence of insurance, while risk-return tradeoff and diversification are concepts related to portfolio management and not applicable to this scenario.

Question 6

By holding insurance a person
A)reduces the risk of a bad outcome,such as their house burning down.
B)shares risk and so reduces the burden of risk.
C)Both A and B are correct.
D)Neither A nor B are correct.

Accepted Answer

The answer of By holding insurance a person
A)reduces the risk...

Question 7

Which of the following statements is correct?
A)A high-risk person is more likely to apply for insurance than a low-risk person because a high-risk person would benefit more from insurance protection.
B)A low-risk person is more likely to apply for insurance than a high-risk person because a low-risk person would benefit more from insurance protection.
C)Insurance companies can fully guard against the problem of adverse selection,but they cannot fully guard against the problem of moral hazard.
D)Insurance companies can fully guard against the problem of moral hazard,but they cannot fully guard against the problem of adverse selection.

Accepted Answer

A high-risk person is more likely to apply for insurance because they face a higher likelihood of experiencing a loss that could lead to financial hardship. Insurance provides more benefit and protection to those who face higher risk, so it makes sense that they would be more likely to seek out coverage. Low-risk individuals may not see the same need for insurance, as their chances of experiencing a significant loss are lower.

Question 8

If a stock or bond is risky
A)risk averse people may be willing to hold it as part of a diversified portfolio.
B)risk averse people may be willing to hold it if the expected return is high enough.
C)both A and B are correct.
D)risk averse people will not hold it.

Accepted Answer

Risk averse people may be willing to hold a risky stock or bond if it is part of a well-diversified portfolio, and/or if the expected return is high enough to compensate for the perceived risk. Therefore, both options A and B are correct. However, if the perceived risk is too high and the expected return is not sufficient, risk averse people will likely not hold the security.

Question 9

Kayla faces risks and she pays a fee to ABC Company;in return,ABC Company agrees to accept some or all of Kayla's risks.ABC Company is
A)a mutual fund.
B)an insurance company.
C)a diversified company.
D)an equity-financed company.

Accepted Answer

The scenario described is that of an insurance contract, where Kayla is paying a fee (premium) to ABC Company in exchange for them accepting her risks.

Question 10

The risk of a portfolio
A)increases as the number of stocks in the portfolio increases.
B)is usually measured using a statistic called the standard diversification.
C)is positively related to the average return of the portfolio.
D)bears no relationship to the average return of the portfolio.

Accepted Answer

The risk of a portfolio is positively related to the average return of the portfolio, as higher returns are typically associated with higher risk.

Question 11

Lori,who currently owns stock in four companies,has decided to expand her portfolio by purchasing stock in virtually every company that sells stock.In doing so,Lori will
A)increase the risk of her portfolio.
B)decrease some,but not all,of the risk of her portfolio.
C)decrease all of the risk of her portfolio.
D)leave the risk of her portfolio unchanged from its present level.

Accepted Answer

By diversifying her portfolio and investing in a wide range of companies, Lori will reduce unsystematic risk, which is specific to individual companies. However, she cannot eliminate systematic risk, which affects the entire market.

Question 12

Which of the following make(s)insurance premiums higher than otherwise?
A)adverse selection and moral hazard
B)adverse selection,but not moral hazard
C)moral hazard,but not adverse selection
D)neither adverse selection nor moral hazard

Accepted Answer

Adverse selection occurs when individuals who are more likely to file claims are the ones who purchase insurance, leading to an imbalanced risk pool and higher premiums. Moral hazard refers to the tendency of insured individuals to engage in riskier behavior or file more claims simply because they have insurance, which increases the overall cost of insurance and drives up premiums. Therefore, both adverse selection and moral hazard contribute to making insurance premiums higher than they would be otherwise.

Question 13

Which of the following pairs of portfolios exemplifies the risk-return tradeoff?
A)For Portfolio A,the average return is 6 percent and the standard deviation is 15 percent;for Portfolio B,the average return is 6 percent and the standard deviation is 25 percent.
B)For Portfolio A,the average return is 5 percent and the standard deviation is 15 percent;for Portfolio B,the average return is 8 percent and the standard deviation is 15 percent.
C)For Portfolio A,the average return is 5 percent and the standard deviation is 25 percent;for Portfolio B,the average return is 8 percent and the standard deviation is 15 percent.
D)For Portfolio A,the average return is 5 percent and the standard deviation is 15 percent;for Portfolio B,the average return is 8 percent and the standard deviation is 25 percent.

Accepted Answer

The pair of portfolios in option D exemplifies the risk-return tradeoff as Portfolio B has a higher average return but also a higher standard deviation, indicating a higher level of risk. Portfolio A, on the other hand, has a lower average return but also a lower standard deviation, indicating a lower level of risk. This demonstrates the concept of risk-return tradeoff, where investments with higher potential returns come with higher levels of risk.

Question 14

Susan is planning to invest in one of four stock portfolios,and her financial advisor has given her details regarding the risk associated with each portfolio.Which of the following portfolios would you expect to have the lowest average annual rate of return?
A)​A portfolio with a standard deviation of 3%.
B)​​​A portfolio with a standard deviation of 6%.
C)​A portfolio with a standard deviation of 9%.
D)​A portfolio with a standard deviation of 12%.

Accepted Answer

Generally, a lower standard deviation indicates lower risk, which is often associated with a lower average annual rate of return.

Question 15

By diversifying,the risk of holding stock
A)can be eliminated.On average over the past two centuries stocks paid a higher average real return than bonds.
B)can be eliminated.On average over the past two centuries stocks paid a lower average real return than bonds.
C)can be reduced but not eliminated.On average over the past two centuries stocks paid a higher average real return than bonds.
D)can be reduced but not eliminated.On average over the past two centuries stocks paid a lower average real return than bonds.

Accepted Answer

Diversification helps in reducing the risk but not completely eliminating it. On average over the past two centuries, stocks have provided a higher average real return than bonds, making them an attractive investment option despite the inherent risk involved.

Question 16

Samantha holds stocks in four companies.If she adds stocks of several more companies she will decrease
A)firm specific risk and market risk.
B)firm specific risk but not market risk.
C)market risk but not firm specific risk.
D)neither firm specific nor market risk.

Accepted Answer

By adding stocks of several more different companies, Samantha is increasing her diversification, which will decrease her firm specific risk but not necessarily her market risk as a whole. This is because the market risk is an inherent risk that cannot be diversified away.

Question 17

Suppose that Albert can buy a bond for $1,000 that matures in two years and pays Albert $1,102.5 with certainty.He is indifferent between this bond and one that has some risk but on which the interest rate is 3% higher.How much,to the nearest penny,does the riskier bond pay in two years?
A)$1,160.00
B)$1,166.40
C)$1,168.65
D)$1,169.64

Accepted Answer

The answer of Suppose that Albert can buy a bond...

Question 18

Susan is planning to invest in one of four stock portfolios,and her financial advisor has given her details regarding the risk associated with each portfolio.Which of the following portfolios would you expect to have the highest average annual rate of return?
A)​A portfolio with a standard deviation of 3%.
B)​​​A portfolio with a standard deviation of 6%.
C)​A portfolio with a standard deviation of 9%.
D)​A portfolio with a standard deviation of 12%.

Accepted Answer

Generally, portfolios with higher risk, as measured by standard deviation, are expected to have higher average returns. Therefore, the portfolio with the highest standard deviation, which is 12%, is the one that would be expected to have the highest average annual rate of return.

Question 19

A person who is risk averse might accept a 50% chance of losing $100 today in exchange for a 50% chance of winning $125 in two years if the interest rate was
A)9% but not 10%
B)10% but not 11%
C)11% but not 12%
D)None of the above is correct;a risk averse person would not accept any of the above bets.

Accepted Answer

A risk averse person values certainty and is hesitant to take on risks that have a high likelihood of loss. Therefore, they would prefer a smaller but certain outcome over a larger but uncertain outcome. In this scenario, the expected value of both options is the same - $12.50 ($125 x 50% - $100 x 50% = $12.50). However, the time value of money and the interest rate play a role. At a lower interest rate, the present value of the potential $125 in two years is higher, making the uncertainty of the outcome less appealing. At a higher interest rate, the present value of the potential $125 in two years is lower, making the uncertainty more appealing. Therefore, a risk averse person might be willing to accept the 50/50 bet at an interest rate of 11% but not at an interest rate of 10% or 12%.

Question 20

Stockholders of ComfortAir Corporation,an air conditioner and furnace manufacturer,are concerned that the companies executives may take on greater risks than stockholders desire.This example illustrates
A)moral hazard and market risk.
B)moral hazard and firm specific risk.
C)adverse selection and market risk.
D)adverse selection and firm specific risk.

Accepted Answer

Moral hazard refers to the situation where one party, typically an agent, has an incentive to take on greater risks than another party, typically a principal, desires. In this case, the executives of ComfortAir Corporation may be motivated to take on excessive risks in order to maximize their own benefits, while the stockholders would prefer a more conservative approach. Firm-specific risk refers to risks that affect a particular company, such as operational or financial risks. This is relevant in this case since the stockholders are concerned about the actions of their own company's executives, rather than risks that affect the market as a whole. Therefore, the correct answer is B) moral hazard and firm-specific risk.

Quiz 14: The Basic Tools of Finance: Managing Risk

From the standpoint of the economy as a whole,the role of

A bank might make mortgages to people in different regions of the country.By doing so

Suppose interest of 5% for two years can be earned on $1,000 saved today with no risk.What is the least amount a person would need to have a 50% chance of winning to be willing to face a 50% chance of losing $1,000 today and be considered risk averse?

Consider the following two situations.Irene accepts a job where she will be driving in dangerous traffic,so she seeks auto insurance.After Victor buys health insurance,he visits the gym less frequently.Which of these person's actions illustrates moral hazard?

John has been a sky diver for many years.When the company John works for offers its employees the option to purchase a life insurance policy,John purchases a policy.This illustrates the problem of

By holding insurance a person

Which of the following statements is correct?

If a stock or bond is risky

Kayla faces risks and she pays a fee to ABC Company;in return,ABC Company agrees to accept some or all of Kayla's risks.ABC Company is

The risk of a portfolio

Lori,who currently owns stock in four companies,has decided to expand her portfolio by purchasing stock in virtually every company that sells stock.In doing so,Lori will

Which of the following make(s) insurance premiums higher than otherwise?

Which of the following pairs of portfolios exemplifies the risk-return tradeoff?

Susan is planning to invest in one of four stock portfolios,and her financial advisor has given her details regarding the risk associated with each portfolio.Which of the following portfolios would you expect to have the lowest average annual rate of return?

By diversifying,the risk of holding stock

Samantha holds stocks in four companies.If she adds stocks of several more companies she will decrease

Suppose that Albert can buy a bond for $1,000 that matures in two years and pays Albert $1,102.5 with certainty.He is indifferent between this bond and one that has some risk but on which the interest rate is 3% higher.How much,to the nearest penny,does the riskier bond pay in two years?

Susan is planning to invest in one of four stock portfolios,and her financial advisor has given her details regarding the risk associated with each portfolio.Which of the following portfolios would you expect to have the highest average annual rate of return?

A person who is risk averse might accept a 50% chance of losing $100 today in exchange for a 50% chance of winning $125 in two years if the interest rate was

Stockholders of ComfortAir Corporation,an air conditioner and furnace manufacturer,are concerned that the companies executives may take on greater risks than stockholders desire.This example illustrates