Chapter 27: GAP 7

B. Britney is risk averse.

Figure 27-2. The figure shows a utility function for Britney. http://sjc.cengagenow.com/ilrn/books/mank07t/mank07t.193.017.1.png Refer to Figure 27-2. From the appearance of the utility function, we know that A. the property of increasing marginal utility applies to Britney. B. Britney is risk averse. C. Britney gains more satisfaction when her wealth increases by X dollars than she loses in satisfaction when her wealth decreases by X dollars. D. All of the above are correct.

D. All of the above are correct.

Fundamental analysis determines the value of a stock based on A. the ability of the corporation to earn profits. B. the expected final sale price. C. dividends. D. All of the above are correct.

A. the study of a company's accounting statements and future prospects to determine its value.

Fundamental analysis is A. the study of a company's accounting statements and future prospects to determine its value. B. the study of the relation between risk and return of stock portfolios. C. the determination of the allocation of savings between stocks and bonds based on a person's degree of risk aversion. D. a method used to determine how adding stocks to a portfolio will change the risk of the portfolio.

D. This stock is overvalued; you shouldn't consider adding it to your portfolio.

Fundamental analysis shows that stock in Widgets-R-Us has a present value that is lower than its price. A. This stock is undervalued; you shouldn't consider adding it to your portfolio. B. This stock is overvalued; you should consider adding it to your portfolio. C. This stock is undervalued; you should consider adding it to your portfolio. D. This stock is overvalued; you shouldn't consider adding it to your portfolio.

B. decreases both risk and the average rate of return.

Kyle puts a greater proportion of his portfolio into government bonds. Kyle's action A. decreases risk, but increases the average rate of return. B. decreases both risk and the average rate of return. C. increases risk, but decreases the average rate of return. D. increases both risk and the average rate of return.

A. True

When the price of an asset rises above what appears to be its fundamental value, the market is said to be experiencing a speculative bubble. A. True B. False

B. Albert Einstein

Which famous person referred to compounding as "the greatest mathematical discovery of all time?" A. Benjamin Franklin B. Albert Einstein C. Abraham Lincoln D. Thomas Edison

D. the fall in interest rates, but not the announcement

A previously well-respected and trusted president of a corporation is accused of fraud. At the same time interest rates unexpectedly fall. Which of the above would tend to make the price of the stock rise? A. the announcement but not the fall in interest rates B. the announcement and the fall in interest rates C. neither the announcement nor the fall in interest rates D. the fall in interest rates, but not the announcement

A. Stan

Al, Ralph, and Stan are all intending to retire. Each currently has $1 million in assets. Al will earn 16% interest and retire in two years. Ralph will earn 8% interest and retire in four years. Stan will earn 4% interest and retire in eight years. Who will have the largest sum when he retires? A. Stan B. Ralph C. Al D. They all retire with the same amount.

A. the price of the asset rises above what appears to be its fundamental value.

An asset market is said to experience a speculative bubble when A. the price of the asset rises above what appears to be its fundamental value. B. the asset is a natural resource and its supply is manipulated by foreign nations and foreign firms. C. the market cannot establish an equilibrium price for the asset. D. the price of the asset appears to follow a random walk.

A. holds all the stocks in a given stock index.

An index fund A. holds all the stocks in a given stock index. B. guarantees a return that follows the index of leading economic indicators. C. typically has a lower return than a managed fund. D. holds only stocks and bonds that are indexed to inflation.

B. People who are risk averse should never hold stock.

Angela reads financial advice columns and concludes the following. Which, if any, of her conclusions are incorrect? A. Diversification cannot eliminate all of the risk in stock portfolio. B. People who are risk averse should never hold stock. C. Higher average returns come at the price of higher risk. D. None of her conclusions are incorrect.

D. the pain of losing $200 of her wealth would exceed the pleasure of adding $200 to her wealth.

Figure 27-1. The figure shows a utility function. http://sjc.cengagenow.com/ilrn/books/mank07t/mank07t.193.014.1.png Refer to Figure 27-1. Suppose the person to whom this utility function applies begins with $600 in wealth. Starting from there, A. the pain of losing $200 of her wealth would equal the pleasure of adding $200 to her wealth. B. the pleasure of adding $200 to her wealth would exceed the pain of losing $200 of her wealth. C. she would be willing to accept a coin-flip bet that would result in her winning $200 if the result was "heads" or losing $200 if the result was "tails." D. the pain of losing $200 of her wealth would exceed the pleasure of adding $200 to her wealth.

C. $1,000(1.06)2

If you put $1,000 in the bank today at an interest rate of 6% what is its value in two years? A. $1,000 + $(1.06)2 B. $2,000(1.06) C. $1,000(1.06)2 D. None of the above are correct.

C. $68,058.32

You want to have $100,000 in five years. If the interest rate is 8 percent, about how much do you need to have today? A. $66,225.25 B. $71,428.57 C. $68,058.32 D. $67,556.42

D. 7 percent

A University of Iowa basketball standout is offered a choice of contracts by the New York Liberty. The first one gives her $100,000 one year from today and $100,000 two years from today. The second one gives her $132,000 one year from today and $66,000 two years from today. As her agent, you must compute the present value of each contract. Which of the following interest rates is the lowest one at which the present value of the second contract exceeds that of the first? A. 9 percent B. 8 percent C. 10 percent D. 7 percent

C. Option C

A firm has three different investment options. Option A will give the firm $10 million at the end of one year, $10 million at the end of two years, and $10 million at the end of three years. Option B will give the firm $15 million at the end of one year, $10 million at the end of two years, and $5 million at the end of three years. Option C will give the firm $30 million at the end of one year, and nothing thereafter. Which of these options has the highest present value? A. Option A B. Option B C. Option C D. The answer depends on the rate of interest, which is not specified here.

C. is interested in the likely ability of a corporation to pay dividends in the future.

A person who believes strongly in the use of fundamental analysis to choose a portfolio of stocks A. has a better chance of outperforming the market if stock prices follow a random walk than if they do not follow a random walk. B. almost always chooses to hold index funds in his or her portfolio rather than actively-managed funds. C. is interested in the likely ability of a corporation to pay dividends in the future. D. is spending his or her time wisely if the efficient markets hypothesis is correct.

B. about 14 years

According to the rule of 70, if the interest rate is 5 percent, how long will it take for the value of a savings account to double? A. about 12 years B. about 14 years C. about 6.3 years D. about 3.5 years

C. Victor's but not Irene's

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

C. reduces the likely fluctuation in a portfolio's return. Thus, the likely standard deviation of the portfolio's return is lower.

Diversification A. increases the likely fluctuation in a portfolio's return. Thus, the likely standard deviation of the portfolio's return is lower. B. increases the likely fluctuation in a portfolio's return. Thus, the likely standard deviation of the portfolio's return is higher. C. reduces the likely fluctuation in a portfolio's return. Thus, the likely standard deviation of the portfolio's return is lower. D. reduces the likely fluctuation in a portfolio's return. Thus, the likely standard deviation of the portfolio's return is higher.

B. can eliminate firm-specific risk, but it cannot eliminate market risk.

Diversification of a portfolio A. can eliminate market risk, but it cannot eliminate firm-specific risk. B. can eliminate firm-specific risk, but it cannot eliminate market risk. C. is not necessary for a person who is risk averse. D. increases the portfolio's standard deviation.

B. Britney would prefer to hold a portfolio of stocks with an average return of 8 percent and a standard deviation of 2 percent to a portfolio of stocks with an average return of 8 percent and a standard deviation of 5 percent.

Figure 27-2. The figure shows a utility function for Britney. http://sjc.cengagenow.com/ilrn/books/mank07t/mank07t.193.019.1.png Refer to Figure 27-2. From the appearance of the utility function, we know that A. Britney would prefer to hold a portfolio of stocks with an average return of 8 percent and a standard deviation of 5 percent to a portfolio of stocks with an average return of 6 percent and a standard deviation of 3 percent. B. Britney would prefer to hold a portfolio of stocks with an average return of 8 percent and a standard deviation of 2 percent to a portfolio of stocks with an average return of 8 percent and a standard deviation of 5 percent. C. if Britney owns a house, she would not consider buying fire insurance. D. All of the above are correct.

A. the pleasure of adding $500 to his wealth would exceed the pain of losing $500 of his wealth.

Figure 27-5. The figure shows a utility function for Dexter. http://sjc.cengagenow.com/ilrn/books/mank07t/mank07t.193.032.1.png Refer to Figure 27-5. Suppose Dexter begins with $1,300 in wealth. Starting from there, A. the pleasure of adding $500 to his wealth would exceed the pain of losing $500 of his wealth. B. the pain of losing $500 of his wealth would exceed the pleasure of adding $500 to his wealth. C. the pain of losing $500 of his wealth would equal the pleasure of adding $500 to his wealth. D. This cannot be determined from the graph.

B. Dexter's level of satisfaction increases by more when his wealth increases from $1,001 to $1,002 than it does when his wealth increases from $1,000 to $1,001.

Figure 27-5. The figure shows a utility function for Dexter. http://sjc.cengagenow.com/ilrn/books/mank07t/mank07t.193.028.1.png Refer to Figure 27-5. From the appearance of the graph, we know that A. Dexter's level of satisfaction increases by less when his wealth increases from $1,001 to $1,002 than it does when his wealth increases from $1,000 to $1,001. B. Dexter's level of satisfaction increases by more when his wealth increases from $1,001 to $1,002 than it does when his wealth increases from $1,000 to $1,001. C. Dexter's level of satisfaction increases by the same amount when his wealth increases from $1,001 to $1,002 as it does when his wealth increases from $1,000 to $1,001. D. None of the above answers can be inferred from the appearance of the utility function.

D. not to eliminate the risks inherent in life, but to spread them around more efficiently.

From the standpoint of the economy as a whole, the role of insurance is A. not to spread risks, but to eliminate them for individual policy holders. B. to entice risk-loving people to become risk averse. C. to promote the phenomenon of adverse selection. D. not to eliminate the risks inherent in life, but to spread them around more efficiently.

A. chance of winning $110 in two years and the interest rate was 3%.

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 $110 in two years and the interest rate was 3%. B. chance of winning $114 in two years and the interest rate was 7%. C. chance of winning $120 in two years and the interest rate was 11%. D. None of the above are correct; a risk averse person would not accept any of the above bets.

C. decreasing marginal utility of wealth and is risk averse.

If Cara's utility falls more by losing $600 than it rises by gaining $600, she has A. decreasing marginal utility of wealth but is not risk averse. B. increasing marginal utility of wealth but is not risk averse. C. decreasing marginal utility of wealth and is risk averse. D. increasing marginal utility of wealth and is risk averse.

B. increases at a decreasing rate.

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

A. 5 percent

Of the following interest rates, which is the highest one at which you would prefer to have $170 ten years from today instead of $100 today? A. 5 percent B. 7 percent C. 9 percent D. 3 percent

B. rise, and investment spending fall.

Other things the same, an increase in the interest rate makes the quantity of loanable funds supplied A. fall, and investment spending rise. B. rise, and investment spending fall. C. fall, and investment spending fall. D. rise, and investment spending rise.

D. All of the above are correct.

Ron decides which stocks to purchase by throwing darts at the stock pages of The Wall Street Journal. Ron probably believes that A. it is better to own stock in 20 companies than it is to own stock in 2 companies. B. the stock market is informationally efficient. C. stock prices follow a random walk. D. All of the above are correct.

A. Option 3 has the highest present value and Option 1 has the lowest.

Suppose the interest rate is 8 percent. Consider three payment options: 1. $200 today. 2. $220 one year from today. 3. $240 two years from today. Which of the following is correct? A. Option 3 has the highest present value and Option 1 has the lowest. B. Option 1 has the highest present value and Option 2 has the lowest. C. Option 2 has the highest present value and Option 3 has the lowest. D. None of the above is correct.

C. $653.48 after 5 years and $854.07 after 10 years.

Suppose you put $500 into a bank account today. Interest is paid annually and the annual interest rate is 5.5 percent. The future value of the $500 is A. $637.50 after 5 years and $775.00 after 10 years. B. $688.36 after 5 years and $915.56 after 10 years. C. $653.48 after 5 years and $854.07 after 10 years. D. $637.50 after 5 years and $822.09 after 10 years.

C. K-Nine would buy the equipment in both cases.

The K-Nine dog food company is considering the purchase of additional canning equipment. They expect that adding the equipment will yield $200,000 at the end of the first year and $250,000 at the end of the second year and then nothing after that. At which of the following prices and interest rates would K-Nine buy the equipment? A. $415,000 if the interest rate is 5% B. $419,000 if the interest rate is 4% C. K-Nine would buy the equipment in both cases. D. K-Nine would not buy the equipment in either case.

B. the present value of the factory rises. It's more likely the company will build the factory.

The You Look Marvelous! cosmetic company is considering building a new shampoo factory. Its accountants and board of directors meet and decide that it is not a good idea to build the factory. If interest rates fall after the meeting A. the present value of the factory falls. It's more likely the company will build the factory. B. the present value of the factory rises. It's more likely the company will build the factory. C. the present value of the factory rises. It's less likely the company will build the factory. D. the present value of the factory falls. It's less likely the company will build the factory.

B. False

The fact that we observe a trade-off between risk and return is puzzling to economists, because that observation conflicts with the notion that most people are risk averse. A. True B. False

D. All of the above are correct.

The financial system A. involves bank accounts, mortgages, stock prices, and many other items. B. coordinates the economy's saving and investment. C. involves decisions and actions undertaken by people at a point in time that affect their lives in the future. D. All of the above are correct.

A. provides evidence in support of the efficient markets hypothesis.

The performance of index funds A. provides evidence in support of the efficient markets hypothesis. B. usually falls short of the performance of actively-managed funds. C. provides evidence in support of the notion that stock-market participants are irrational. D. provides evidence in support of the notion that stock prices do not depend upon supply and demand.

B. False

The sooner a payment is received and the higher the interest rate, the greater the present value of a future payment. A. True B. False

C. A person who has narrowly avoided many accidents applies for automobile insurance.

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

B. a decrease in the interest rate

Which of the following changes would increase the present value of a future payment? A. an increase in the time until the payment is made B. a decrease in the interest rate C. a decrease in the size of the payment D. All of the above are correct.

D. a game where she has a 60 percent chance of winning $1 and a 40 percent chance of losing $1

Which of the following games might a risk-averse person play? A. a game where she has a 50 percent chance of winning $100 and a 50 percent chance of losing $100 B. a game where she has a 40 percent chance of winning $1 and a 60 percent chance of losing $1 C. a game where she has a 50 percent chance of winning $1 and a 50 percent chance of losing $1 D. a game where she has a 60 percent chance of winning $1 and a 40 percent chance of losing $1

A. Index funds typically have a higher rate of return than managed funds. This tends to support the efficient market hypothesis.

Which of the following is correct? A. Index funds typically have a higher rate of return than managed funds. This tends to support the efficient market hypothesis. B. Index funds typically have a higher rate of return than managed funds. This tends to refute the efficient market hypothesis. C. Managed funds typically have a higher return than indexed funds. This tends to refute the efficient market hypothesis. D. Managed funds typically have a higher return than indexed funds. This tends to support the efficient market hypothesis.

D. None of the above are correct to the nearest cent.

Which, if any, of the present values below are correctly computed? A. A payment of $1,000 to be received one year from today, with a 9 percent interest rate, has a present value of $911.11. B. A payment of $1,000 to be received one year from today, with a 8 percent interest rate, has a present value of $945.45. C. A payment of $1,000 to be received one year from today, with a 10 percent interest rate, has a present value of $905.06. D. None of the above are correct to the nearest cent.

A. $2,300.00.

You could borrow $2,000 today from Bank A and repay the loan, with interest, by paying Bank A $2,154 one year from today. Or, you could borrow X dollars today from Bank B and repay the loan, with interest, by paying Bank B $2,477.10 one year from today. In order for the same interest rate to apply to the two loans, X = A. $2,300.00. B. $2,500.00. C. $2,450.00. D. $2,525.50.

B. You receive the payment 5 years from now and the interest rate is 5 percent.

You have been promised a payment of $400 in the future. In which of the following cases is the present value of this payment the lowest? A. You receive the payment 4 years from now and the interest rate is 4 percent. B. You receive the payment 5 years from now and the interest rate is 5 percent. C. You receive the payment 5 years from now and the interest rate is 4 percent. D. You receive the payment 4 years from now and the interest rate is 5 percent.

B. The first example primarily illustrates adverse selection; the second primarily illustrates moral hazard.

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 moral hazard. B. The first example primarily illustrates adverse selection; the second primarily illustrates moral hazard. C. Both examples primarily illustrate adverse selection. D. The first example primarily illustrates moral hazard; the second primarily illustrates adverse selection.

C. 6 percent

Your accountant tells you that if you can continue to earn the current interest rate on your balance of $800 for the next two years you will have $898.88 in your account. If your accountant is correct, then what is the current interest rate? A. 7 percent B. 8 percent C. 6 percent D. 9 percent

B. 9.6 percent

Zoey wants to have about $750,000 when she retires in 10 years. She has $300,000 to deposit now. At which of the following interest rates would Zoey's deposit come closest to $750,000 after 10 years? A. 10.5 percent B. 9.6 percent C. 10.2 percent D. 9.9 percent