Tools of finance: Economics Chapter 14

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

False

The present value of a payment of $500 to be made two years from today is greater if the interest rate is 7% than if it is 6%. a. True b. False

False

Bert put $75 into an account and one year later had $100. What interest rate was paid on Bert's deposit? a. 20 percent b. 25 percent c. 28 percent d. None of the above is correct.

None of the above is correct.

If a savings account pays 5 percent annual interest, then the rule of 70 tells us that the account value will double in approximately 14 years. a. True b. False

True

11. Diminishing marginal utility of wealth implies that the utility function is a. upward-sloping and has decreasing slope. b. upward-sloping and has increasing slope. c. downward-sloping and has decreasing slope. d. downward-sloping and has increasing slope.

Upward sloping and has a decreasing slope

Refer to Figure 27-2. From the appearance of the utility function, we know that a. Britney is risk averse. b. Britney gains less satisfaction when her wealth increases by X dollars than she loses in satisfaction when her wealth decreases by X dollars. c. the property of diminishing marginal utility applies to Britney. d. All of the above are correct.

All of the above are correct

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.

an insurance company.

Rita puts $10,000 into each of two different assets. The first asset pays 10 percent interest and the second pays 5 percent. According to the rule of 70, what is the approximate difference in the value of the two assets after 14 years? a. $12,000 b. $14,000 c. $15,500 d. $20,000

$20,000

Suppose you put $350 into a bank account today. Interest is paid annually and the annual interest rate is 6 percent. The future value of the $350 after 4 years is a. $414.09. b. $434.00. c. $441.87. d. $481.24.

$441.87

Dobson Construction has an investment project that would cost $150,000 today and yield a one-time payoff of $167,000 in three years. Among the following interest rates, which is the highest one at which Dobson would find this project profitable? a. 5 percent b. 4 percent c. 3 percent d. 2 percent

3 percent

A judge requires Harry to make a payment to Sally. The judge says that Harry can pay her either $10,000 today or $11,000 two years from today. Of the following interest rates, which is the lowest one at which Harry would be better off paying $11,000 two years from today? a. 2 percent b. 3 percent c. 4 percent d. 5 percent

5 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. 7 percent b. 8 percent c. 9 percent d. 10 percent

7 Percent

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

Adverse selection and moral hazard

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.

Increases at a decreasing rate

. 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.

Is upward sloping and her marginal utility function is downward sloping

A measure of the volatility of a variable is its a. present value. b. future value. c. return. d. standard deviation.

Standard deviation

Historically, stocks have offered higher rates of return than bonds. a. True b. False

True

6. Veronica deposited $1,000 into an account two years ago. The first year she earned 7 percent interest; the second year she earned 5 percent. How much money does Veronica have in her account today? a. $1,133.31 b. $1,120.00 c. $1,123.50 d. None of the above are correct to the nearest cent.

$1,123.50

Which of the following is the correct way to compute the future value of $100 put into an account that earns 4 percent interest for 10 years? a. $100(1 + .0410) b. $100(1 + .04 10) c. $100 × 10 (1 + .04) d. $100(1 + .04)10

$100(1 + .04)10

Anna deposited $10,000 into an account three years ago. The first year she earned 12 percent interest, the second year she earned 8 percent interest, and the third year she earned 4 percent interest. How much money does she have in her account today? a. $12,579.84 b. $12,596.80 c. $12,597.12 d. None of the above are correct to the nearest cent.

$12,579.84

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. $2,450.00. c. $2,500.00. d. $2,525.50.

$2,300.00.

There are many concerns for risk-averse lenders. Consider the following: 1. Lenders are concerned that borrowers with the greatest risk are the ones most likely to actively pursue loans. 2. Lenders are concerned that real GDP will decline leading to reduced corporate profits. 3. Lenders are concerned that products produced by certain corporations will become obsolete. a. 1 is market risk; 2 is firm-specific risk b. 2 is market risk; 3 is firm-specific risk c. 3 is market risk; 1 is firm-specific risk d. 2 is firm-specific risk; 3 is market risk

2 is market risk; 3 is firm-specific risk

Suppose you win a small lottery and you are given the following choice: You can (1) receive an immediate payment of $10,000 or (2) three annual payments, each in the amount of $3,600, with the first payment coming one year from now, the second two years from now, and the third three years from now. You would choose to take the three annual payments if the interest rate is a. 2 percent, but not if the interest rate is 3 percent. b. 3 percent, but not if the interest rate is 4 percent. c. 4 percent, but not if the interest rate is 5 percent. d. 5 percent, but not if the interest rate is 6 percent.

3 percent, but not if the interest rate is 4 percent.

2. Missy recently rearranged her portfolio so that it has a higher average return. As a result of this rearranging, Missy a. raised both firm-specific risk and market risk. b. raised firm-specific risk, but not market risk. c. raised market risk, but not firm-specific risk. d. None of the above is correct.

Raised firm specific risk, but not market risk

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.

The average risk averse person will earn a lower rate if return than the average non risk averse person

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.

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

According to the efficient markets hypothesis, the number of people who think a stock is overvalued exactly balances the number of people who think a stock is undervalued. a. True b. False

True

Which of the following is correct? a. Risk-averse people will not hold stock. b. Diversification cannot reduce firm-specific risk. c. The larger the percentage of stock in a portfolio, the greater the risk, but the greater the average return. d. Stock prices are determined by fundamental analysis rather than by supply and demand.

The larger the percentage of stock in a portfolio, the greater the risk, but the greater the average return

5. As the number of stocks in a person's portfolio increases, a. the risk of the portfolio increases, as indicated by the increasing value of the standard deviation of the portfolio. b. the risk of the portfolio increases, as indicated by the decreasing value of the standard deviation of the portfolio. c. the risk of the portfolio decreases, as indicated by the increasing value of the standard deviation of the portfolio. d. the risk of the portfolio decreases, as indicated by the decreasing value of the standard deviation of the portfolio.

The risk of the portfolio decreases, as indicated by the decreasing value of the standard deviation of the portfolio

A risk-averse person has a. a utility function whose slope gets flatter as wealth rises. This means they have increasing marginal utility of wealth. b. a utility function whose slope gets flatter as wealth rises. This means they have diminishing marginal utility of wealth. c. a utility function whose slope gets steeper as wealth rises. This means they have increasing marginal utility of wealth. d. a utility function whose slope gets steeper as wealth rises. This means they have diminishing utility of wealth.

a utility function whose slope gets flatter as wealth rises. This means they have diminishing marginal utility of wealth.