Ch 14

The efficient market hypothesis implies that news has no effect on stock prices. True False

False: Unexpected news, either good or bad, influence the demand for certain stock and thus affect the price of the stock.

Fundamental analysis refers to a detailed analysis of a company to determine its value. True False

True: Fundamental analysis is the study of a company's accounting statements and future prospects to determine its value

Discounting refers to finding the present value of a future sum of money. True False

True: The possibility of earning interest reduces the present value below the amount X. Thus the process of finding a present value of a future sum of money is called discounting.

At an annual interest rate of 7%, about how many years will it take $200 to double in value? a.10 b.11 c.7 d.9

A: According to the rule of 70, if some variable grows at a rate of x percent per year, then that variable doubles in approximately 70/x years. In this case, $200 grows at 7% each year, which means that it'll double in value in 70/7 = 10 years.

All other things being the same, the future value of a deposit in a savings account will be larger the longer a person waits to withdraw the funds. True False

True: The future value of the deposit ($X) is the amount of money in the future (say, in n years) that $X will yield, given prevailing interest rates (r): $X × (1 + r)n. The formula implies a positive relationship between the future value and the time period. In other words, if the interest rate remains the same, the future value of $X will be larger the longer the deposit is not withdrawn.

Speculative bubbles may occur in the stock market a. because rational people may buy an overvalued stock if they think they can sell it to someone for even more at a later date. b. when stocks are fairly valued. c. during periods of extreme pessimism because so many stocks become undervalued. d. only when people are irrational.

a

Suppose Klara is a risk averse person, which of the following games might she play? a.A game where she has a 50% chance of winning $100 and a 50% chance of losing $100. b.A game where she has a 60% chance of winning $1 and a 40% chance of losing $1. c.A game where she has a 90% chance of winning $1 and a 10% chance of losing $10. d.A game where she has a 40% chance of winning $1 and a 60% chance of losing $1.

B: As a risk averse individual, Klara dislikes a loss more than is pleased by a comparable gain. Therefore, she will only play a game when the chance of winning a certain amount is significantly higher than the chance of losing the same amount. Then a game where she has a 60% chance of winning $1 and a 40% chance of losing $1 is the only worthwhile option for Klara.

Suppose fundamental analysis indicates that a stock is undervalued. Which of the following is true? a.This means its value is less than its price and you should consider adding the stock to your portfolio. b.This means its value is more than its price and you should consider adding the stock to your portfolio. c.This means its value is more than its price and you shouldn't consider adding the stock to your portfolio. d.This means its value is less than its price and you shouldn't consider adding the stock to your portfolio.

B: If a stock is undervalued, its value is more than its price. You should prefer undervalued stocks as you are getting a bargain by paying less than the business is worth

Suppose that Bertha's wealth is $11,000. Which of the following explains why Bertha is risk averse? a.Utility gain from additional $1,000 is the same as utility loss from losing $1,000. b.Utility gain from additional $1,000 is less than utility loss from losing $1,000. c.Utility gain from additional $1,000 is greater than utility loss from losing $1,000. d.Bertha is not risk averse because her utility gain from additional $1,000 is less than utility loss from losing $1,000

B: Incorrect. Bertha's utility function shows that if her wealth is $11,000, then additional $1,000 will increase her utility by 350 - 250 = 100 points, whereas a loss of the same amount of money will result in a loss of 250 - 100 = 150 points. Bertha's utility function exhibits the property of diminishing marginal utility as it gets flatter as wealth increases.

Insured people tend to be less careful than uninsured people about their risky behavior. This is called a.the adverse selection problem. b.the moral hazard problem. c.the free-rider problem. d.diversification.

B: Moral hazard refers to the fact that after people buy insurance, they have less incentive to be careful about their risky behavior because the insurance company will cover much of the resulting losses. Insurance companies cannot perfectly distinguish between high-risk and low-risk customers, and cannot monitor all of its customers' risky behavior.

Refer to the Figure. Suppose Bertha begins with $1,050 in wealth. Which of the following coin-flip bets would she definitely not be willing to accept? a.If it is "heads," she wins $150; if it is tails, she loses $140. b.If it is "heads," she wins $150; if it is tails, she loses $150. c.If it is "heads," she wins $100; if it is tails, she loses $95. d.She definitely would not accept any of these bets.

B: The utility function exhibits the property of diminishing marginal utility, which means that it declines with wealth. Thus Bertha would definitely not be willing to accept the bet of either winning $150 or losing $150. The property of diminishing marginal utility, however, does not prevent Bertha from accepting a bet if the potential gain exceeds the potential loss, like winning $100 versus losing $95.

The utility function exhibits the property of a.diminishing risk aversion. b.diminishing marginal utility. c.diminishing marginal wealth. d.increasing marginal wealth

B: The utility function shown exhibits the property of diminishing marginal utility. The more wealth this person has, the less utility she gets from an additional dollar. In other words, the function gets flatter as wealth increases.

Which of the following investment options would a risk averse investor of $100,000 prefer? a.A high-risk stock that is expected to be worth $120,000 in four years. b.A risk-free government bond that pays 3% each year for two years. c.A low-risk stock that will be worth $106,090 in two years. d.Either a risk-free government bond or a low-risk stock.

B: When deciding how to allocate their savings, investors decide how much risk they are willing to undertake to earn a higher return. Risk averse investors dislike a loss more than are pleased by a comparable gain. A risk-free government bond that pays 3% each year for two years gives an incentive to invest by offering a gain and minimizing the risk of a loss. A low-risk stock still carries a greater risk of default than the government bond. Although a high-risk stock offers a higher gain, it carries a great risk of default and thus will be rejected by a risk averse investor.

Firm-specific risk is the a. risk associated with moral hazard. b. risk associated with adverse selection. c. uncertainty associated with specific companies. d. uncertainty associated with the entire economy.

C

If two countries start with the same real GDP per person, and one country grows at 2 percent while the other grows at 4 percent, a. one country will always have 2 percent more real GDP per person than the other. b. the standard of living in the two countries will converge. c. the standard of living in the country growing at 4 percent will start to accelerate away from the slower growing country due to compound growth. d. next year the country growing at 4 percent will have twice the GDP per person as the country growing at 2 percent

C

Which of the following does not help reduce the risk that people face? a. buying insurance b. diversifying their portfolio c. increasing the rate of return within their portfolio d. All of the above help reduce risk.

C

If people are risk averse, then a. they dislike bad things more than they like comparable good things. b. their utility functions exhibit the property of diminishing marginal utility of wealth. c. the utility they would lose from losing a $50 bet would exceed the utility they would gain from winning a $50 bet. d. all of the above are true. e. none of the above is true.

D

Using the rule of 70, if your parents place $10,000 in a deposit for you on the day you are born, approximately how much will be in the account when you retire at 70 years old if the deposit earns 3 percent per year? a. $20,000 b. $300 c. $3,000 d. $80,000 e. $70,000

D

Which of the following should cause the price of a share of stock to rise? a. a reduction in market risk b. an increase in expected dividends c. a reduction in the interest rate d. All of the above should cause the price to rise. e. None of the above should cause the price to rise

D

A public company announces that it has hired a new chief executive officer who has a reputation of successfully raising the profitability of the corporation. Which of the following is the most likely consequence of the announcement? a.The company will soon announce a new product. b.The value of the company's stock will fall. c.The company will be privatized. d.The value of the company's stock will rise.

D: Although at any moment in time, the market price is the best guess of the company's value based on available information, stock prices change when information changes. When an unexpected good news such as a hire of an experienced CEO becomes public, the value and the stock price both rise.

In the 1990s, Fed Chairperson Alan Greenspan questioned whether the stock market a.boom at that time reflected "animal spirits." b.decline at that time reflected "irrational funk." c.decline at that time reflected "rational exuberance." d.boom at that time reflected "irrational exuberance."

D: Correct. In the 1930s, economist John Maynard Keynes suggested that asset markets are driven by the "animal spirits" of investors-irrational waves of optimism and pessimism. In the 1990s, as the stock market soared to new heights, Fed Chairman Alan Greenspan questioned whether the boom reflected "irrational exuberance."

Which of the following most accurately describes what data are included in fundamental analysis of the value of a stock? a.The ability of the corporation to earn profits. b.The expected final sale price. c.The expected final sale price and the ability of the corporation to earn profits. d.Dividends, the expected final sale price, and the ability of the corporation to earn profits.

D: Fundamental analysis is the study of a company's accounting statements and future prospects to determine its value. It is based on the study of the company's dividends, the expected final sale price of its stock, and the ability of the company to earn profit.

Suppose that fundamental analysis indicates a particular company's stock is overvalued. Which of the following is true? a.You should consider adding the stock to your portfolio. b.The stock's present value is greater than its price. c.The stock's value will decline soon. d.You avoid adding the stock to your portfolio.

D: If a stock is overvalued, its present value is less than its price. When choosing stocks for your portfolio, you should avoid overvalued stocks. Otherwise you will be paying more than the business is worth.

Fundamental analysis shows that the stock of Gold Fish corporation has a present value that is lower than its price. Which of the following is true? a.The stock will be rapidly losing value. b.This stock is undervalued. c.The stock will be rapidly gaining value. d.This stock is overvalued.

D: If the price is less than the value, the stock is said to be undervalued. If the price exceeds the value, the stock is said to be overvalued.

Suppose that your research shows that the present value of a stock's dividend stream and future price exceeds its price. This should lead you to believe that the stock is a.overvalued so you should consider buying it. b.undervalued and you should consider selling it. c.overvalued so you should not consider buying it. d.undervalued and you should consider buying it.

D: If the price is less than the value, the stock is said to be undervalued. When choosing stocks for your portfolio, you should prefer undervalued stocks. In these cases, you are getting a bargain by paying less than the business is worth.

Suppose you believe in the efficient markets hypothesis. Which of the following is true? a.You believe that stock prices never follow a random walk. b.You believe that the stock market is informationally inefficient. c.You do not believe that there is positive relationship between risk and return. d.You believe that stock prices follow a random walk.

D: One implication of the efficient markets hypothesis is that stock prices should follow a random walk, which means that changes in stock prices are impossible to predict from available information.

Which of the following does the efficient market hypothesis imply? a.Mutual funds should outperform index funds. And they usually do. b.Index funds should outperform professionally managed funds. But they usually do not. c.Mutual funds should outperform professionally managed funds. But they usually do not. d.Index funds should outperform professionally managed funds. And they usually do.

D: Professional portfolio managers are supposed to buy only the best stocks i.e. picking stocks based on extensive research and alleged expertise. An index fund is a mutual fund that buys all the stocks in a given index. If the efficient markets hypothesis is correct, then index funds should outperform professionally managed funds. Active managers usually fail to beat index funds. And even mutual fund managers with a history of superior performance usually fail to maintain it in subsequent periods.

Which of the following is consistent with the efficient market hypothesis? a.News has no effect on stock prices. b.Highly managed funds typically outperform Index funds. c.Investors engage in fundamental analysis to discover undervalued stocks. d.Stock prices follow a random walk.

D: The efficient markets hypothesis is the theory that asset prices reflect all publicly available information about the value of an asset. The theory implies that stock prices should follow a random walk. That is, changes in stock prices are impossible to predict from available information. If based on publicly available information, you could predict that a stock price would rise by 10% tomorrow, then the stock market must be failing to incorporate that information today. The only thing that can move stock prices is an unexpected news that changes the market's perception of the company's value.

Which of the following is an example of stock market irrationality? a.Informed and experienced rational managers of mutual funds generally beat the market. b.The price of a stock is completely unrelated of public opinion about the future demand for this stock. c.The stock market moves in ways that can be predicted by a careful analysis of political and economic events. d.Speculative bubbles in the stock market occur because the price that people pay for stock depends on what they think someone else will pay for it in the future.

D: The possibility of speculative bubbles in the stock market arises in part because the value of the stock to a stockholder depends not only on the stream of dividend payments but also on the final sale price. Thus, investors might be willing to pay more than a stock is worth today if they expect another person to pay even more for it tomorrow.

The value of a stock is based on the present values of the dividend stream and final price. As a result, a.the value of a stock falls when interest rates fall. b.the value of a stock rises when interest rates rise. c.changes in interest rates have no effect on the value of a stock. d.the value of a stock falls when interest rates rise.

D: There is an inverse relationship between the present value or the price of the stock and the interest rate. Thus, the value of a stock falls when interest rates rise (and the value of a stock rises when interest rates fall).

The efficient markets hypothesis implies that a worse-than-expected news about a company's performance will a.raise the price of the stock. b.have no effect on its stock price. c.change the price of the stock in a random direction. d.lower the price of the stock.

D: When unexpectedly bad news becomes public, the value and the stock price both should decline. The fact that the company has performed worse than investors had anticipated is a bad news and the efficient markets hypothesis predicts that the value of the company's stock will decline.

Whenever the price of an asset rises above what appears to be its fundamental value, the market is said to be experiencing a a."random bubble." b."random walk." c."speculative hedge." d."speculative bubble."

D:If the price of an asset rises above what appears to be its fundamental value, the market is said to be experiencing a speculative bubble. Stock market bubbles arise in part because investors are willing to pay more than a stock is worth today if they expect others to pay even more for it tomorrow.

General Electric has the opportunity to purchase a new factory today that will provide them with a $50 million return four years from now. If prevailing interest rates are 6 percent, what is the maximum that the project can cost for General Electric to be willing to undertake the project? a. $50,000,000 b. $53,406,002 c. $43,456,838 d. $34,583,902 e. $39,604,682

E

Using the rule of 70, if your income grows at 10 percent per year, your income will double in approximately a. 700 years. b. 10 years. c. There is not enough information to answer this question. d. 70 years. e. 7 years.

E

An index fund holds only stocks and bonds that are indexed to inflation. True False

False: An index fund holds all the stocks in a given stock index

An index fund includes only the best stocks available in the stock market. True False

False: An index fund holds all the stocks in a given stock index.

Bertha is risk averse but only in the wealth range from $10,000 to $12,000

False: Bertha's utility function exhibits the property of diminishing marginal utility. The more wealth Bertha has, the less utility she gets from an additional dollar. In other words, the function gets flatter as wealth increases. Therefore, Bertha is risk averse at each level of wealth, not only between $10,000 and $12,000.

Compounding refers to finding the future value of a present sum of money. True False

False: Compounding refers to interest being earned on previously-earned interest.

Diversification of a portfolio can eliminate market risk, but it cannot eliminate firm-specific risk. True False

False: Diversification can eliminate firm-specific risk-the uncertainty associated with the specific companies. But diversification cannot eliminate market risk-the uncertainty associated with the entire economy, which affects all companies traded on the stock market.

If the efficient markets hypothesis is correct then some stocks may be better buys than other. True False

False: If the efficient markets hypothesis is correct, that all stocks are fairly valued all the time and that no stock is a better buy than any other.

Refer to the Figure. If most people's utility functions look like Amir's utility function, then it is easy to explain why people buy various types of insurance. True False

False: Most people are risk averse and their utility function exhibits the property of diminishing marginal returns. This means that such people dislike a loss more than are pleased by a comparable gain and would prefer facing a risk to pay a fee to an insurance company to accepting the risk of a loss in an event of a fire, auto accident, or expensive medical treatment. However, the property of diminishing marginal utility does not apply to Amir. Thus, unlike most people, Amir is not risk averse.

Suppose that Black&White Company announces that its revenue in the last quarter decreased by less than its investors had anticipated. According to the efficient markets hypothesis, the value of the company's stock will decline. True False

False: Stock prices change when information changes. When good and unexpected news becomes public, the value and the stock price both should rise. The fact that Black&White Company's revenue declined by less than investors had anticipated, is a good news and the efficient markets hypothesis predicts that the value of the company's stock should increase.

The efficient markets hypothesis implies that building a portfolio based on a published list of the "most respected" companies is likely to produce a better-than-average return. True False

False: The efficient markets hypothesis implies that all stocks are fairly valued all the time and that no stock is a better buy than any other.

Today, you deposit $350 into a bank account, which pays an annual interest rate of 6%. The future value of the $350 in 4 years is $1,400. True False

False: The formula for the future value of $350 in 4 years, if the interest rate is 6%, is as follows (where Y is the number of years): Present Value × (1 + Interest Rate )Y = $350 × (1 + 0.06)4 = $441.87.

Diminishing marginal utility of wealth implies that the utility lost from losing a $100 bet is less than the utility gained from winning it. True False

False: The property of diminishing marginal utility implies that the more wealth a person has, the less utility she gets from an additional dollar. Thus the utility lost from losing a $100 bet is greater than the utility gained from winning it.

As the number of stocks in a person's portfolio increases, the risk of the portfolio decreases, as indicated by the increasing value of the standard deviation of the portfolio. True False

False: The standard deviation measures the volatility of a variable-that is, how much the variable is likely to fluctuate. Increasing the number of stocks in a portfolio reduces firm-specific risk through diversification, which will be reflected by a lower standard deviation of the portfolio.

Refer to the Figure. Dexter's utility function exhibits the property of diminishing marginal utility. True False

False: The utility function of risk averse people exhibits the property of diminishing marginal returns to reflect the fact that such people dislike a loss more than are pleased by a comparable gain. However, Dexter gains more satisfaction when his wealth increases by $X than he loses in satisfaction when his wealth decreases by $X. This means that the property of diminishing marginal utility does not apply to Dexter's utility function.

You would prefer $100 today to receiving $200 in 10 years if the interest rate were 5%. True False

False: To compare $100 today with $200 in 10 years, you should compute the present value of the $200: $200/(1 + 0.05)10 = $122.78. Since the present value of the future $200 is greater than $100, you are better off waiting for the future sum.

Suppose that Orange Company announced that it hired a new CEO away from its successful competitor. The efficient markets hypothesis implies that the price of the stock should increase. True False

True: At any moment in time, the market price is the best guess of the company's value based on available information. However, stock prices change when information changes. When an unexpected good news such as a hire of an experienced CEO becomes public, the value and the stock price both rise.

Bertha is a risk averse person. Therefore she will be upset losing $1,000 on a bet more than pleased winning $1,000 on a bet. True False

True: Bertha is risk averse, which not only means that she dislikes bad things but rather that she dislikes bad things more than she likes comparable good things. Thus she will be upset losing $1,000 more than pleased winning $1,000.

Diversification of a portfolio can eliminate firm-specific risk, but it cannot eliminate market risk. True False

True: Diversification can eliminate firm-specific risk-the uncertainty associated with the specific companies. But diversification cannot eliminate market risk-the uncertainty associated with the entire economy, which affects all companies traded on the stock market.

The formula $X × (1 + r)n determines the future value of $X that earns r percent interest for n years. True False

True: Future value is the amount of money in the future (say, n years) that an amount of money today ($X) will yield, given prevailing interest rates (r). Thus the formula to compute the future value is $X × (1 + r)n.

From the standpoint of the economy as a whole, the role of insurance is not to eliminate the risks inherent in life, but to spread them around more efficiently. True False

True: Most people will not make claims on their policies. This allows insurance companies to accumulate enough funds to pay out large claims to the unlucky few and still stay in business. Thus from the standpoint of the economy as a whole, insurance does not eliminate the risks inherent in life but rather spreads them around more efficiently.

If stock prices follow a random walk, it means that stock prices are just as likely to rise as to fall at any given time. True False

True: The efficient markets hypothesis implies that stock prices should follow a random walk. This means that changes in stock prices are impossible to predict from available information.

If today you deposit $700 into a bank account, which pays the annual interest rate of 2.5%, in 2 years, the future value of the deposit will be $735.44. True False

True: The formula for the future value of $700 in 2 years if the interest rate is 2.5%, is as follows: Present Value × (1 + Interest Rate)Years = $700 × (1 + 0.025)2 = $735.44.

If the interest rate is 4.5%, you are better off having $1,000 today than $X in 7 years if and only if X is less than $1,360.86 (or X < $1,360.86). True False

True: The future value of $1,000 to be received in 7 years if the interest rate is 4.5% equals $1,000 × (1 + 0.045)7 = $1,360.86. This means that you are better off taking $1,000 today than $X in the future, only if $X is less than $1,360.86. Otherwise, you are better off waiting for the future sum.

All other things being the same, the future value of a deposit in a savings account will be larger the higher the interest rate is. True False

True: The future value of the deposit ($X) is the amount of money in the future (say, in n years) that $X will yield, given prevailing interest rates (r): $X × (1 + r)n. The formula implies a positive relationship between the future value and the interest rate. In other words, if the time period n does not change, the future value of $X will be larger the higher the interest rate, r.

You will receive $500 at some point in the future. If the annual interest rate is 7.5%, then in 5 years, the present value of the $500 is $348.28. In 10 years, the present value of the $500 will decrease to $242.60. True False

True: The present value of any future sum of money is the amount today that would be needed, at current interest rates, to produce that future sum. The formula for the present value is as follows: Present Value = Future Value/(1 + Interest Rate)Years. The present value of $500 to be received in 5 years, if the interest rate is 7.5%, is $500/(1 + 0.075)5 = $348.28; for the 10-year period, however, it decreases to $500/(1 + 0.075)10 = $242.60.

As the number of stocks in a person's portfolio increases, the risk of the portfolio decreases, as indicated by the decreasing value of the standard deviation of the portfolio. True False

True: The standard deviation measures the volatility of a variable-that is, how much the variable is likely to fluctuate. Increasing the number of stocks in a portfolio reduces firm-specific risk through diversification, which will be reflected by a lower standard deviation of the portfolio.

Refer to the Figure. The utility function shows that if wealth increases from $1,050 to $1,350, then utility increases by less than the decline in utility when wealth decreases by the same amount, from $1,050 to $750. True False

True: The utility function exhibits the property of diminishing marginal utility, which means that it declines with wealth. This explains the fact that if wealth increased from $1,050 to $1,350, then utility would increase by less than if wealth decreased by the same $300

Refer to the Figure. The property of diminishing marginal utility does not apply to Dexter's utility function. True False

True: The utility function of risk averse people exhibits the property of diminishing marginal returns to reflect the fact that such people dislike a loss more than are pleased by a comparable gain. However, Dexter gains more satisfaction when his wealth increases by $X than he loses in satisfaction when his wealth decreases by $X. Thus the property of diminishing marginal utility does not apply to Dexter's utility function.

You have to choose between $200 today and $400 in 10 years. Suppose that the interest rate is 5%. You would prefer the $200 today if the interest rate were 8%, but would rather wait for the future amount if the interest rate were 5%.

True: To answer this question you should compute the present value of $400 to be received in 10 years for both interest rates. If the interest rate is 8%, the present value is $400/(1 + 0.08)10 = $185.28, which is less than $200. This means that you are better off taking the $200 today. When the interest rate declines to 5%, the present values of the future $400 increases to $400/(1 + 0.05)10 = $245.57, which is greater than $200. Therefore, you are better off waiting for the future sum.

Refer to the Figure. The property of diminishing marginal utility does not apply to Amir, which implies that Amir is not risk averse. True False

True: When Amir's wealth increases by $800 from $2,800 to $3,600, his utility gain is the same as his utility loss from a decrease in wealth by $800. But by definition, risk averse individuals dislike bad things happening to them more than they like comparable good things. This definition, therefore, does not apply to Amir.

Suppose that Purple Company unexpectedly announces a significant improvement in the production technology. The efficient markets hypothesis implies the price of the stock should increase. Suppose this news has no effect on the price of the stock. Fundamental analysis would now show that the company's stock is undervalued. True False

True: When an unexpected good news such as availability of a new technology becomes public, the value and the stock price both should rise. If the price does not rise, fundamental analysis-the study of a company's accounting statements and future prospects to determine its value-will show that the company's stock is undervalued.

It is difficult for an actively managed mutual fund to outperform an index fund because a. index funds generally do better fundamental analysis. b. stock markets tend to be inefficient. c. actively managed funds trade more often and charge fees for their alleged expertise. d. index funds are able to buy undervalued stocks. e. all of the above are true.

c

Stock prices will follow a random walk if a. stocks are undervalued. b. people behave irrationally when choosing stock. c. markets reflect all available information in a rational way. d. stocks are overvalued.

c

The term "efficient markets hypothesis" refers to a.efficiency of investors' preferences. b.the efficiency of fundamental analysis to identify which stocks to buy or sell. c.efficient management of mutual funds. d."informational efficiency" of the stock market.

d."informational efficiency" of the stock market. Efficient markets hypothesis refers to informational efficiency of the stock market. Stock prices reflect all available information about the value of the asset. Stock prices change when information changes.

An increase in the prevailing interest rate a. decreases the present value of future returns from investment and decreases investment. b. decreases the present value of future returns from investment and increases investment. c. increases the present value of future returns from investment and increases investment. d. increases the present value of future returns from investment and decreases investment.

A

Diversification of a portfolio can a. reduce firm-specific risk. b. eliminate all risk. c. reduce market risk. d. increase the standard deviation of the portfolio's return.

A

The amount of money today needed to produce a particular sum in the future, given prevailing interest rates, is known as a. present value. b. beginning value. c. fair value. d. compound value. e. future value.

A

The study of a company's accounting statements and future prospects to determine its value is known as a. fundamental analysis. b. information analysis. c. diversification. d. risk management.

A

Which of the following is an example of moral hazard? a. After Joe buys fire insurance, he begins to smoke cigarettes in bed. b. Doug has been feeling poorly lately so he seeks health insurance. c. Both of Susan's parents lost their teeth due to gum disease, so Susan buys dental insurance. d. All of the above demonstrate moral hazard. e. None of the above demonstrates moral hazard.

A

Which of the following reduces risk in a portfolio the greatest? a. increasing the number of stocks in the portfolio from 1 to 10 b. increasing the number of stocks from 10 to 20 c. increasing the number of stocks from 20 to 30 d. All of the above provide the same amount of risk reduction

A

Anna deposited $5,000 into an account three years ago. The first year she earned 12% interest, the second year the interest rate was 8%, and the third year the interest rate was 4%. How much money does she have in her account today? a.$6,289.92 b.$6,048.00 c.$5,616.00 d.$5,824.00

A. $6,289.92 The future value in three years taking into account the fact that every year the interest rate is different is as follows: (1 + Interest Rateyear1) × (1 + Interest Rateyear2) × (1 + Interest Rateyear3) × Present Value. Thus in three years, Anna's account earns (1 + 0.12) × (1 + 0.08) × (1 + 0.04) × $5,000 = $6,289.92.

A scholarship gives you $2,000 today and promises to pay you $1,000 one year from today. Which formula determines the present value of these payments? a.$2,000 + $1,000/(1 + r) b.$1,000(1 + r) + $1,000(1 + r)2 c.$2,000/(1 + r)2. d.$1,000/(1 + r) + $1,000/(1 + r)2

A: First, you receive $2,000 today. Second, you will also receive $1,000 in one year. Generally, if r is the interest rate, then an amount X to be received in N years has a present value of X/(1 + r)N (or X×(1 + r)-N). Since N = 1 year, the present value of both payments is $2,000 + $1,000/(1 + r).

You would be equally happy, assuming that the interest rate is 4%, if you received a gift of either $100 today or a gift of a.$112.49 three years from today. b.$123.67 five years from today. c.$110.00 four years from today. d.$116.00 two years from today.

A: Future value = Present Value × (1 + Interest Rate)Years. To answer this question, you should have calculated future values of $100 in 2, 3, 4, and 5 years. In 3 years, $100 × (1 + 0.04)3 = $112.49.

Which of the following formulas determines the future value of $600 put into an account that earns 2% interest for 10 years? a.$600 × (1 + 0.02)10 b.$600/(1 + 0.021) c.$600/(1 + 0.0210) d.$600 × 10 × (1 + 0.02)

A: Future value is the amount of money in the future (say, n years) that an amount of money today ($X) will yield, given prevailing interest rates (r). Thus the formula to compute the future value is $X × (1 + r)n = $600 × (1 + 0.02)10.

Suppose, the annual interest rate is 3.45%. In which of the following instances is the future value of the present payment of $1,000 the largest? a.In 7 years b.In 1 year c.In 5 years d.In 3 years

A: Future value is the amount of money in the future that an amount of money today will yield, given prevailing interest rates. It is computed using the following formula: Present Value × (1 + Interest Rate)Years . Other things being the same, the longer you keep your money deposited in the account that pays 3.45% annually, the greater the future value. In this example, therefore, $1,000 will yield the largest future value in 7 years.

Suppose that you deposited $175 in the bank. In one year, the bank statement shows that you have $190 in your account. What interest rate did your account earn? a.8.6% b.7.0% c.1.08% d.6.0%

A: Here, $190 is the future value of $175 in one year: (1 + r) × $175 = $190. This implies, the interest rate, r = ($190 - $175)/$175 = 8.6%.

Three friends go to the bank to cash in their accounts. Keira kept her money in the bank for 25 years at 4% interest. Sasha held her money for 20 years at 5% interest. Anna held her money for 5 years at 20% interest. If each of them originally deposited $1,000, who gets the most money when they cash in their accounts? a.Keira b.They each get the same amount. c.Sasha d.Anna

A: The formula for the future value is as follows: Present Value × (1 + Interest rate)Years. Keira's future value is $1,000 × (1 + 0.04)25= $2,665.84. Sasha's future value is $1,000 × (1 + 0.05)20= $2,653.3. Anna's future value is $1,000 × (1 + 0.2)5= $2,488.32. Therefore, Keira's account makes the most money.

If today you deposit $600 into a bank account, which pays the annual interest rate of 3%, in 1 year, the future value of the deposit will be a.$618.00. b.$515.28. c.$485.44. d.$496.50.

A: The formula for the future value of $600 in 1 year if the interest rate is 3% is as follows: Present Value × (1 + Interest Rate) Years = $600 × (1 + 0.03) = $618.

Sasha deposited $1,500 into an account three years ago. In the first two years the interest rate was 5%, whereas in the third year the interest rate was 6%. How much money does Sasha have in her account today? a.$1,752.98 b.$2,051.45 c.$1,736.44 d.$1,653.75

A: The future value in three years taking into account the fact that the interest rate in the first two years is the same but changes in the third year is as follows: (1 + Interest Rateyear1 and year2)2 × (1 + Interest Rateyear3) × Present Value. Thus in three years, Sasha's account earns (1 + 0.05)2 × (1 + 0.06) × $1,500 = $1,752.98.

Keira deposited $2,000 into an account two years ago. In the first year the interest rate was 5%; in the second year the interest rate was 6%. How much money does Keira have in her account today? a.$2,226.00 b.$2,464.20 c.$2,205.00 d.$2,247.20

A: The future value in two years taking into account the fact that the interest rate varies over time is as follows: (1 + Interest Rateyear1) × (1 + Interest Rateyear2) × Present Value. Thus in two years, Keira's account earns (1 + 0.05) * (1 + 0.06) * $2,000 = $2,226.00

Which of the following describes the difference between compounding and discounting? a.Compounding produces a future value, whereas discounting produces a present value. b.Compounding produces a present value, whereas discounting produces a future value. c.Compounding involves the assumption that the interest rate is zero, whereas discounting does not involve that assumption. d.Discounting involves the assumption that the interest rate is zero, whereas compounding does not involve that assumption.

A: The possibility of earning interest reduces the present value below the amount X. Therefore the process of finding a present value of a future sum of money is called discounting. By contrast, compounding refers to interest being earned on previously-earned interest.

You have to decide between $X today or $2,500 in 5 years. If the interest rate is 4%, you are better off taking the $X today if and only if a.X > $2,054.82. b.X > $1,338.26. c.X > $1,120.89. d.X > $1,232.89.

A: The present value of $2,500 to be received in 5 years if the interest rate is 4% equals $2,500/(1 + 0.04)5 = $2,054.82. This means that you are better off taking $X today only if $X is greater than $2,054.82. Otherwise, you are better off waiting for the future sum.

Which of the following is the present value of $4,000 to be received in 6 years, if the interest rate is 4%? a.$3,161.26 b.$3,040.63 c.$1,000.00 d.$2,996.33

A: The present value of any future sum of money is the amount today that would be needed, at current interest rates, to produce that future sum. The formula for the present value of $4,000 to be received in 6 years, if the interest rate is 4% is as follows: Present Value = Future Value/(1 + Interest Rate)Years = $4,000/(1 + 0.04)6 = $3,161.26.

A year ago, Bertha created a new saving account, which earned 4%. Now, the bank statement shows that she has $130 in her account. How much did Bertha deposit one year ago? a.$125.00 b.$103.24 c.$100.96 d.$102.04

A:Here, $130 is the future value of $X in one year. Given a 4% interest rate: (1 + 0.04) × $X = $130. Therefore, $X = $130/(1 + 0.04) = $125.

You consider whether to buy a bond that would pay $20,000 in 4 years. If the interest rate is 6%, you will buy the bond only if its price today is no greater than a.$15,841.87. b.$16,998.98. c.$17,920.94. d.$17,672.58.

A:The formula for the present value of $20,000 to be received in 4 years, if the interest rate is 6% is as follows: Present Value = Future Value/(1 + Interest Rate)Years = $20,000/(1 + 0.06)4 = $15,841.87. Therefore you will buy this bond if its price is no greater than $15,841.87.

Compared to a portfolio composed entirely of stock, a portfolio that is 50 percent government bonds and 50 percent stock will have a a. lower return and a higher level of risk. b. lower return and a lower level of risk. c. higher return and a higher level of risk. d. higher return and a lower level of risk.

B

If a depositor puts $100 in a bank account that earns 4 percent interest compounded annually, how much will be in the account after five years? a. $120.00 b. $121.67 c. $123.98 d. $104.00 e. $400.00

B

If the efficient markets hypothesis is true, then a. stocks tend to be overvalued. b. the stock market is informationally efficient so stock prices should follow a random walk. c. fundamental analysis is a valuable tool for increasing one's stock returns. d. an index fund is a poor investment. e. all of the above are true

B