CH. 19

Created by Ktjones27 

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If the interest rate is 8 percent, then the present value of $1,000 to be received in 4 years is $735.03.

TRUE

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.

TRUE

The present value of $100 to be paid in two years is less than the present value of $100 to be paid in three years.

FALSE

The future value of $1 saved today is $1/(1 + r).

FALSE

The present value of any future sum of money is the amount that would be needed today, at current interest rates, to produce that future sum.

TRUE

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

FALSE

A company that can build a project that will cost $50,000, but returns $52,000 in one year would make a good decision by turning this project down if the interest rate were 3 percent.

FALSE

As the interest rate increases, the present value of future sums decreases, so firms will find fewer investment projects profitable.

TRUE

According to the rule of 70, if you earn an interest rate of 3.5 percent, your savings will double about every 20 years.

TRUE

The rule of 70 applies to a growing savings account but not to a growing economy.

FALSE

The concept of present value helps explain why the quantity of loanable funds demanded decreases when the interest rate increases.

TRUE

An increase in the interest rate causes a decrease in the future value of $1,000 that you have in a bank account today.

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%.

FALSE

PZX Corporation has the opportunity to undertake an investment project that will cost $10,000 today and yield the company $13,310 in 3 years. PZX will forgo the project if the interest rate is higher than 10 percent.

TRUE

ZZL Corporation has the opportunity to undertake an investment project that will cost $20,000 today. If the interest rate is 20 percent and if the project will yield the company $30,000 in 3 years, then ZZL will undertake the project.

FALSE

Risk aversion simply means that people dislike bad things to happen.

FALSE

Risk-averse individuals like good things more than they dislike comparable bad things.

FALSE

People who are risk averse dislike bad outcomes more than they like comparable good outcomes.

TRUE

The market for insurance is an example of diversification.

TRUE

A person's subjective measure of well-being or satisfaction is called aversion.

FALSE

Historically, stocks have offered higher rates of return than bonds.

TRUE

Historically the return on stocks has been higher than the return on bonds. In part this reflects the higher risk from holding stock.

TRUE

Risk-averse persons will take no risks.

FALSE

If you are faced with the choice of receiving $500 today or $800 6 years from today, you will be indifferent between the two possibilities if the interest rate is 8.148 percent.

TRUE

The market for insurance is one example of reducing risk by using diversification.

TRUE

A person with diminishing marginal utility of wealth is risk averse.

TRUE

Adverse selection is illustrated by people who take greater risks after they purchase insurance.

FALSE

Increasing the number of corporations whose stocks are in your portfolio reduces market risk.

FALSE

Diversification can reduce firm-specific risk.

TRUE

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.

FALSE

From the standpoint of the economy as a whole, the role of insurance is to greatly reduce or eliminate the risks inherent in life.

FALSE

If a person had increasing marginal utility, then the decline in utility from losing $1,000 would be greater than the increase in utility from gaining $1,000.

FALSE

Moral hazard is illustrated by people who take greater risks after they purchase insurance.

TRUE

Diversification cannot reduce market risk.

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.

TRUE

Because the statistic called the standard deviation measures the volatility of a variable, it is used to measure the return of a portfolio.

FALSE

The value of a stock depends on the ability of the company to generate dividends and the expected price of the stock when the stockholder sells her shares

TRUE

According to fundamental analysis, when choosing stocks for your portfolio, you should prefer undervalued stocks.

TRUE

According to the efficient markets hypothesis, at any moment in time, the market price is the best estimate of the company's value based on publicly available information.

TRUE

According to the efficient markets hypothesis, stocks follow a random walk so that stocks that increase in price one year are more likely to increase than decrease in the next year.

FALSE

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.

TRUE

Studies find that mutual fund managers who do well in one year are likely to do well the next year.

FALSE

Managed mutual funds usually outperform mutual funds that are supposed to follow some stock index.

FALSE

Speculative bubbles may arise in part because the value of the stock to a stockholder depends on the final sale price.

TRUE

Available evidence indicates that stock prices, even if not exactly a random walk, are very close to a random walk.

TRUE

If you wish to rely on fundamental analysis to choose a portfolio of stocks, then you have no choice but to do all the necessary research yourself.

FALSE

If you believe the stock market is informationally efficient, then it is a waste of time to engage in fundamental analysis.

TRUE

Actively managed mutual funds usually fail to outperform index funds, and this fact provides evidence in favor of the efficient markets hypothesis.

TRUE

In the 15 years ending June 2010, most active portfolio managers failed to beat the market.

TRUE

Most financial decisions involve two related elements:

Time & risk

The field of finance primarily studies

the implications of time and risk for allocating resources over time.

The financial system

All of the above are correct.

Which of the following statements best describes the economist's view of finance and the financial system?

The financial system is very important to the functioning of the economy, and the tools of finance are often helpful to us as individuals when we find ourselves making certain decisions.

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

$441.87

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

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

If the interest rate is 7.5 percent, then what is the present value of $4,000 to be received in 6 years?

$2,591.85

Risk aversion helps to explain various things we observe in the economy, including

All the above are correct

Economists have developed models of risk aversion using the concept of

utility and the associated assumption of diminishing marginal utility.

For a risk averse person,

the pain of losing $1,000 on a bet exceeds the pleasure of winning $1,000 on a bet.

If Matt's current wealth is $51,000, then

his gain in utility from gaining $1,000 is less than his loss in utility from losing $1,000. Matt is risk averse.

What is measured along the vertical axis?

utility

The utility function that is shown exhibits the property of diminishing

marginal utility

Which distance along the vertical axis represents the marginal utility of an increase in wealth from $600 to $800?

the distance between point B and point C

Let 0A represent the distance between the origin and point A; let AB represent the distance between point A and point B; etc. Which of the following ratios best represents the marginal utility per dollar when wealth increases from $400 to $600?

...

For the person to whom this utility function applies,

the more wealth she has, the less utility she gets from an additional dollar of wealth.

Suppose the person to whom this utility function applies begins with $600 in wealth. Starting from there,

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

The properties exhibited by this utility function help to explain various things we observe in the economy, including

All the above are correct

From the appearance of the utility function, we know that

All the above are correct

From the appearance of the utility function, we know that

Mary Ann is risk averse.

Suppose the vertical distance between the points (0, A) and (0, B) is 5. If her wealth increased from $1,050 to $1,350, then

Mary Ann's subjective measure of her well-being would increase by less than 5 units.

From the appearance of the utility function, we know that

Mary Ann 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.

Suppose Mary Ann begins with $1,050 in wealth. Starting from there,

the pain of losing $300 of her wealth would exceed the pleasure of adding $300 to her wealth.

Suppose Mary Ann begins with $1,050 in wealth. Which of the following coin-flip bets would she definitely not be willing to accept?

If it is "heads," she wins $150; if it is tails, she loses $150.

From the appearance of Rob's utility function, we know that

the property of diminishing marginal utility does not apply to Rob.

From the appearance of Rob's utility function, we know that

Rob is not risk averse.

If most people's utility functions look like Rob's utility function, then it is easy to explain why

None of the above are correct

In what way(s) does the graph differ from the usual case?-Dexter

The utility function shown here is bowed downward (convex), whereas in the usual case the utility function is bowed upward (concave).

From the appearance of the graph, we know that

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.

From the appearance of the utility function, we know that Dexter

the property of diminishing marginal utility does not apply to Dexter.

From the appearance of the utility function, we know that Dexter

gains more satisfaction when his wealth increases by X dollars than he loses in satisfaction when his wealth decreases by X dollars.

Suppose the vertical distance between the points (0, A) and (0, B) is 12. If his wealth increased from $1,300 to $1,800, then

Dexter's subjective measure of his well-being would increase by more than 12 units.

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.

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.

The problem of moral hazard arises because

after people buy insurance, they have less incentive to be careful about their risky behavior.

The largest reduction in a portfolio's risk is achieved when the number of stocks in the portfolio is increased from

1 to 10

Diversification of a portfolio

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

Mary Beth is risk averse and has $1,000 with which to make a financial investment. She has three options. Option A is a risk-free government bond that pays 5 percent interest each year for two years. Option B is a low-risk stock that analysts expect to be worth about $1,102.50 in two years. Option C is a high-risk stock that is expected to be worth about $1,200 in four years. Mary Beth should choose

Option A

A measure of the volatility of a variable is its

Standard Deviation

A risk-averse person

has a utility curve where the slope decreases with wealth, and might take a bet with a 70 percent chance of wining $400 and a 30 per chance of losing $400.

If a person is risk averse, then she has

diminishing marginal utility of wealth, implying that her utility function gets flatter as wealth increases.

If Robert is risk-averse, then he will always

choose not to play a game where he has a 50 percent chance of winning $1 and a 50 percent chance of losing $1.

Which of the following games might a risk-averse person play?

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?

All the above are correct.

Which of the following is correct concerning a risk-averse person?

All the above are correct.

Svetlana is risk averse. Which of the following is correct about Svetlana?

None are correct.

The utility function of a risk-averse person has a

positive slope but gets flatter as wealth increases.

A risk-averse person has

a utility curve that slopes upward and a marginal utility curve that slopes downward.

Diminishing marginal utility of wealth implies that the utility function is

upward-sloping and has decreasing slope.

If a person is risk averse, then as wealth increases, total utility of wealth

increases at a decreasing rate.

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

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

Risk

Both A & B.

The last $2,000 of Rolanda's wealth adds less to her utility than the previous $2,000. Based on this information, Rolanda has

decreasing marginal utility of wealth and is risk averse.

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

is upward sloping and her marginal utility function is downward sloping.

Suppose that Thom experiences a greater loss in utility if he loses $50 than he would gain in utility if he wins $50. This implies that Thom's

marginal utility diminishes as wealth rises, so he must be risk averse.

Which of the following defines an annuity?

For a fee, an insurance company provides you with regular income until you die.

In effect, an annuity provides insurance

against the risk of living too long.

Which of the following actions best illustrates adverse selection?

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

Which of the following actions best illustrates moral hazard?

A person purchases homeowners insurance and then checks his smoke detector batteries less frequently.

Tami knows that people in her family die young, and so she buys life insurance. Preston knows he is a reckless driver and so he applies for automobile insurance.

These are both examples of adverse selection.

Which of the following is adverse selection?

a high-risk person being more likely to apply for insurance

Which of the following best illustrates moral hazard?

After a person obtains life insurance, she takes up skydiving.

When you rent a car, you might treat it with less care than you would if it were your own. This is an example of

Moral hazard

Financial intermediaries typically require mortgage borrowers to have homeowner's insurance and do credit checks before making the loan.

The insurance requirement is designed primarily to reduce the risk of moral hazard; the credit check is designed primarily to reduce adverse selection.

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'd use on your own car.

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

Over the past two centuries, the average annual rates of return were about

8 percent for stocks and about 3 percent for short-term government bonds.

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

the average risk-averse person will earn a lower rate of return than the average non-risk-averse person.

Which of the following is not correct?

Insurance markets reduce risk, but not by diversification.

Amanda talks with several different brokers at a social gathering. She hears the following advice from brokers A, B, and C. Which broker, if any, gave her incorrect advice?

Broker C: "Stocks with greater risks offer lower average returns."

Mary talked to several stockbrokers and made the following conclusions. Which, if any, of her conclusions are correct?

All Mary's conclusions are correct.

Other things the same, as the number of stocks in a portfolio rises,

Risk decreases and the standard deviation of the return falls.

Other things the same, as the stocks of a greater number of corporations are held in a portfolio,

Risk decreases at a decreasing rate.

Point A represents a situation is which

All of the above are correct.

Which of the following statements is correct?

The figure shows that the greater the risk, the greater the return.

Diversification reduce

Only firm-specific risk.

Which of the following is not correct?

Diversification can eliminate market risk but not firm-specific risk.

Which of the following is a source of market risk?

Real GDP varies over time & sales & profits move with the real GDP.

An increase in the number of corporations in a portfolio from 1 to 10 reduces

Firm-specific risk by more than an increase from 110-120.

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.

2 is market risk; 3 is firm-specific risk

An increase in the number of corporations in a portfolio from 110 to 120 reduces

Firm-specific risk by less than an increase from 1 to 10

Angela reads financial advice columns and concludes the following. Which, if any, of her conclusions are incorrect?

People who are risk averse should never hold stock.

Ben decided to increase the number of stocks in his portfolio. In doing so, Ben reduced

the firm-specific risk, but not the market risk of his portfolio.

David increases the number of companies in which he holds stocks.

This reduces risk's standard deviation and firm-specific risk.

Phillip is a mortgage broker, who is paid by commission. When interest rates decline, he does a lot of business and earns a lot of money, as more people buy houses or refinance their mortgages. But when interest rates rise, business falls substantially. To diversify, Phillip should choose investments that

pay higher returns when interest rates rise and lower returns when interest rates fall.

To diversify, a homeowner with a variable-rate mortgage should choose investments that

pay higher returns when interest rates rise and lower returns when interest rates fall.

Dakota rearranges her portfolio so that it has a higher average return. In doing this rearranging, she

raised firm-specific risk, but not market risk.

Marcus puts a greater proportion of his portfolio into government bonds. Marcus's action

decreases both risk and the average rate of return.

Manufacturers of Weightbegone are concerned that genetic advances in weight control might reduce the demand for their diet snacks. This is an example of

firm-specific risk, which will likely raise shareholders' demand for higher return.

Suppose that fundamental analysis indicates a particular company's stock is overvalued.

This means its present value is less than its price. You shouldn't consider adding the stock to your portfolio.

A risk-averse person has

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

The idea of insurance

Is to share risk.

Which of the following actions best illustrates adverse selection?

A person intending to take up dangerous hobbies applies for life insurance.

Which of the following best illustrates diversification?

Instead of holding only the stocks of companies engaged in the banking business, a person decides to hold stock in a number of different companies producing different goods and services.

In general, as a person includes fewer stocks and more bonds in his portfolio,

Both risk & expected return fall.

According to fundamental analysis, a saver should prefer to buy stocks that are

Undervalued. This means the price of the stock is low given the value of the corporation.

People who hold well-diversified portfolios of stocks have greatly reduced or eliminated

Firm-specific risk, but still they have reason to worry about their wealth decreasing as a result of recessions.

If Cara's utility falls more by losing $600 than it rises by gaining $600, she has

Decreasing marginal utility of wealth and is risk averse.

Diversifying

Decreases the standard deviation of the value of a portfolio indicating its risk has decreased.

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

11% but not 12%.

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?

$1,102.51 to be paid in two years

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