Deck 18: Risk and Uncertainty

Question 1

People have rational expectations when their predictions are correct more often than not.

Answer 1

False

Question 2

All points on a risk-neutral individual's indifference curve have the same expected value.

Answer 2

True

Question 3

There is only one possible market portfolio-the portfolio consisting of all the risky assets in the economy.

Answer 3

False

Question 4

Speculators will sell futures contracts when they believe future demand will be lower than suppliers expect.

Question 5

Risk aversion leads individuals to underinvest from a social point of view.

Question 6

Firms are more likely to exhibit risk-neutral behavior than are individuals.

Question 7

A nuclear disaster is an uninsurable risk because it would adversely affect a large number of people simultaneously.

Question 8

Both ex ante and ex post preferences depend solely on the individual's tastes.

Question 9

To deal with the problem of adverse selection,insurance companies may limit the amount of insurance that can be purchased at the most favorable odds.

Question 10

Buyers of risky assets are commonly known as speculators.

Question 11

Risk-averse investors choose to hold only two assets: a risk-free asset and a market portfolio.

Question 12

A risk-free basket has only one possible outcome.

Question 13

When faced with two portfolios that offer the same expected return,a risk-averse investor prefers the one with the higher standard deviation.

Question 14

Diversification tends to raise the standard deviation of a portfolio.

Question 15

A risk-averse individual chooses to never place a bet.

Question 16

An insurance company faces an adverse selection problem when people start taking additional risks after they acquire insurance.

Question 17

The standard deviation of a portfolio is exactly equal to the average standard deviations of the individual stocks.

Question 18

When a gamble is repeated many times,the average outcome is the expected value.

Question 19

Even when econometric equations predict very well,they can be entirely useless as guides to policy.

Question 20

Odds are said to be fair if they reflect the true probabilities of the various states of the world.

Question 21

When offered a bet at unfair odds,a risk-neutral individual will

A) not bet.
B) bet everything on the outcome favored by the unfair odds.
C) bet everything on the outcome not favored by the unfair odds.
D) be indifferent about the amount that he bets.

Question 22

According to the law of large numbers,when a gamble is repeated many times,

A) the average outcome increases.
B) the average outcome is the expected value.
C) the probability of each outcome changes.
D) insurance becomes less profitable when many people buy it.

Question 23

What type(s)of individual will always choose a risk-free basket when offered a bet at fair odds?

A) A risk-neutral individual.
B) A risk-averse individual.
C) A risk-preferring individual.
D) Risk-neutral and risk-averse individuals.

Question 24

By definition,a risk preferring person will gamble no matter what the odds.

Question 25

A risk neutral individual has indifference curves that are identical to the iso-expected lines of a fair gamble.

Question 26

Uninsurable risks is one reason why fair-odds insurance is not always available.

Question 27

A state lottery commission offers a new millionaire game - a one in a million chance to win one million dollars.If the price of a lottery ticket is $1.50,who would buy any?

A) Only risk-neutral individuals.
B) Only risk-preferring individuals.
C) Both risk-neutral and risk-preferring individuals.
D) Anyone,risk preferences would not matter.

Question 28

When offered a bet at fair odds,a risk-neutral individual

A) accepts the bet if it is sufficiently small.
B) always wagers everything on one outcome or the other.
C) is indifferent about the amount that he bets.
D) chooses a risk-free basket of outcomes.

Question 29

When will an individual's indifference curves be identical with the iso-expected value lines?

A) Never.
B) When the individual is risk averse.
C) When the individual is risk neutral.
D) When the individual is risk preferring.

Question 30

Of two baskets with identical standard deviations,a risk-averse person will prefer the basket with the higher expected value.

Question 31

The spot market is the market for goods that are to be delivered at a particular location,or "at that spot".

Question 32

When will an individual's budget line coincide with an iso-expected value line?

A) Always.
B) Never.
C) When the individual is risk-neutral.
D) When the individual is offered fair odds.

Question 33

A stock that is guaranteed to increase in value is risk-free.

Question 34

Hillary and Bill are playing backgammon.Hillary offers to place a wager on the game's outcome at fair odds.Bill is risk-averse and believes that he has a 60% chance of winning the game.When will Bill accept the wager?

A) Always.
B) When the wager is sufficiently small.
C) When the wager is sufficiently large.
D) Never.

Question 35

A risk-averse individual always prefers the basket with the highest standard deviation when choosing among baskets with the same expected value.

Question 36

The preferences between baskets of outcomes when the state of the world is not yet known are called

A) ex ante preferences.
B) ex post preferences.
C) risk-averse preferences.
D) diversified preferences.

Question 37

Consider a risk-averse individual whose initial situation is a risk-free basket of outcomes.How does this person react when he is offered a wager at favorable odds?

A) He always declines the wager.
B) He always accepts the wager.
C) He accepts the wager only if it is sufficiently small.
D) He accepts the wager only if it is sufficiently large.

Question 38

A risk neutral person earning $30,000 per year would likely be willing to pay a year's worth of income for a 50-50 chance at winning $70,000.

Question 39

A farmer with $1000 worth of crops in the field faces a .10 probability that a hail storm will destroy the value of her crop before she can harvest it.If she is risk averse,the most she would be willing to pay to insure against this loss is

A) $0.
B) $10.
C) $100.
D) $900.

Question 40

The expected value of a basket with different outcomes is

A) the average of the values of the different outcomes.
B) the average of the values of different outcomes multiplied by the average of the probabilities of the outcomes.
C) the sum of the values of the different outcomes.
D) the sum of the value of each outcome multiplied by its probability.

Question 41

If people have rational expectations,then they

A) are correct at least 50% of the time.
B) do not make systematic and correctable errors in prediction.
C) sometimes overestimate,but never underestimate,economic variables.
D) revise their expectations upward when their predictions are too low and downward when they are too high.

Question 42

Consider a portfolio with three stocks,each with the same value.The three stocks have standard deviations of 20%,40%,and 90%.The standard deviation of this portfolio is

A) no greater than 50%.
B) less than 20%.
C) exactly 40%.
D) more than 90%.

Question 43

The key assumption of the capital asset pricing model is that an investor cares only about his portfolio's

A) degree of diversification.
B) expected income.
C) level of risk.
D) expected return and standard deviation.

Question 44

Suppose it is February,and a speculator believes that the demand for corn in March will be higher than everyone else expects.In this situation,the speculator will

A) bid down the price of March futures contracts.
B) bid down the spot price of corn.
C) give suppliers an incentive to sell more corn in February.
D) buy March futures contracts.

Question 45

Shareholders with diversified portfolios will encourage

A) social decision-makers to be risk-neutral.
B) corporate decision-makers to be risk-neutral.
C) corporate decision-makers to be risk-preferring.
D) individual entrepreneurs to be risk preferring.

Question 46

In the market for insurance,the adverse selection problem arises because

A) fair odds are different for different people,and the insurance company cannot tell who is who.
B) people tend to behave more recklessly when they are insured.
C) some events simultaneously affect a large number of people.
D) insurance companies must tilt the odds in their favor to cover their basic operating costs.

Question 47

Suppose there are two types of people: "good risks" who have 1 to 9 odds of falling ill,and "bad risks" who have a 1 to 3 odds of falling ill.If an insurance company cannot distinguish good risks from bad risks,what is the best way for it to deal with this problem?

A) Do not offer any insurance at 1 to 3 odds.
B) Make everyone purchase insurance that offers 1 to 3 odds.
C) Limit the amount of insurance that can be purchased at 1 to 9 odds.
D) Provide policies that offer 1 to 9 odds and 1 to 3 odds,allowing each group to purchase the appropriate policy.

Question 48

Shares in XM Radio currently sell for $20.If the satellite it plans to launch works well,the share value will increase by $35.If the satellite fails to function,the share price will fall by $5.The expected return of the stock is

A) 25%.
B) 50%.
C) 75%.
D) 100%.

Question 49

In popular usage the term investor is used to refer to

A) a speculator in futures markets.
B) a buyer of risky assets.
C) an entrepreneur who purchases machinery and equipment to expand production.
D) individuals whose primary source of income is from returns on financial assets.

Question 50

Consider a portfolio that consists of all of the risky assets in the economy,held in proportion to their existing quantities.This portfolio is

A) a risk-free asset.
B) the only asset that a risk-averse investor chooses to hold.
C) a market portfolio.
D) in the center of the set of all risky assets.

Question 51

When a person is risk-preferring,his indifference curves are

A) convex.
B) concave.
C) linear.
D) upward sloping.

Question 52

What do we call a person who attempts to earn profits in the futures markets by predicting future changes in supply or demand?

A) An investor.
B) A speculator.
C) A risk-preferring individual.
D) A contractor.

Question 53

Demand and Supply for Grapes

The following tables show the demand and supply for grapes. Demand is uncertain, with D1 and D2 each occurring 50% of the time. Suppliers must base their decisions on the expected price and must sell all grapes they bring to the market at the going market price.



-If suppliers have rational expectations,what will be their expected price of grapes?

A) $2.00 per pound.
B) $2.50 per pound.
C) $3.00 per pound.
D) $3.50 per pound.

Question 54

An uninsurable risk is one

A) where everyone wishes to bet on the same outcome.
B) in which information is asymmetrically distributed.
C) for which the odds of an event's occurrence cannot be accurately estimated.
D) that cannot be diversified.

Question 55

Consider a potato farmer whose cost of production is $2.25 a bushel.In May,she expects that the potato when harvested in July will sell for either $2 a bushel or $3.00.She could avoid the probability of a loss by contracting to deliver the potatoes in July at $2.50.Such a contract is traded in a

A) futures market.
B) spot market.
C) portfolio market.
D) diversified market.

Question 56

When will speculators' actions raise social welfare?

A) Always.
B) When they drive down market prices.
C) When their expectations prove to be correct.
D) When they are not risk averse.

Question 57

The curve representing the set of efficient portfolios must be

A) concave.
B) linear.
C) convex.
D) a ray from the origin.

Question 58

Why might an equation that has always predicted accurately in the past prove to be wrong following a policy change?

A) Because the policy may change people's behavior and invalidate the equation.
B) Because people's expectations may cease to be rational.
C) Because uncertainty means that every equation contains some degree of error.
D) Because the policy change may affect economic variables not contained in the equation.

Question 59

When speculators begin to sell futures contracts,suppliers will

A) try to sell more in the spot market.
B) store more of their crop to sell in the future.
C) not have any incentive to change their plans.
D) earn larger profits.

Question 60

Consider a portfolio with three stocks,each with the same value.The three stocks have expected returns of 15%,25%,and 50%.The expected return of this portfolio is

A) 25%.
B) 30%.
C) 50%.
D) 90%.

Question 61

A die is rolled.The individual rolling the die will receive the number that lands in dollars (i.e.if it lands 1,they receive $1,if it lands two,they receive $2,etc).The expected value of the die roll is

A) $1.00
B) $2.25
C) $3.50
D) $6.00

Question 62

The market line must

A) pass through the risk-free asset.
B) be linear.
C) be tangent to the efficient set.
D) all of the above.

Question 63

Describe how a speculator can improve social welfare when he correctly anticipates that future demand will be higher than suppliers expect.

Question 64

Explain how

Question 65

Great Benefit is a health insurance company with two types of customers: healthy persons and sickly persons.A healthy person has 1-to-5 odds of getting ill,and a sickly person has 1-to-1 odds of getting ill.However,the insurance company cannot distinguish between healthy and sickly persons.Brett is a risk-averse person who purchases health insurance from Great Benefit.Without insurance,Brett's income will be $8,000 if he remains healthy and $2,000 if he becomes ill.Brett's situation is diagrammed below.

Question 66

There are two states of the world.In state one the person receives one hundred dollars.In state two the person receives fifty dollars.If the person is rational and their expected return is $87.50,then the probability with which state one occurs must be

A) 0.25.
B) 0.50.
C) 0.75.
D) 1.00.

Question 67

A person is seen placing a wager on the Super Bowl.It can be concluded that

A) the person is risk-preferring.
B) the person is either risk-averse or risk-neutral,but not risk-preferring.
C) the person is either risk-neutral or risk-preferring,but not risk-averse.
D) we need more information before making a conclusion regarding this person's attitudes towards risk.

Question 68

A businessman is confronted with the following opportunity.He can invest $10,000 in a project that will either succeed wildly,fail miserably,or simply pay him back his $10,000.If wildly successful,the project will earn the businessman $110,000,but if it fails he will not get any money back.

Question 69

The northwest boundary of the set of all portfolios is

A) the portfolio that maximizes return.
B) the efficient set.
C) the efficient portfolio.
D) the portfolio that minimizes risk.

Question 70

A fair coin is flipped.If it lands heads the person receives $1.00.If it lands tails,the person receives $11.00.If the person is willing to pay $6.00 to take this gamble,they must be

A) risk-averse.
B) risk-neutral.
C) risk-preferring.
D) either risk-neutral or risk-preferring (not risk-averse).

Question 71

There are two states of the world.The person receives $100 in state one which occurs with probability 0.6.If the person is rational and their expected return is $80,then in state two the person must receive

A) $20
B) $25
C) $50
D) $100

Question 72

A fair coin is flipped.If it lands heads the person receives $1.00.If it lands tails,the person receives $11.00.If the person is not willing to pay $6.00 to take this gamble,they must be

A) risk-neutral.
B) risk-averse.
C) risk-preferring.
D) either risk-neutral or risk-preferring (i.e.not risk averse)

Question 73

A die is rolled.If it lands 1 or 2,the person receives $90.If it 3 or 4,the person receives $30.00.If it lands 5 or 6,the person receives $60.If the person is willing to pay $60 to take this gamble,they must be

A) risk-averse.
B) risk-neutral.
C) risk-preferring.
D) either risk-neutral or risk-preferring (not risk-averse).

Question 74

Define the term adverse selection.Why is an insurance company unable to offer fair odds when it faces an adverse selection problem? How might the insurance company deal with an adverse selection problem?

Question 75

Consider the accompanying diagram,which shows an investor who can choose to hold the risky assets on the efficient set and/or the risk-free asset labeled R.

Question 76

Suppose an econometrician discovers that during the past decade,lower unemployment rates have always been accompanied by higher inflation rates.When asked how to reduce unemployment,the econometrician recommends the policy of increasing the money supply to trigger more inflation.Explain why this policy may fail to work in a world where people have rational expectations.