Deck 5: Understanding Risk

Question 1

If the probability of an outcome equals one, the outcome:

A) is more likely to occur than the others listed.
B) is certain to occur.
C) is certain not to occur.
D) has unquantifiable risk.

Answer 1

B

Question 2

Which of the following is true?

A) Investments with higher risk generally have a higher expected return than risk-free investments.
B) Investments that pay a return over a longer time horizon generally have less risk.
C) Investments with a greater variance in the size of the future payoff generally pay a lower expected return.
D) Risk-free investments are the best benchmark for measuring the risk of all investment strategies.

Answer 2

A

Question 3

All other factors held constant, an investment:

A) with more risk should offer a lower return and sell for a higher price.
B) with less risk should sell for a lower price and offer a higher expected return.
C) with more risk should sell for a lower price and offer a higher expected return.
D) with less risk should sell for a lower price and offer a lower return.

Answer 3

C

Question 4

An investor puts $1,000 into an investment that will return $1,250 one-half of the time and $900 the remainder of the time. The expected return for this investor is:

A) $1,075
B) 5.0%
C) 7.5%
D) 15.0%

Question 5

An investor puts $2,000 into an investment that will pay $2,500 one-fourth of the time; $2,000 one-half of the time, and $1,750 the rest of the time. What is the investor's expected return?

A) 12.5%
B) $250.00
C) 6.25%
D) 3.125%

Question 6

An investment pays $1,500 half of the time and $500 half of the time. Its expected value and variance respectively are:

A) $1,000; 500,000 dollars
B) $2,000; (250,000 dollars)²
C) $1,000; 250,000 dollars
D) $1,000; 250,000 dollars²

Question 7

An investment pays $1,200 a quarter of the time; $1,000 half of the time; and $800 a quarter of the time. Its expected value and variance respectively are:

A) $1,000; 20,000 dollars²
B) $1,050; 20,000 dollars²
C) $1,000; 40,000 dollars²
D) $1,000; 80,000 dollars²

Question 8

Inflation presents risk because:

A) inflation is always present.
B) inflation cannot be measured.
C) there are different ways to measure it.
D) there is no certainty regarding what inflation will be in the future.

Question 9

When measuring the risk of an asset:

A) one must measure the uncertainty about the size of future payoffs.
B) it is necessary to incorporate uncertainties that are not quantifiable.
C) one must remember that the concept of risk applies only to financial markets, not to financial intermediaries.
D) one cannot use other investments to evaluate the asset's risk.

Question 10

If an investment will return $1,500 half of the time and $700 half of the time, the expected value of the investment is:

A) $1,250.
B) $1,050.
C) $1,100.
D) $2,200.

Question 11

Risk-free investments have rates of return:

A) equal to zero.
B) with a standard deviation equal to zero.
C) that are uncertain, but have a certain time horizon.
D) that exhibit a large spread of potential payoffs.

Question 12

Another name for the expected value of an investment would be the:

A) mean value.
B) upper-end value.
C) certain value.
D) risk-free value.

Question 13

Suppose that Fly-By-Night Airlines, Inc. has a return of 5% twenty percent of the time and 0% the rest of the time. The expected return from Fly-By-Night is:

A) 10%.
B) 0.1%.
C) 0.2%.
D) 1.0%.

Question 14

Uncertainties that are not quantifiable:

A) are what we define as risk.
B) are factored into the price of an asset.
C) cannot be priced.
D) are benchmarks against which quantifiable risks can be assessed.

Question 15

Which of the following would not be included in a definition of risk?

A) Risk is a measure of uncertainty.
B) Risk can always be avoided at no cost.
C) Risk has a time horizon.
D) Risk usually involves some future payoff.

Question 16

If a fair coin is tossed, the probability of coming up with either a head or a tail is:

A) ½ or 50 percent.
B) Zero.
C) 1 or 100 percent.
D) Unquantifiable.

Question 17

If an investment has a 20% (0.20) probability of returning $1,000; a 30% (0.30) probability of returning $1,500; and a 50% (0.50) probability of returning $1,800; the expected value of the investment is:

A) $1,433.33
B) $1,550.00
C) $2,800.00
D) $1,600.00

Question 18

An investment with a large spread between possible payoffs will generally have:

A) a low expected return.
B) a high standard deviation.
C) a low value at risk.
D) both a low expected return and a low value at risk.

Question 19

If the probability of an outcome is zero, you know the outcome is:

A) more likely to occur.
B) certain to occur.
C) less likely to occur.
D) certain not to occur.

Question 20

The expected value of an investment:

A) is what the owner will receive when the investment is sold.
B) is the sum of the payoffs.
C) is the probability-weighted sum of the possible outcomes.
D) cannot be determined in advance.

Question 21

An investment pays $1,000 three quarters of the time, and $0 the remaining time. Its expected value and variance respectively are:

A) $1,000: 62,500 dollars²
B) $750; 46,875 dollars
C) $750; 62,500 dollars
D) $750; 187,500 dollars²

Question 22

The measure of risk that focuses on the worst possible outcome is called:

A) expected rate of return.
B) risk-free rate of return.
C) standard deviation of return.
D) value at risk.

Question 23

A $600 investment has the following payoff frequency: a quarter of the time it will be $0; three quarters of the time it will pay off $1000. Its standard deviation and value at risk respectively are:

A) $750; $600
B) $433; $600
C) $0; $1,000
D) $433; $1,000

Question 24

A risk-averse investor will:

A) always accept a greater risk with a greater expected return.
B) only invest in assets providing certain returns.
C) never accept lower risk if it means accepting a lower expected return.
D) sometimes accept a lower expected return if it means less risk.

Question 25

The difference between standard deviation and value at risk is:

A) nothing, they are two names for the same thing.
B) value at risk is a more common measure in financial circles than is standard deviation.
C) standard deviation reflects the spread of possible outcomes where value at risk focuses on the value of the worst outcome.
D) value at risk is expected value times the standard deviation.

Question 26

Leverage:

A) reduces risk.
B) is synonymous with risk-free investment.
C) increases expected rate of return.
D) leads to smaller changes in the investment's price.

Question 27

Investment A pays $1,200 half of the time and $800 half of the time. Investment B pays $1,400 half of the time and $600 half of the time. Which of the following statements is correct?

A) Investment A and B have the same expected value, but A has greater risk.
B) Investment B has a higher expected value than A, but also greater risk.
C) Investment A has a greater expected value than B, but B has less risk.
D) None of the statements are correct

Question 28

Which of the following statements is true?

A) Leverage increases expected return and increases risk.
B) Leverage increases expected return and reduces risk.
C) Leverage decreases expected return but has no effect on risk.
D) Leverage decreases expected return and increases risk.

Question 29

Investment A pays $1,200 half of the time and $800 half of the time. Investment B pays $1,400 half of the time and $600 half of the time. Which of the following statements is correct?

A) Investment A and B have the same expected value, but A has greater risk.
B) Investment B has a higher expected value than A, but also greater risk.
C) Investment A and B have the same expected value, but A has lower risk than B.
D) Investment A has a greater expected value than B, but B has less risk.

Question 30

A risk-averse investor versus a risk-neutral investor:

A) will never take a risk, while the risk neutral investor will.
B) needs greater compensation for the same risk versus the risk neutral investor.
C) will take the same risks as the risk neutral investor if the expected returns are equal.
D) needs less compensation for the same risk versus the risk neutral investor.

Question 31

Given a choice between two investments with the same expected payoff most people will:

A) choose the one with the lower standard deviation.
B) opt for the one with the higher standard deviation.
C) be indifferent since the expected payoffs are the same.
D) calculate the variance to assess the relative risks of the two choices.

Question 32

Comparing a lottery where a $1 ticket purchases a chance to win $1 million with another lottery in which a $5,000 ticket purchases a chance to win $5 billion, we notice many people would participate in the first but not the second, even though the odds of winning both lotteries are the same. We can perhaps best explain this outcome by:

A) higher expected value for the lottery paying $1 million.
B) higher expected value for the lottery paying $5 billion.
C) lower value at risk for the lottery paying $1 million.
D) higher value at risk for the lottery paying $1 million.

Question 33

Which of the following investment strategies involves generating a higher expected rate of return through increasing risk?

A) Diversifying
B) Hedging risk
C) Leverage
D) Value at risk

Question 34

An investment will pay $2,000 half of the time and $1,400 half of the time. The standard deviation for this investment is:

A) $90,000.
B) $300.
C) $1,700.
D) $30.

Question 35

Which of the following statements is true?

A) Leverage increases expected return while lowering risk.
B) Leverage increases risk.
C) Leverage lowers the expected return and lowers risk.
D) Leverage lowers the expected return and increases risk.

Question 36

A $500 investment has the following payoff frequency: half of the time it will pay $350 and the other half of the time it will pay $900. Its standard deviation and value at risk respectively are:

A) $275; $150
B) $625; $275
C) $275; $350
D) $125; $500

Question 37

The greater the standard deviation of an investment the:

A) lower the return.
B) greater the risk.
C) lower the risk.
D) lower the risk and return.

Question 38

The standard deviation is generally more useful than the variance because:

A) it is easier to calculate.
B) variance is a measure of risk, where standard deviation is a measure of return.
C) standard deviation is calculated in the same units as payoffs and variance isn't.
D) it can measure unquantifiable risk.

Question 39

Which of the following individuals is least likely to use value at risk as an important factor in his/her investment decision?

A) An individual considering a mortgage to buy his first home.
B) A family considering purchasing health insurance.
C) A policy maker considering regulation of depository institutions.
D) A mutual fund manager choosing the allocation of investments in the fund's portfolio.

Question 40

An investment will pay $2,000 a quarter of the time; $1,600 half of the time and $1,400 a quarter of the time. The standard deviation of this asset is:

A) $600
B) $1,650
C) $47,500
D) $217.94

Question 41

The risk premium for an investment:

A) is negative for U.S. treasury securities.
B) is a fixed amount added to the risk-free return, regardless of the level of risk.
C) increases with risk.
D) is zero (0) for risk-averse investors.

Question 42

A risk-averse investor compared to a risk-neutral investor would:

A) offer the same price for an investment as the risk-neutral investor.
B) require a higher risk premium for the same investment as a risk-neutral investor.
C) place more focus on expected return and less on return than the risk-neutral investor.
D) place less focus on expected return than the risk-neutral investor.

Question 43

Up to what amount would a risk-neutral gambler pay to enter a game where on the flip of a fair coin, if you call the correct outcome the payoff is $2,000?

A) More than $1000 but less than $2000.
B) Up to $2,000.
C) Up to $1,000.
D) More than $1,500.

Question 44

A risk-averse investor will:

A) never prefer an investment with a lower expected return.
B) always prefer an investment with a certain return to one with the same expected return but that has any amount of uncertainty.
C) always require a certain return.
D) always focus exclusively on the expected return.

Question 45

Unexpected inflation can benefit some people/firms and harm others. This is an example of:

A) systematic risk.
B) unmeasured risk.
C) idiosyncratic risk.
D) zero risk since the effects balance.

Question 46

When the home construction industry does poorly due to a recession, this is an example of:

A) systematic risk.
B) idiosyncratic risk.
C) risk premium.
D) unique risk.

Question 47

An investor who diversifies by purchasing a 50-50 mix of two stocks that are not perfectly positively correlated will find that the standard deviation of the portfolio is:

A) the sum of the standard deviations of the two individual stocks.
B) greater than the sum of the standard deviations of the individual stocks.
C) greater than the standard deviation from holding the same balance in only one of these stocks.
D) less than the standard deviation from holding the same balance in only one of these stocks.

Question 48

Which of the following statements is most correct?

A) Usually higher expected returns are associated with higher risk premiums.
B) Usually higher risk premiums are associated with lower expected returns.
C) Usually lower expected returns are associated with higher risk premiums.
D) Usually expected returns are not associated with risk premiums.

Question 49

Diversification is the principle of:

A) eliminating risk.
B) reducing the risk we carry to just two.
C) holding more than one asset to reduce risk.
D) eliminating investments from our portfolio that have idiosyncratic risk.

Question 50

An investor practicing hedging would be most likely to:

A) avoid the stock market and focus on bonds.
B) purchase shares in general motors and buy U.S. treasury bonds.
C) purchase shares in general motors and Amoco oil.
D) put his/her invested funds in CDs.

Question 51

Unique risk is another name for:

A) market risk.
B) systematic risk.
C) the risk premium.
D) idiosyncratic risk.

Question 52

High oil prices tend to harm the auto industry and benefit oil companies; therefore, high oil prices are an example of:

A) systematic risk.
B) idiosyncratic risk.
C) neither systematic nor idiosyncratic risk.
D) both systematic and idiosyncratic risk.

Question 53

Which of the following statements is false?

A) Diversification can reduce risk.
B) Diversification can reduce risk but only by reducing the expected return.
C) Diversification reduces idiosyncratic risk.
D) Diversification allocates savings across more than one asset.

Question 54

Diversification can eliminate:

A) all risk in a portfolio.
B) risk only if the investor is risk averse.
C) the systematic risk in a portfolio.
D) the idiosyncratic risk in a portfolio.

Question 55

Hedging is possible only when investments have:

A) opposite payoff patterns.
B) the same payoff patterns.
C) payoffs that are independent of each other.
D) the same risk premiums.

Question 56

Changes in general economic conditions usually produce:

A) systematic risk.
B) idiosyncratic risk.
C) risk reduction.
D) lower risk premiums.

Question 57

When considering different investments, a risk-averse investor is most likely to focus on purchasing:

A) investments with the greatest spread in the expected rate of return.
B) investments that offer the lowest standard deviation in the investments' expected rates of return for any given expected rate of return.
C) only risk-free investments.
D) investments with the lowest risk premium, regardless of the expected rate of return.

Question 58

Systematic risk:

A) is the risk eliminated through diversification.
B) represents the risk affecting a specific company.
C) cannot be eliminated through diversification.
D) is another name for risk unique to an individual asset.

Question 59

The fact that over the long run the return on common stocks has been higher than that on long-term U.S. Treasury bonds is partially explained by the fact that:

A) A lot more money is invested in common stocks than U.S. Treasury bonds.
B) There are regulations on the interest rates U.S. Treasury bonds can offer.
C) The risk premium is higher on common stocks.
D) Risk-averse investors buy more common stock.

Question 60

Professional gamblers know that the odds are always in favor of the house (casinos). The fact that they gamble says they are:

A) irrational.
B) risk-neutral.
C) risk-averse.
D) risk seekers.

Question 61

If the returns of two assets are perfectly positively correlated, an investor who puts half of his/her savings into each will:

A) reduce risk.
B) have a higher expected return.
C) not gain from diversification.
D) reduce risk but lower the expected return.

Question 62

Investing in a mutual fund made up of hundreds of stocks of different companies is an example of all of the following except:

A) spreading risk.
B) diversifying.
C) risk reduction.
D) increasing the variance of a portfolio.

Question 63

The expected return from a portfolio made up equally of two assets that move perfectly opposite of each other would have a standard deviation equal to:

A) 1.0
B) -1.0
C) 0.0
D) 0.5

Question 64

Sometimes spreading has an advantage over hedging to lower risk because:

A) it can be difficult to find assets that move predictably in opposite directions.
B) it is cheaper to spread than hedge.
C) spreading increases expected returns, hedging does not.
D) spreading does not affect expected returns.

Question 65

The variance of a portfolio of assets:

A) decreases as the number of assets increases.
B) increases as the number of assets increase.
C) approaches 0 as the number of assets decreases.
D) approaches 1 as the number of assets increases.

Question 66

An automobile insurance company that writes millions of policies is practicing a form of:

A) mutual fund.
B) hedging risk.
C) spreading risk.
D) eliminating systematic risk.

Question 67

An individual who is risk-averse:

A) never takes risks.
B) accepts risk but only when the expected return is very small.
C) requires larger compensation when the risk increases.
D) will accept a lower return as risk rises.

Question 68

If ABC Inc. and XYZ Inc. have returns that are perfectly positively correlated:

A) adding XYZ Inc to a portfolio that consists of only ABC Inc. will reduce risk.
B) adding ABC Inc to a portfolio that includes only XYZ Inc. will increase risk.
C) adding XYZ Inc. to a portfolio that consists of only ABC Inc. will neither increase nor decrease the risk of the portfolio.
D) adding XYZ Inc to a portfolio that consists of only ABC Inc. will neither increase nor decrease idiosyncratic risk but will lower systematic risk.

Question 69

In order to benefit from diversification, the returns on assets in a portfolio must:

A) be perfectly positively correlated.
B) be perfectly negatively correlated.
C) positively correlated but not perfectly.
D) have the same idiosyncratic risks.

Question 70

Hedging risk and spreading risk are two ways to:

A) increase expected returns from a portfolio.
B) diversify a portfolio.
C) lower transaction costs.
D) match up perfectly positively correlated assets.

Question 71

The Russian wheat crop fails, driving up wheat prices in the U.S. This is an example of:

A) idiosyncratic risk.
B) diversification.
C) systematic risk.
D) quantifiable risk.

Question 72

The variance of a portfolio containing n assets with independent returns:

A) increases as n increases.
B) decreases as n increases.
C) is constant for any n greater than two.
D) does not change in a predictable way when n increases.

Question 73

If an investment offered an expected payoff of $100 with $0 variance, you would know that:

A) half of the time the payoff is $100 and the other half it is $0.
B) the payoff is always $100.
C) half of the time the payoff is $200 and the other half it is $0.
D) half of the time the payoff is $200 and the other half it is $50.

Question 74

Spreading risk involves:

A) finding assets whose returns are perfectly negatively correlated.
B) adding assets to a portfolio that move independently.
C) investing in bonds and avoiding stocks during bad times.
D) building a portfolio of assets whose returns move together.

Question 75

An individual faces two alternatives for an investment: Asset A has the following probability return schedule:

Asset B has a certain return of 8.0%. If the individual selects asset A does she violate the principle of risk aversion? Explain.

Question 76

The main reason for diversification for an investor is to:

A) take advantage of the fact that returns of assets are perfectly positively correlated.
B) take advantage of the fact that returns on assets are not perfectly correlated.
C) lower transaction costs.
D) gain from the greater returns that come from greater risk.

Question 77

An automobile insurance company on average charges a premium that:

A) equals the expected loss from each driver.
B) is less than the expected loss from each driver.
C) is greater than the expected loss from each driver.
D) equals 1/(expected loss) of each driver.

Question 78

In investment matters, generally young workers compared to older workers will:

A) minimize expected return and focus more on variability.
B) be less risk-averse.
C) have equal concern for expected return and variability.
D) be more risk-averse.

Question 79

The fact that not everyone places all of his/her savings in U.S. Treasury bonds indicates that:

A) most investors are not risk averse.
B) many investors are actually risk seekers.
C) even risk-averse people will take risk if they are compensated for it.
D) most people are risk-neutral.

Question 80

A portfolio of assets has lower risk than holding one asset, but the same expected return and higher transaction costs. Which of the following statements is most correct?

A) The portfolio is attractive to people who are risk-averse and risk-neutral, but not to risk seekers.
B) The portfolio is attractive to investors who are risk-neutral.
C) The portfolio is not attractive to investors who are risk-neutral.
D) The portfolio is attractive to investors who are risk seekers.