Deck 5: Understanding Risk

Question 1

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

Answer 1

B

Question 2

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%

Answer 2

C

Question 3

Which of the following is true?

A)Investments with higher risk generally pay a higher 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 3

A

Question 4

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 5

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

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

Question 6

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 7

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

A)The outcome is more likely to occur
B)The outcome is certain to occur
C)The outcome is less likely to occur
D)The outcome will not occur

Question 8

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

Question 9

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 10

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 11

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 return
C)With more risk should sell for a lower price and offer a higher return
D)With less risk should sell for a lower price and offer a lower return

Question 12

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
C)$1,000; 250,000 dollars
D)$1,000; 250,000 dollars

Question 13

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 14

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 15

If an individual voluntarily purchases insurance on his/her home to protect against a loss due to fire, the individual:

A)Is convinced a fire will occur
B)Believes the premium for the policy is less than the expected loss from a fire
C)Has calculated the probability of a fire to be high
D)Has underestimated the probability that a fire will occur

Question 16

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 17

When measuring the risk of an asset:

A)There may be 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 18

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 19

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 20

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

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

Question 21

An investment will pay $2000 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 22

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 23

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 24

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 25

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

Question 26

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 27

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 28

An investment pays $1000 three quarters of the time, and $0 the remaining time.Its expected value and variance respectively are:

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

Question 29

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

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

Question 30

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 31

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 32

The greater the standard deviation of an investment:

A)The lower the return
B)The greater the risk
C)The lower the risk
D)The greater the return

Question 33

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)Investments A and B have the same expected value and equal risk
E)None of the above

Question 34

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 35

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 36

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 37

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 38

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 39

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 40

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; $1000
D)$433; $1000

Question 41

Idiosyncratic risk:

A)Affects all firms in the economy
B)Affects one or a few firms, not everyone
C)Is fixed across all firms
D)Impacts all firms in the same industry equally

Question 42

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 43

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 44

Unique risk is another name for:

A)Market risk
B)Systematic risk
C)The risk premium
D)Idiosyncratic risk

Question 45

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 46

We observe an increase in the price for Apple stock, while other Nasdaq-listed companies experience no change in their share prices.The increase in Apple's stock price most likely reflects (with respect to Apple):

A)An increase in systematic risk
B)A decrease in systematic risk
C)An increase in idiosyncratic risk
D)A decrease in idiosyncratic risk

Question 47

Uncertainty associated with the expected rate of return on an individual stock reflects all of the following except:

A)Idiosyncratic risk
B)Changes in the performance of the individual company relative to others
C)Change in macroeconomic conditions
D)Systematic risk

Question 48

Diversification is the principle of:

A)Eliminating risk
B)Reducing the risk we carry to just two
C)Holding more than one risk at a time
D)Eliminating investments from our portfolio that have idiosyncratic risk

Question 49

Changes in general economic conditions usually produce:

A)Systematic risk
B)Idiosyncratic risk
C)Risk reduction
D)Lower risk premiums

Question 50

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 51

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 52

The most a risk-averse individual would pay to participate in a flip of a fair coin with a payoff of $500 if the correct outcome is called is:

A)$500
B)An amount less than $250
C)$250
D)An amount not to exceed $500

Question 53

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 54

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 55

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 56

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 57

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 58

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 59

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 60

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 $2000?

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

Question 61

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 62

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 63

A risk-neutral investor:

A)Highly values diversification
B)Is the only type of investor who benefits from diversification
C)Gains nothing from diversification
D)Does not believe that diversification can reduce risk

Question 64

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 65

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 66

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 67

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 68

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 69

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 70

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 71

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 72

The variance of a portfolio of assets:

A)Decreases as the number of assets increases
B)Increases as the number of assets increases
C)Approaches 0 as the number of assets decreases
D)Approaches 1 as the number of assets increases

Question 73

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)Not be perfectly positively correlated
D)Have the same idiosyncratic risks

Question 74

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 75

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 76

Spreading 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 77

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 78

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 79

The main reason for diversification for an investor is:

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

Question 80

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