Deck 7: The Pricing of Risky Financial Assets

Question 1

If an asset has a 0.7 probability of yielding 10 percent and a 0.3 probability of yielding 20 percent, the expected yield of the asset is

A) 30 percent.
B) 20 percent.
C) 13 percent.
D) 10 percent.

Answer 1

C

Question 2

If asset A is a 30-year U.S. Treasury bond yielding 9 percent and asset B is a 30-year corporate bond issued by General Motors that also yields 9 percent, risk averse investors would

A) prefer asset A.
B) prefer asset B.
C) be indifferent between the two assets.
D) differ according to their rate of time preference.

Answer 2

A

Question 3

If a person prefers a gamble with an expected value of $100 to a sure $100 that person is

A) irrational.
B) a risk lover.
C) nonsystematic.
D) managing a portfolio.

Answer 3

B

Question 4

In a world of certainty, the key decisions influenced by the riskless interest rate are

A) risk premiums demanded by investors.
B) portfolio decisions.
C) diversification decisions.
D) consumption versus saving decisions.

Question 5

Assume that a security has two possible outcomes. There is a 50 percent chance that the yield will equal 12 percent and a 50 percent chance that the yield will equal 4 percent. The expected yield for this security is

A) 16 percent.
B) 12 percent.
C) 8 percent.
D) 4 percent.

Question 6

A potential drawback of using the standard deviation to measure risk is that

A) positive and negative deviations from the mean cancel each other out.
B) both positive and negative deviations are included to compute deviations around the mean.
C) the probability distribution of returns is symmetrical.
D) None of the above.

Question 7

The current price of a government bond is $920. The bond pays $90 in interest this year. At the end of the current year, the bond matures, and the principal of $1,000 is repaid. What is the return to the holder of this bond?

A) 1 percent
B) 8 percent
C) 9 percent
D) 17 percent

Question 8

Assume that the yield on a security has two possible outcomes. There is a 60 percent chance it will yield 10 percent and a 40 percent chance it will yield 5 percent. The expected yield for this security is

A) 10.0 percent.
B) 8.0 percent.
C) 7.5 percent.
D) 6.0 percent.

Question 9

Assume that a security has equally possible outcomes of yielding 8 percent and 4 percent. The standard deviation of the probability distribution of returns for this security is

A) 6 percent.
B) 4 percent.
C) 3 percent.
D) 2 percent.

Question 10

The most fundamental proposition of modern portfolio theory is that

A) investment risk is reduced by investing in on security.
B) the smaller the standard deviation is, the larger is the risk of a portfolio.
C) even though an asset is risky in isolation, when combined with other assets the risk of the portfolio is less, perhaps even zero.
D) uncertain outcomes make for risky investments.

Question 11

If the interest rate on a security consists only of the riskless rate, then

A) there is no uncertainty.
B) velocity is constant.
C) the money supply is fixed.
D) the price level is fixed.

Question 12

Modern portfolio analysis assumes that individuals

A) are risk-averse.
B) attempt to maximize liquidity.
C) attempt to maximize returns regardless of risk.
D) never take risks.

Question 13

Most people are

A) risk lovers.
B) risk-averse.
C) indifferent toward risk.
D) None of the above.

Question 14

In a world of certainty, the interest rate reflects

A) the degree of risk.
B) differing time patterns of individuals' consumption preferences.
C) economic growth.
D) qualifications of borrowers.

Question 15

The expected yield on an asset with two possible outcomes is equal to the

A) difference between the two outcomes.
B) sum of the possible outcomes multiplied by their respective probabilities.
C) standard deviation of the two outcomes.
D) product of the two outcomes.

Question 16

The standard deviation around an expected value is a useful measure of

A) expected value of an asset.
B) economic value of an asset.
C) the difference between the best-case return of an asset and its worst-case return.
D) deviation of an asset's actual returns from its expected returns.

Question 17

Risk aversion implies that

A) individuals will not take on risk.
B) investors must be compensated for about half of the risk they take on.
C) investors must be compensated for the risk they take on.
D) None of the above.

Question 18

If asset A is a risky asset yielding 10 percent and asset B is a riskless asset with the same maturity with a yield of 8 percent, investors would

A) prefer asset A.
B) prefer asset B.
C) be indifferent between the two assets.
D) None of the above.

Question 19

Evidence that most investors are risk averse is that they

A) buy a diversified portfolio.
B) buy different bonds with the same yield and maturity.
C) put most of their funds in one company's stock.
D) like to gamble.

Question 20

Assume an asset has a 50 percent probability of yielding 10 percent and an equal probability of yielding 6 percent. The standard deviation for this asset is

A) 10 percent.
B) 8 percent.
C) 6 percent.
D) 2 percent.

Question 21

The risk premium that risk averse investors will demand on a security will be in proportion to the __________ of the portfolio.

A) systematic risk
B) nonsystematic risk
C) risk of the worst case return
D) diversification

Question 22

Assume a portfolio in which there is equal investment in two assets that are perfectly positively correlated, with equally expected returns of 10 percent and 6 percent for asset A and 8 percent and 4 percent for asset B. The expected yield on this portfolio is

A) 8 percent.
B) 7 percent.
C) 6 percent.
D) 5 percent.

Question 23

Some amount of every security in existence is held in the hypothetical __________ portfolio

A) perfect
B) market
C) systematic
D) nonsystematic

Question 24

Empirical evidence indicates that security returns have

A) greater probability of exceeding expected value yields.
B) greater probability of yielding below expected value returns.
C) a symmetrical probability distribution.
D) a probability distribution that cannot be measured.

Question 25

Which of the following statements is not true?

A) Portfolio diversification implies that investors earn a return above the risk-free rate that compensates for the risk inherent in each and every security.
B) The risk of the market portfolio is less than the sum of each security's risk.
C) The risk premium depends the systematic risk of securities.
D) All of the statements above are true.

Question 26

Portfolio diversification is ineffective when

A) assets in the portfolio have precisely the same pattern of returns.
B) assets in the portfolio have negative correlations.
C) assets in the portfolio are uncorrelated.
D) Portfolio diversification is ineffective in each of the above scenarios.

Question 27

Assets with zero covariance have yields that are

A) inversely related.
B) positively correlated.
C) negatively correlated.
D) independent.

Question 28

Because most asset yields are affected in a systematic way by economic conditions, most securities in portfolios

A) have a covariance greater than zero.
B) have negative yields.
C) have covariance greater than one.
D) increase in risk as new assets are added.

Question 29

We can be more confident that standard deviation is a good measure of the risk of an asset (held in isolation)when

A) the number of different possible returns on the asset rises.
B) the probabilities attached to the possible returns on the asset are less equal.
C) the possible returns on the asset are distributed symmetrically around the mean.
D) the asset has a longer maturity.

Question 30

The __________ the nonsystematic risk of a portfolio, the __________ the risk premium will be.

A) higher; lower
B) higher; higher
C) lower; lower
D) None of the above.

Question 31

Assume a portfolio in which there is equal investment in two assets that are perfectly negatively correlated, with equally expected returns of 10 percent and 6 percent for asset A and 8 percent and 4 percent for asset B. The expected yield on this portfolio is

A) 8 percent.
B) 7 percent.
C) 6 percent.
D) 5 percent.

Question 32

Holding a group of assets reduces risk relative to holding a single asset as long as the assets

A) are dependent on each other.
B) are positively correlated.
C) are uncorrelated.
D) do not have precisely the same pattern of returns.

Question 33

If asset returns are less than perfectly correlated, portfolio diversification

A) reduces systematic risk.
B) reduces nonsystematic risk.
C) increases systematic yields.
D) reduces systematic yields.

Question 34

If an investor holds two risky assets with a perfect negative correlation, then risk

A) falls to zero.
B) is increased.
C) is unaffected.
D) is reduced by 50 percent.

Question 35

A venture capital fund wants to invest $1000 in each of one thousand mad scientists. The first scientist applying to the fund is working on the legendary pill that turns water into gasoline, and the second scientist is working on the even more legendary perpetual motion machine. The smart venture capitalist here will

A) back the pill and look for 999 other scientists working on the same pill.
B) back the machine and look for 999 other scientists working on the same machine.
C) look for 500 scientists working on the pill and 500 working on the machine.
D) back the pill, the machine, and 998 other different projects.

Question 36

If two risky assets, A and B, have negative correlation, then when A's yield increases

A) B's yield increases.
B) B's yield decreases.
C) B's yield can increase or decrease.
D) There is not enough information to determine what B's yield will do.

Question 37

A mutual fund that purchases a wide variety of stocks will

A) eliminate systematic risk.
B) minimize nonsystematic risk.
C) minimize market risk.
D) minimize default risk.