Question 1

Suppose an investor equally allocates their wealth between a risk-free asset and a risky asset. If the MRS of the current allocation is less than the slope of the budget line, then the investor should:
A) shift more of their wealth to the risky asset.
B) shift more of their wealth to the risk-free asset.
C) keep the same asset allocation.
D) We do not have enough information to answer this question.

Accepted Answer

When the Marginal Rate of Substitution (MRS) of the current allocation is less than the slope of the budget line, it indicates that the investor values the risky asset's return more than the risk-free asset's return, relative to their respective risks. Therefore, the investor should shift more of their wealth to the risky asset to increase utility.

Question 2

Joan Summers has $100,000 to invest and is considering two alternatives. She can buy a risk free asset that will pay 10% or she can invest in a stock that has a 0.4 chance of paying 15%, a 0.3 chance of paying 18%, and a 0.3 chance of providing a 6% return. Joan plans to invest $70,000 in the stock and $30,000 in the risk free asset.
a. Determine the expected percentage return on the stock and the standard deviation.
b. Calculate the weighted average return on the portfolio, given the planned investment strategy outlined above.
c. Determine the standard deviation for the portfolio.
d. Write the equation that represents the budget line in the risk-return tradeoff. What is the slope of the budget line? Interpret this slope.

Accepted Answer

The answer of Joan Summers has $100,000 to invest and...

Question 3

Is it possible for an investor to allocate more than 100% of their assets to the stock market?
A) No, this is not theoretically plausible.
B) No, federal law prohibits this kind of investment.
C) Yes, investors can borrow money to buy stocks on margin.
D) none of the above

Accepted Answer

Investors can use margin accounts offered by their brokerage firms to borrow funds to purchase stocks, which would allow them to allocate more than 100% of their assets to the stock market. However, this strategy comes with higher risks and potential losses if stock prices decline.

Question 4

Donna is considering the option of becoming a co-owner in a business. Her investment choices are to hold a risk free asset that has a return of and co-ownership of the business, which has a rate of return of and a level of risk of . Donna's marginal rate of substitution of return for risk where is Donna's portfolio rate of return and σ_Pis her optimal portfolio risk. Donna's budget constraint is given by Solve for Donna's optimal portfolio rate of return and risk as a function of , and . Suppose the table below lists the relevant rates of returns and risks. Use this table to determine Donna's optimal rate or return and risk. Investment Rate of Return Risk Risk Free 0.06 0 Business 0.25 0.39

Accepted Answer

The answer of Donna is considering the option of becoming...

Question 5

The risk-return indifference curves for a risk-neutral investor are:
A) vertical lines.
B) straight lines with slope equal to one.
C) horizontal lines.
D) upward sloping lines that are bowed downward.

Accepted Answer

Risk-neutral investors have no preference for higher returns or lower risk, they only care about the absolute level of return. Therefore, their risk-return indifference curves are horizontal lines, indicating that they are indifferent to changes in risk as long as the return stays constant.

Question 6

Consider the following statements when answering this question: I. The allocation of a risk-averse investor's portfolio between a risk free asset and a risky asset never changes if the rate of return on both assets increases by the same amount.
II) Given the choice between investing in a risk free asset or a risky asset with higher expected returns, the utility maximizing portfolio of a risk neutral or risk loving investor would never include the risk free asset.
A) I and II are true.
B) I is true and II is false.
C) I is false and II is true.
D) I and II are false.

Accepted Answer

Statement I is true according to the principles of modern portfolio theory. However, statement II is false because a risk neutral or risk loving investor may still include a risk-free asset in their portfolio to diversify and reduce overall risk.

Question 7

Consider the following statements when answering this question; I. The variance of the returns of an investor's portfolio can be reduced by selling assets from the portfolio, and investing the proceeds in other assets where returns are positively correlated with the portfolio's remaining assets.
II) The value of complete information is always positive.
A) I and II are true.
B) I is true and II is false.
C) I is false and II is true.
D) I and II are false.

Accepted Answer

Statement I is false because investing in assets with positively correlated returns does not reduce variance; it may increase it. Statement II is false because the value of complete information can be zero if the information does not change the decision outcome.

Question 8

Use the following statements to answer this question: I. The real rate of return on an investment is the nominal return minus the rate of inflation.
II) The real rate of return on an investment cannot be negative.
A) I and II are true.
B) I is true and II is false.
C) II is true and I is false.
D) I and II are false.

Accepted Answer

I is true because the real rate of return is indeed calculated by subtracting the inflation rate from the nominal return. II is false because the real rate of return can be negative if the rate of inflation is higher than the nominal return.

Question 9

Jack is near retirement and worried that if the stock market falls he will not be able to wait to take his funds out, and will have to sell at the bottom of the market. Richard thinks the probability of a stock market downturn is the same, but he is only 40 and could therefore wait for another turnaround. They face the same budget line. Jack's risk/return indifference curve:
A) will be concave; Richard's will be convex.
B) will be convex; Richard's will be concave.
C) will be tangent to the budget line at a point to the left of Richard's.
D) will be tangent to the budget line at a point to the right of Richard's.
E) must still be tangent to the budget line at the same point as Richard's.

Accepted Answer

Jack's risk/return indifference curve will be tangent to the budget line at a point to the left of Richard's because he is more risk-averse and therefore requires a higher return for the same level of risk. This means that he would need a higher return on his investments to be willing to take on the risk of potential losses. As a result, his optimal portfolio would consist of a higher proportion of less risky assets, which would be located to the left of Richard's optimal portfolio on the efficient frontier. Therefore, his indifference curve would be tangent to the budget line at a point to the left of Richard's.

Question 10

Mel and Christy are co-workers with different risk attitudes. Both have investments in the stock market and hold U.S. Treasury securities (which provide the risk free rate of return). Mel's marginal rate of substitution of return for risk  where  is the individual's portfolio rate of return and σP is the individual's portfolio risk. Christy's  Each co-worker's budget constraint is  where  is the risk-free rate of return,  is the stock market rate of return, and  is the stock market risk. Solve for each co-worker's optimal portfolio rate of return as a function of  ,  and  .

Accepted Answer

The answer of Mel and Christy are co-workers with different...

Quiz 5: Uncertainty and Consumer Behavior

Suppose an investor equally allocates their wealth between a risk-free asset and a risky asset. If the MRS of the current allocation is less than the slope of the budget line, then the investor should:

Is it possible for an investor to allocate more than 100% of their assets to the stock market?

The risk-return indifference curves for a risk-neutral investor are:

Use the following statements to answer this question: I. The real rate of return on an investment is the nominal return minus the rate of inflation. II) The real rate of return on an investment cannot be negative.