Question 1

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.

Accepted Answer

Rational expectations assume that individuals make predictions based on all available information and do not make systematic and correctable errors in prediction.

Question 2

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%.

Accepted Answer

The standard deviation of a portfolio depends on the standard deviations of the individual stocks, their correlations, and their weights in the portfolio. Given that each stock has the same value (implying equal weights) and without information on the correlations between the stocks, it's impossible to precisely calculate the portfolio's standard deviation. However, it's unlikely to exceed the highest individual standard deviation (90%) because diversification generally reduces a portfolio's overall risk. Therefore, the best answer with the given information is that the portfolio's standard deviation is no greater than 50%, which suggests some level of risk reduction through diversification without specifying the exact impact.

Question 3

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.

Accepted Answer

The capital asset pricing model (CAPM) assumes that investors are rational and risk-averse, caring primarily about two aspects of their portfolio: expected return and the standard deviation of return, which represents risk. This model focuses on optimizing these two parameters to achieve the best possible portfolio performance.

Question 4

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.

Accepted Answer

The speculator believes that the demand for corn in March will increase, so they would want to buy March futures contracts in anticipation of a price increase in the future. This way, if the demand does increase as expected, the speculator can sell the futures contracts at a higher price and make a profit. If they were to bid down the price of futures contracts or the spot price of corn, it would not align with their belief that the demand will increase, and they would not be able to make a profit. Giving suppliers an incentive to sell more corn in February would not necessarily affect the demand for corn in March, so it would not be a beneficial action for the speculator in this situation.

Question 5

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.

Accepted Answer

Shareholders with diversified portfolios have investments in multiple companies, industries, and markets, which means that they are exposed to a variety of risks. They are more likely to prefer that corporate decision-makers be risk-neutral, as this will help to ensure the stability and long-term success of the company, which in turn benefits the shareholders. Risk-preferring behavior by corporate decision-makers may lead to excessive risk-taking, which can result in volatile profits and losses that can harm shareholders.

Question 6

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.

Accepted Answer

The adverse selection problem arises because fair odds are different for different people, but the insurance company cannot tell who is who. This leads to the possibility that high-risk individuals are more likely to purchase insurance, while low-risk individuals may opt out, resulting in an imbalance in the risk pool that can make it more difficult and expensive for insurers to provide coverage.

Question 7

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.

Accepted Answer

The answer of Suppose there are two types of people:...

Question 8

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%.

Accepted Answer

The answer of Shares in XM Radio currently sell for...

Question 9

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.

Accepted Answer

The answer of In popular usage the term investor is...

Question 10

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.

Accepted Answer

This portfolio is known as a market portfolio. It is the portfolio that contains all of the risky assets in the economy held in proportion to their existing quantities. It is considered to be the most diversified portfolio and represents the systemic risk of the entire market. Investors who want to hold a diversified portfolio will choose to invest in the market portfolio.

Question 11

When a person is risk-preferring,his indifference curves are
A) convex.
B) concave.
C) linear.
D) upward sloping.

Accepted Answer

Risk-preferring individuals have concave indifference curves because they derive more utility from uncertain or risky outcomes compared to certain ones, indicating a willingness to accept more risk for potentially higher rewards.

Question 12

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.

Accepted Answer

A speculator is a person who attempts to earn profits in the futures markets by predicting future changes in supply or demand. An investor is a person who invests money in the hope of increasing wealth over time. A risk-preferring individual refers to a person who is willing to take on higher levels of risk in exchange for potentially higher returns. A contractor is a person or company that agrees to provide goods or services to another entity under a contract.

Question 13

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.

Accepted Answer

Rational expectations result in suppliers predicting prices based on the best available information. Based on the historical prices given, a rational expectation for suppliers would be to anticipate a price of $2.50 per pound for grapes.

Question 14

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.

Accepted Answer

The answer of An uninsurable risk is one
A) where everyone...

Question 15

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.

Accepted Answer

A futures market allows the farmer to hedge against the uncertain price of potatoes by securing a contract to sell at a fixed price in the future. This way, the farmer is protected against potential losses if the price drops below the cost of production. A spot market is for immediate delivery, and a portfolio market and diversified market are not relevant in this scenario.

Question 16

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.

Accepted Answer

Speculators' actions can only raise social welfare when their expectations prove to be correct. This is because speculators are taking a risk by making predictions about future market conditions, and if their predictions ultimately benefit society by leading to lower prices or increased efficiency, then their actions can be seen as beneficial. However, if their expectations turn out to be incorrect, then their actions may lead to harm for society. Therefore, it is only when speculators successfully predict market outcomes that their actions can be seen as raising social welfare.

Question 17

The curve representing the set of efficient portfolios must be
A) concave.
B) linear.
C) convex.
D) a ray from the origin.

Accepted Answer

The answer of The curve representing the set of efficient...

Question 18

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.

Accepted Answer

A policy change can alter people's behavior, which can invalidate the assumptions or relationships that the equation was based on.

Question 19

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.

Accepted Answer

When speculators begin to sell futures contracts, it indicates a bearish sentiment in the market. Suppliers, in this case, will try to increase their current supply in the spot market to ensure they can sell it at a profitable price before the market drops further. This behavior is represented by choice A.

Question 20

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%.

Accepted Answer

To find the expected return of a portfolio, we need to weigh each stock's expected return by its percentage of the total portfolio value. Since each stock has the same value, we can simply take the average of the expected returns:
(0.15 + 0.25 + 0.5) / 3 = 0.3 or 30%.
Therefore, the best choice is B.

Quiz 18: Risk and Uncertainty

If people have rational expectations,then they

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

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

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

Shareholders with diversified portfolios will encourage

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

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?

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

In popular usage the term investor is used to refer to

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

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

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

An uninsurable risk is one

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

When will speculators' actions raise social welfare?

The curve representing the set of efficient portfolios must be

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

When speculators begin to sell futures contracts,suppliers will

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