Question 1

Missy recently rearranged her portfolio so that it has a higher average return. As a result of this rearranging, Missy
A) raised both firm-specific risk and market risk.
B) raised firm-specific risk, but not market risk.
C) raised market risk, but not firm-specific risk.
D) None of the above is correct.

Accepted Answer

By rearranging her portfolio to achieve a higher average return, Missy likely took on additional firm-specific risk by concentrating her investments in certain companies or industries. However, this does not necessarily raise market risk, which is the risk that affects all securities in the market. Therefore, choice B is the best answer.

Question 2

Angela reads financial advice columns and concludes the following. Which, if any, of her conclusions are incorrect?
A) Higher average returns come at the price of higher risk.
B) People who are risk averse should never hold stock.
C) Diversification cannot eliminate all of the risk in stock portfolio.
D) None of her conclusions are incorrect.

Accepted Answer

The answer of Angela reads financial advice columns and concludes...

Question 3

Manufacturers of Weightbegone are concerned that genetic advances in weight control might reduce the demand for their diet snacks. This is an example of
A) firm­specific risk, which will likely raise shareholders' demand for higher return.
B) firm­specific risk, which will likely not likely raise shareholders' demand for higher return.
C) market risk, which will likely raise shareholders' demand for higher return.
D) market risk, which will likely not raise shareholders' demand for higher return.

Accepted Answer

The answer of Manufacturers of Weightbegone are concerned that genetic...

Question 4

Figure 27-6. On the graph, x represents risk and y represents return. 
-Refer to Figure 27-6. Point A represents a situation in which
A) all of a person's savings are allocated to a class of safe assets.
B) the person knows with certainty that his or her return will be 3 percent.
C) the standard deviation of the person's portfolio is zero.
D) All of the above are correct.

Accepted Answer

Point A represents a situation in which all of a person's savings are allocated to a class of safe assets, resulting in a known and low return with no risk (represented by zero standard deviation). Therefore, all three statements in options A, B, and C are correct.

Question 5

Which of the following actions best illustrates adverse selection?
A) A person purposely chooses bonds of corporations with high default risk because of the high returns.
B) A person dislikes losing $400 more than he likes winning $400.
C) After obtaining automobile insurance a person drives less carefully than before.
D) A person intending to take up dangerous hobbies applies for life insurance.

Accepted Answer

Adverse selection occurs when one party with superior information takes advantage of another party with inferior information. In this case, the person intending to take up dangerous hobbies has information about their risky behavior that the insurer does not have. By applying for life insurance, they are selecting themselves into a riskier pool of insured individuals, which could lead to adverse financial consequences for the insurer.

Question 6

Figure 27-6. On the graph, x represents risk and y represents return. 
-Refer to Figure 27-6. Which of the following statements is correct?
A) At point A the standard deviation of the portfolio is 3.
B) A risk averse person always will choose to be at point A.
C) At point D the portfolio consists of about 15 percent stocks and 85 percent safe assets.
D) The figure shows that the greater the risk, the greater the return.

Accepted Answer

The graph shows a positive correlation between risk and return, meaning that the greater the risk, the greater the return. This is reflected by the upward sloping line. Point A represents a low risk and low return portfolio, which may not be preferred by a risk averse person. The standard deviation of the portfolio is not shown on the graph. The composition of the portfolio at point D is not given on the graph.

Question 7

To diversify, a homeowner with a variable-rate mortgage should choose investments that
A) pay higher returns when interest rates rise and lower returns when interest rates fall.
B) pay lower returns when interest rates rise and higher returns when interest rates fall.
C) provide a higher return than the market average.
D) provide a lower return than the market average.

Accepted Answer

Since a homeowner with a variable-rate mortgage is vulnerable to interest rate fluctuations, they should invest in securities that pay higher returns when interest rates rise and lower returns when interest rates fall. This will help to offset any increase in mortgage payments due to rising interest rates.

Question 8

There are many concerns for risk-averse lenders. Consider the following: 1. Lenders are concerned that borrowers with the greatest risk are the ones most likely to actively pursue loans. 2. Lenders are concerned that real GDP will decline leading to reduced corporate profits. 3. Lenders are concerned that products produced by certain corporations will become obsolete.
A) 1 is market risk; 2 is firm-specific risk
B) 2 is market risk; 3 is firm-specific risk
C) 3 is market risk; 1 is firm-specific risk
D) 2 is firm-specific risk; 3 is market risk

Accepted Answer

1. Lenders being concerned that borrowers with the greatest risk are more likely to pursue loans is an example of adverse selection, which is a type of firm-specific risk.
2. Lenders being concerned about a decline in real GDP and reduced corporate profits is a market risk because it would affect many different firms in the market, not just a specific one.
3. Lenders being concerned about certain corporations producing obsolete products is a firm-specific risk because it only affects those particular corporations, not the overall market.

Question 9

Which of the following is a source of market risk?
A) Holding stocks in many companies carries the risk of a reduced average return.
B) Real GDP varies over time and sales and profits move with real GDP.
C) When a paper producer has declining sales, it is likely that so will other paper producers.
D) If stockholders become aggravated with the way a CEO runs a company, the price of that company's stock might fall in the stock market.

Accepted Answer

Real GDP variability affects the market risk as it leads to the variability of sales and profits, which ultimately affects the stock prices.

Question 10

Phillip is a mortgage broker, who is paid by commission. When interest rates decline, he does a lot of business and earns a lot of money, as more people buy houses or refinance their mortgages. But when interest rates rise, business falls substantially. To diversify, Phillip should choose investments that
A) provide a higher return than the market average.
B) provide a lower return than the market average.
C) pay higher returns when interest rates rise and lower returns when interest rates fall.
D) pay lower returns when interest rates rise and higher returns when interest rates fall.

Accepted Answer

Phillip should choose investments that pay higher returns when interest rates rise and lower returns when interest rates fall. This will help offset the negative impact on his business when interest rates rise, and also provide additional income during times of high interest rates. By diversifying his income sources in this way, Phillip can better protect his financial stability and continue to earn a steady income even when one source is affected by market conditions.

Question 11

An increase in the number of corporations in a portfolio from 110 to 120 reduces
A) market risk by more than an increase from 1 to 10.
B) market risk by less than an increase from 1 to 10.
C) firm-specific risk by more than an increase from 1 to 10.
D) firm-specific risk by less than an increase from 1 to 10.

Accepted Answer

An increase in the number of corporations in a portfolio reduces firm-specific risk because the portfolio is more diversified. However, the reduction in firm-specific risk will be less than an increase from 1 to 10 corporations because the portfolio is already somewhat diversified with 110 corporations. The reduction in market risk cannot be determined based on the information given.

Question 12

A risk-averse person has
A) a utility function whose slope gets flatter as wealth rises. This means they have increasing marginal utility of wealth.
B) a utility function whose slope gets flatter as wealth rises. This means they have diminishing marginal utility of wealth.
C) a utility function whose slope gets steeper as wealth rises. This means they have increasing marginal utility of wealth.
D) a utility function whose slope gets steeper as wealth rises. This means they have diminishing utility of wealth.

Accepted Answer

A risk-averse person is more concerned about avoiding losses than gaining profits. Therefore, they have diminishing marginal utility of wealth, which means that as their wealth increases, the additional utility they derive from each additional unit of wealth decreases. This is reflected in a utility function with a flatter slope as wealth rises, as described in choice B.

Question 13

David increases the number of companies in which he holds stocks.
A) This reduces risk's standard deviation and firm-specific risk.
B) This reduces risk's standard deviation and market risk.
C) This raises market risk, but lowers firm-specific risk. What happens to overall risk is unclear.
D) This raises firm-specific risk, but lowers market risk. What happens to overall risk is unclear.

Accepted Answer

The more companies in which David holds stocks, the more diversified his portfolio becomes. This leads to a reduction in risk's standard deviation and firm-specific risk because he is no longer heavily reliant on any one company. By increasing the number of companies, he has spread his risk across multiple industries and sectors.

Question 14

Kyle puts a greater proportion of his portfolio into government bonds. Kyle's action
A) increases both risk and the average rate of return.
B) decreases both risk and the average rate of return.
C) increases risk, but decreases the average rate of return.
D) decreases risk, but increases the average rate of return.

Accepted Answer

The answer of Kyle puts a greater proportion of his...

Question 15

Which of the following best illustrates diversification?
A) A company that produces many different products decides to produce fewer.
B) After selling stock, corporate management spends funds on projects with greater risks than shareholders had anticipated.
C) Instead of holding only the stocks of companies engaged in the banking business, a person decides to hold stock in a number of different companies producing different goods and services.
D) A person decides to purchase only stocks that have paid high dividends in the past.

Accepted Answer

Diversification refers to the practice of spreading investments across different industries or types of assets to reduce risks. Holding stocks in a variety of companies producing different goods and services is an example of diversification. Options A, B, and D do not relate to diversification.

Question 16

Diversification reduces
A) only market risk.
B) only firm-specific risk.
C) neither market or firm-specific risk.
D) both market and firm-specific risk.

Accepted Answer

The answer of Diversification reduces
A) only market risk.
B) only firm-specific...

Question 17

Other things the same, as the stocks of a greater number of corporations are held in a portfolio,
A) risk increases at an increasing rate.
B) risk increases at a decreasing rate.
C) risk decreases at an increasing rate.
D) risk decreases at a decreasing rate.

Accepted Answer

The answer of Other things the same, as the stocks...

Question 18

An increase in the number of corporations in a portfolio from 1 to 10 reduces
A) market risk by more than an increase from 110 to 120.
B) market risk by less than an increase from 110 to 120.
C) firm-specific risk by more than an increase from 110 to 120.
D) firm-specific risk by less than an increase from 110 to 120.

Accepted Answer

Increasing the number of corporations in a portfolio decreases firm-specific risk as the impact of any one company's performance is diluted due to the presence of other companies. However, increasing the portfolio from 110 to 120 does not necessarily reduce market risk, as market risk is determined by broader economic factors that affect all companies in the market.

Question 19

Kurt decided to increase the number of stocks in his portfolio. In doing so, Kurt reduced
A) both the firm-specific risk and the market risk of his portfolio.
B) the firm-specific risk, but not the market risk of his portfolio.
C) the market risk, but not the firm-specific risk of his portfolio.
D) neither the market risk nor the firm-specific risk of his portfolio.

Accepted Answer

By increasing the number of stocks in his portfolio, Kurt diversified his holdings, thus reducing the firm-specific risk that comes with investing in only a few companies. However, his portfolio's market risk, which is the risk associated with overall market movements, may not have decreased. Therefore, choice B is the best answer as it states that Kurt reduced the firm-specific risk, but not the market risk of his portfolio.

Question 20

Which of the following is not correct?
A) A risk averse person might be willing to hold stocks.
B) Other things the same, a portfolio with the stocks of a large number of companies has less risk.
C) Other things the same, the larger a portion of savings a person invests in stocks, the greater his expected return.
D) Diversification can eliminate market risk but not firm-specific risk.

Accepted Answer

The answer of Which of the following is not correct?
A)...

Quiz 27: The Basic Tools of Finance

Missy recently rearranged her portfolio so that it has a higher average return. As a result of this rearranging, Missy

Angela reads financial advice columns and concludes the following. Which, if any, of her conclusions are incorrect?

Manufacturers of Weightbegone are concerned that genetic advances in weight control might reduce the demand for their diet snacks. This is an example of

Figure 27-6. On the graph, x represents risk and y represents return. -Refer to Figure 27-6. Point A represents a situation in which

Which of the following actions best illustrates adverse selection?

Figure 27-6. On the graph, x represents risk and y represents return. -Refer to Figure 27-6. Which of the following statements is correct?

To diversify, a homeowner with a variable-rate mortgage should choose investments that

Which of the following is a source of market risk?

An increase in the number of corporations in a portfolio from 110 to 120 reduces

A risk-averse person has

David increases the number of companies in which he holds stocks.

Kyle puts a greater proportion of his portfolio into government bonds. Kyle's action

Which of the following best illustrates diversification?

Diversification reduces

Other things the same, as the stocks of a greater number of corporations are held in a portfolio,

An increase in the number of corporations in a portfolio from 1 to 10 reduces

Kurt decided to increase the number of stocks in his portfolio. In doing so, Kurt reduced

Which of the following is not correct?