Deck 3: Risk Attitudes: Expected Utility Theory and Demand for Hedging

Question 1

A risk averse individual will always choose to play a gamble at its AFP.

Answer 1

False

Question 2

Expected utility refers to a construct used to explain the level of satisfaction a person gets when faced with uncertain choices.

Answer 2

True

Question 3

Since corporations are risk seekers, they do not buy hedging instruments at prices greater than the AFP.

Answer 3

False

Question 4

Utility theory rests upon the idea that people behave as if they make decisions by assigning imaginary utility values to the original monetary values.

Question 5

Managers can diversify risk, but owners (principals) cannot.

Question 6

Corporations are risk neutral because only the systematic risk matters; they can diversify the idiosyncratic risk.

Question 7

The principle-agent problem is a type of adverse selection problem.

Question 8

Utility theory is a negative theory that dictates that people should behave in the manner prescribed by it.

Question 9

The lesser the degree of risk aversion, the higher the risk premium an individual will be willing to pay.

Question 10

If the probability of a large outcome is very high then the expected value will also be high, and vice versa.

Question 11

Any individual whose preferences are depicted by a convex utility function will forgo a game of chance if its cost equals actuarially fair price (AFP).

Question 12

Adverse selection refers to a particular kind of information asymmetry problem, namely, hidden information.

Question 13

Mathematically, the more-is-better assumption is called the rationality assumption.

Question 14

Anchoring bias has the effect of biasing the probability estimates of individuals.

Question 15

In the language of mathematics, the value function is concave in losses and convex in gains.

Question 16

Studying behavior using subjective probabilities belongs to the realm of traditional rationality-based economics.

Question 17

The realm of academic study that deals with departures from E(U) maximization behavior is called behavioral economics.

Question 18

An individual whose preference is characterized by the increasing marginal utility would have a convex utility function.

Question 19

The risk averter's utility function is concave to the origin.

Question 20

If utility theory is designed to measure satisfaction, and since every individual always tries to maximize satisfaction, it's reasonable to expect that each person tries to maximize his or her own utility.

Question 21

Why do we say that the utility theory has ordinal utility?

A)It is designed to study relative satisfaction levels.
B)It cannot be explained without the expected utility theory.
C)It dictates that people should behave in the manner prescribed by it.
D)It can represent the absolute level of satisfaction.
E)It does not base its beliefs upon individuals' preferences.

Question 22

Identify the utility that can represent the absolute level of satisfaction.

A)Circular utility
B)Ordinal utility
C)Marginal utility
D)Normative utility
E)Cardinal utility

Question 23

Identify the probability that is based on a person's beliefs and experiences, and belongs to the realm of behavioral economics rather than traditional rationality-based economics.

A)Empirical probability
B)Objective probability
C)Experiential probability
D)Philosophical probability
E)Subjective probability

Question 24

According to the utility theory, a glass of milk mixed with Milo (Nestlè's drink mix), will be preferred to milk or Milo alone.Identify this assumption on preference.

A)Completeness
B)More-is-better
C)Rationality
D)Convexity
E)Monotonicity

Question 25

Identify the utility function of a risk seeking individual.

A)U(W) = $\surd$ W
B)U(W) = 1/W²
C)U(W) = W²
D)U(W) = W
E)U(W) = 1/W

Question 26

According to the utility theory, if one week of food is preferred to one week of clothing, then two weeks of food is a preferred package to one week of food.Identify this assumption on preference.

A)Monotonicity
B)Rationality
C)Convexity
D)Mix-is-better
E)Completeness

Question 27

In the utility function of a risk-averse individual, the utility is always increasing although at a decreasing rate.Identify the feature of this utility function.

A)Diminishing ordinal utility
B)Diminishing expected utility
C)Diminishing normative utility
D)Diminishing marginal utility
E)Diminishing cardinal utility

Question 28

Daniel Bernoulli was the first one to provide a solution to the St.Petersburg paradox in the eighteenth century.Identify this solution.

A)Individuals' expectation of the amount of expected wealth depends upon their risk attitudes.Risk seekers have the highest expectations.
B)Individuals do not look at the expected wealth when they bid a lottery price, but the actual wealth of the lottery is the key.
C)Individuals do not look at the expected wealth when they bid a lottery price, but the expected utility of the lottery is the key.
D)Individuals do not look at the expected utility when they bid a lottery price, but the expected wealth of the lottery is the key.
E)Individuals do not look at the expected utility when they bid a lottery price, but the actual wealth of the lottery is the key.

Question 29

Unregulated companies are found to hedge more than regulated ones.

Question 30

An individual's preference is characterized by the diminishing marginal utility function.Identify the risk attitude of this individual.

A)Risk seeking
B)Risk averse
C)Risk loving
D)Risk neutral
E)Risk biased

Question 31

An individual's preference is characterized by the increasing marginal utility function.Identify the risk attitude of this individual.

A)Risk biased
B)Risk averse
C)Risk hating
D)Risk neutral
E)Risk seeking

Question 32

Identify the coding of alternatives that makes individuals vary from E(U) maximizing behavior.

A)Framing effect
B)Self-serving bias
C)Fundamental attribution error
D)Spacing effect
E)Availability bias

Question 33

Identify the utility function of a risk averse individual.

A)U(W) = $\surd$ W
B)U(W) = W³
C)U(W) = W²
D)U(W) = W
E)U(W) = 1/W

Question 34

In a football tournament, if University of Florida beats Ohio State, and Ohio State beats Georgia Tech, it does not mean that Florida beats Georgia Tech.This scenario violates the rationality assumption on preference of the utility theory.Identify this assumption of preference.

A)Transitivity of preference
B)Convexity of preference
C)Completeness of preference
D)Monotonicity of preference
E)Circularity of preference

Question 35

Identify the utility function of a risk seeking individual.

A)U(W) = $\surd$ W
B)U(W) = 1/W²
C)U(W) = W²
D)U(W) = W
E)U(W) = 1/W

Question 36

The preferences a risk neutral individual can be captured in E(U) theory by:

A)a concave utility function.
B)a linear utility function.
C)a convex utility function.
D)an exponential utility function.
E)a circular utility function.

Question 37

While utility theory deals with situations in which there is no uncertainty, this theory deals with choices individuals make when the outcomes they face are uncertain.Identify the theory.

A)Game theory
B)Expected utility theory
C)Expectation theory
D)Normative theory
E)Self-serving theory

Question 38

Individuals can rank order all possible bundles.Rank ordering implies that the utility theory assumes that, no matter how many combinations of consumption bundles are placed in front of the individual, each individual can always rank them in some order based on preferences.Identify this assumption on preference.

A)Monotonicity
B)More-is-better
C)Completeness
D)Mix-is-better
E)Rationality

Question 39

According to the utility theory, if bundle A is preferred to B, and bundle B is preferred to C, then A is also preferred to C.Under no circumstances will the individual prefer C to A.Identify this assumption on preference.

A)Completeness
B)Rationality
C)More-is-better
D)Convexity
E)Monotonicity

Question 40

Identify the correct statement about a fair game.

A)It is a game in which the cost of playing the game is less than the expected winnings of the game.
B)It is a game in which the net value equals zero.
C)It is a game in which the probability of winning or losing is equal to 1.
D)It is a game in which the net value is positive and greater than zero.
E)It is a game in which the cost of playing the game is greater than the expected winnings of the game.

Question 41

Identify the correct statement about corporations.

A)Corporations are risk neutral because they can diversify all risks except idiosyncratic risk.
B)Corporations should ideally hedge risks only at prices lower than the AFP.
C)Corporations buy hedging instruments at greater price than AFP.
D)The individual level utility functions of risk aversion can explain the hedging behavior of corporations.
E)Corporations are risk neutral because they can diversify systematic risk.

Question 42

Information asymmetry problem related to hidden information is referred to as:

A)prisoner's dilemma.
B)principle-agent problem.
C)moral hazard.
D)adverse selection.
E)fundamental attribution error.

Question 43

_____ theory dictates that people should behave in the manner prescribed by it.

Question 44

Systematic departures in behavior from the EU principle stem from "biases" that people exhibit.Such rationales of observed behavior under uncertainty are termed "_____" explanations.

Question 45

A(n) _____ is a mathematical formulation that ranks the preferences of the individual in terms of satisfaction different consumption bundles provide.

Question 46

Regulated companies are found to hedge more than unregulated ones because:

A)regulated companies face more risk.
B)hedging can increase debt capacity.
C)unregulated companies face more risk.
D)unregulated companies are prohibited from hedging.
E)law limits the level of risk taking.

Question 47

Which of the following statements is true about the value function?

A)It is a mathematical formulation that seeks to explain observed behavior by making assumptions about preferences.
B)Economists say that it is risk seeking in losses and risk averse in gains.
C)In the language of mathematics it is concave in losses and convex in gains.
D)Economists say that it is risk averse in losses and risk seeking in gains.
E)The nature of the value function is such that it is much steeper in gains than in losses.

Question 48

Economists use the term "_____" to gauge a person's satisfaction level.

Question 49

Often individuals base their subjective assessments of outcomes based on an initial "guesstimate." Such a guess may not have any reasonable relationship to the outcomes being studied.Identify this bias.

A)Self-serving bias
B)Attributional bias
C)Availability bias
D)Experience bias
E)Anchoring bias

Question 50

The principle-agent problem can be categorized as an information symmetry problem.Identify this information symmetry.

A)Adverse selection
B)Fundamental attribution error
C)Prisoner's dilemma
D)Moral hazard
E)False consensus

Question 51

Which of the following statements is true companies hedging behavior?

A)Managers hedge because they are diversified.
B)Hedging can increase debt capacity.
C)Unregulated companies are found to hedge more than regulated ones.
D)Managers want to increase expected bankruptcy costs.
E)Managers hedge because owners are undiversified.

Question 52

Humans tend to give more weight to events of the recent past than to look at the entire history.Which of the following best explains this bias?

A)Anchoring bias
B)Attributional bias
C)Availability bias
D)Experience bias
E)Conformation bias

Question 53

Optimal capital structure is a company's optimal mix of:

A)short-term and long-term loans.
B)common and preference shares.
C)short-term and long-term liabilities.
D)debt and equity financing.
E)bills receivable and bills payable.

Question 54

According to the utility theory, the property wherein an individual's preferences enable him or her to compare any given bundle with any other bundle is called the _____ property of preferences.

Question 55

A store owner may not be available to monitor the manager' actions continuously and at all times.This inability to observe actions falls under the class of problems called:

A)the principle-agent problem.
B)adverse selection.
C)the conflict of interest.
D)the false consensus problem.
E)fundamental attribution error.

Question 56

Information asymmetry problem related to hidden action is referred to as:

A)prisoner's dilemma.
B)principle-agent problem.
C)moral hazard.
D)adverse selection.
E)fundamental attribution error.

Question 57

In the utility theory, under the assumption of _____, individuals' preferences avoid any kind of circularity.

Question 58

_____ utility is utility that can represent the absolute level of satisfaction.

Question 59

Under partial insurance, companies offer products with deductibles.If an individual opts for a deductible, he/she will have to:

A)bear the entire loss incurred and then get it reimbursed form the insurance company.
B)bear the initial part of the losses incurred.
C)pay very high premiums to gain adequate protection.
D)opt for a whole life insurance policy as additional insurance.
E)return fifty percent of the amount received as face value, back to the insurer.

Question 60

According to the utility theory, the _____ assumption is called the "convexity" assumption on preferences.

Question 61

Neumann and Oskar Morgenstern (1944) advocated an approach that leads to a formal mathematical representation of maximization of _____.

Question 62

A kind of information asymmetry lies in the hidden action, wherein one party's actions are not observable by the counterparty to the contract.Economists study this issue as one of _____.

Question 63

Optimal capital structure is a company's optimal mix of debt and _____ financing.

Question 64

Economists say that the value function is risk seeking in _____ and risk averse in _____.

Question 65

The premium over and above the AFP that a risk-averse person is willing to pay to get rid of the risk is called the _____.

Question 66

To compute a probability empirically, we repeat an experiment with uncertain outcomes.This experiment is called a(n) _____ experiment.

Question 67

Daniel Kahneman and Amos Tversky (1974) were the first to provide evidence that _____ theory doesn't provide a complete description of how people actually decide under uncertain conditions.

Question 68

_____ refers to money spent that cannot be recovered.

Question 69

A risk-averse person will always hedge the risk completely at a cost that equals the expected loss.This cost is the _____.

Question 70

Humans tend to give more weight to events of the recent past than to look at the entire history.We could attribute such a bias to limited memory, individuals' myopic view, or just availability of more recent information.We call this bias a(n) _____ bias.