Deck 25: The Basic Tools of Finance

Question 1

The insurance market demonstrates the problem of adverse selection when those that are sicker than average seek health insurance.

Answer 1

True

Question 2

Diversification cannot eliminate idiosyncratic risk, which is the uncertainty associated with the specific companies.

Answer 2

False

Question 3

If someone's utility function exhibits diminishing marginal utility of wealth, this person is risk averse.

Answer 3

True

Question 4

Which of the following does not help reduce the risk that people face?

A) increasing the rate of return within their portfolio
B) diversifying their portfolio
C) All of these answers help reduce risk.
D) buying insurance

Question 5

A snow plough will generate a net income of €2,000 per year for its owner. After 8 years, the plough will be worn out and have zero value. The owner has worked out the present value of the net income the snow plough will generate using an interest rate of 10%. Which of the following statements is NOT true?

A) The present value of the final year's net income is less than €1,100.
B) The owner would sell the snow plough if she received an offer of €13,000 for it.
C) The owner would sell the snow plough if she received an offer of €3,500.
D) The present value of the income of the net income the snow plough will generate over the 8 year period is more than €10,000.

Question 6

If people are risk averse, the utility gained from winning €1,000 is equal to the utility lost from losing a €1,000 bet.

Question 7

You have a bond that you can redeem for €10,000 one year from now. The interest rate is 10 per cent per year. How much is the bond worth today?

A) €9,090.91
B) €11,000.00
C) €9,000.00
D) €,523.81

Question 8

If the prevailing interest rate is 10 per cent, a rational person should be indifferent between receiving €1,000 today and €1,000 one year from today.

Question 9

JCB (which makes agricultural and construction equipment) has the opportunity to purchase a new factory today that will provide them with a €50 million return four years from now. If prevailing interest rates are 6 percent, what is the maximum that the project can cost for JCB to be willing to undertake the project?

A) €43,456,838
B) €53,406,002
C) €34,583,902
D) €39,604,682
E) €50,000,000

Question 10

Someone who is risk averse

A) suffers a reduction in utility if their wealth declines by €100 that is smaller than the gain in utility they would obtain if their wealth increased by €100.
B) suffers a reduction in utility if their wealth declines by €100 that is larger than the gain in utility they would obtain if their wealth increased by €100.
C) will always buy insurance against all risks they face, regardless of the price of insurance.
D) is irrational.

Question 11

Which of the following changes would increase the present value of a future payment?

A) a decrease in the size of the payment
B) a decrease in the certainty of the payment actually being received
C) an increase in the amount of time that elapses before receiving the payment
D) a decrease in the interest rate

Question 12

The present value of a future sum is the amount of money today that would be needed, at prevailing interest rates, to produce that future sum.

Question 13

As a person allocates more of his savings to shares and less to government bonds, he will earn a higher rate of return but he must accept additional risk.

Question 14

The amount today that would be needed, at prevailing interest rates, to produce a particular sum in the future is known as

A) future value.
B) fair value.
C) present value.
D) compound value.
E) beginning value.

Question 15

If interest is compounded annually, €100 placed in a bank account earning 10 percent interest should generate €30 interest after three years.

Question 16

The value of a share is based on the present value of the future stream of dividend payments and the final sales price.

Question 17

An increase in the prevailing interest rate

A) increases the present value of future returns from investment, and increases investment.
B) decreases the present value of future returns from investment, and decreases investment.
C) decreases the present value of future returns from investment, and increases investment.
D) increases the present value of future returns from investment, and decreases investment.

Question 18

If a depositor puts €100 in a bank account that earns 4 per cent interest compounded annually, how much will be in the account after five years?

A) €104.00
B) €120.00
C) €121.67
D) €123.98
E) €400.00

Question 19

You are going to receive a €100,000 inheritance in ten years. If the prevailing interest rate is 6 percent, the present value of your inheritance is €55,839.48.

Question 20

You have a choice among three options. Option 1: receive €900 immediately. Option 2: receive €1,200 one year from now. Option 3: receive €2,000 five years from now. The interest rate is 15% per year. Rank these three options from highest present value to lowest present value.

A) Option 1; Option 2; Option 3
B) Option 3; Option 2; Option 1
C) Option 2; Option 3; Option 1
D) Option 3; Option 1; Option 2

Question 21

A market in which prices reflect all available information in a rational way is said to be

A) rationally efficient.
B) informationally efficient.
C) hypothetically efficient.
D) a stock market.

Question 22

Which of the following is an example of moral hazard?

A) After Guiseppe buys fire insurance, he begins to smoke cigarettes in bed.
B) None of these answers demonstrate moral hazard.
C) Martin has been feeling poorly lately so he seeks health insurance.
D) Both of Suzanne's parents lost their teeth due to gum disease, so Suzanne buys dental insurance.
E) All of these answers demonstrate moral hazard.

Question 23

Government bonds are preferred to shares by individual investors who

A) need to have immediate access to their money.
B) wish to diversify their investments.
C) prefer a less risky lower return to a more risky higher return.
D) prefer a more risky higher return to a less risky lower return.

Question 24

Risk is the probability of something happening which results in a ___________________.

A) overvalued share.
B) loss or some degree of hazard or damage.
C) optimal level
D) returns from investing in shares.
E) a poor investment.

Question 25

Compared to a portfolio composed entirely of shares, a portfolio that is 50 per cent government bonds and 50 per cent shares will have a

A) lower return and a lower level of risk.
B) lower return and a higher level of risk.
C) higher return and a lower level of risk.
D) higher return and a higher level of risk.

Question 26

The study of a company's accounting statements and future prospects to determine its value is known as

A) information analysis.
B) risk management.
C) fundamental analysis.
D) diversification.

Question 27

The fact that someone with a high risk of medical problems is more likely to buy a lot of health insurance is an example of

A) adverse selection.
B) monitoring.
C) moral hazard.
D) an optimal contract.

Question 28

From the standpoint of the economy as a whole, the role of insurance is not to eliminate the risks inherent in life but to

A) pay for them.
B) spread them around more efficiently.
C) find good uses for them.
D) make do with them.

Question 29

Which of the following factors would a fundamental analyst consider when predicting a firm's share price?

A) recent changes in the share's price
B) the knowledge and skills of the firm's current management
C) the marketing strategies of the firm's competitors
D) Both b and c are correct.

Question 30

The general feature of insurance contracts is that a person facing a risk pays a fee to an insurance company, which in return

A) agrees to accept all or part of the risk.
B) agrees to accept none of the risk.
C) does not agrees to accept any risk.
D) pays out premiums.

Question 31

Diversification has the advantage of

A) reducing expected return.
B) reducing actual return.
C) reducing risk.
D) reducing the profits of insurance companies.

Question 32

Idiosyncratic risk is the

A) uncertainty associated with the entire economy.
B) uncertainty associated with specific companies.
C) risk associated with adverse selection.
D) risk associated with moral hazard.

Question 33

Which of the following statements is true?

A) Diversification reduces idiosyncratic risk but not aggregate risk.
B) Diversification reduces aggregate risk but not idiosyncratic risk.
C) Diversification reduces both idiosyncratic risk and aggregate risk but it reduces idiosyncratic risk by more.
D) Diversification requires an investor to hold at least 100 shares in her portfolio to begin to reduce risk significantly.

Question 34

If the price of shares is greater than what you believe to be the true value of the business then the stock is

A) undervalued.
B) overvalued.
C) fairly valued.
D) no longer going to be traded.

Question 35

Which of the following should cause the price of a share of stock to rise?

A) None of these answers
B) An increase in expected dividends
C) A reduction in aggregate risk
D) A reduction in the interest rate
E) All of these answers

Question 36

Max 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, Max 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.

Question 37

Diversification is the reduction of risk achieved by replacing a single risk with a large number of

A) greater risks.
B) smaller unrelated risks.
C) risk-free investments.
D) risk-free purchases.

Question 38

Diversification of a portfolio can

A) reduce aggregate risk.
B) eliminate all risk.
C) increase the standard deviation of the portfolio's return.
D) reduce idiosyncratic risk.

Question 39

Economists have developed models of risk aversion using the concept of utility, which is a person's subjective measure of

A) distance
B) height.
C) well-being or satisfaction.
D) money.

Question 40

Which of the following reduces risk in a portfolio the greatest?

A) Increasing the number of shares from 10 to 20
B) All of these answers provide the same amount of risk reduction.
C) Increasing the number of shares in the portfolio from 1 to 10
D) Increasing the number of shares from 20 to 30

Question 41

Draw graphs showing the following three relationships.
a. The relation between utility and wealth for a risk averse consumer.
b. The relation between standard deviation and the number of stocks in a portfolio.
c. The relation between return and risk.

Question 42

There is a __________ between risk and return which is at the heart of understanding financial decisions

A) rule.
B) difference.
C) zero sum game.
D) trade-off.

Question 43

Calculate the future value of €800 one year from today if the interest rate is a) 3% b) 5% c) 7%.

Question 44

Risk is measured here with a statistic called _______________.

A) under-valuation.
B) added value.
C) valuation.
D) standard deviation.

Question 45

Investors need to realize that _______ average returns that they want to enjoy comes at the price of ________ risk.

A) higher, lower.
B) lower, higher.
C) higher, higher.
D) none of the above.

Question 46

Why is an understanding of the concept called present value so critical for those who want to understand finance.

Question 47

Give an example of adverse selection and an example of moral hazard using homeowners insurance.

Question 48

As the interest rate increases, what happens to the present value of a future payment? Explain why changes in the interest rate will lead to changes in the quantity of loanable funds demanded and investment spending.

Question 49

An investor who buys stock in a company is placing a bet on the ___________of that company.

A) future profitability.
B) longevity of the CEO.
C) stakeholders.
D) All of the above are correct.

Question 50

Dividends are the cash payments that a company makes to its _____________

A) customers.
B) employees.
C) stakeholders.
D) shareholders.

Question 51

What factors does a company's profitability depend on and whose job is it to take these factors into account?

Question 52

What's the difference between idiosyncratic risk and aggregate risk? Will diversification eliminate one or both? Explain.

Question 53

List three different ways that a risk-averse person can reduce financial risk.

Question 54

In the 1990s, several stocks had very, very high price to earnings ratios. These stocks appeared overvalued to many observers. What might the people who bought them have been thinking?

Question 55

Demonstrate that whether you would prefer to have €225 today or wait five years for €300 depends on the interest rate. Show your calculations.

Question 56

You have three ways to use fundamental analysis in pick a stock portfolio: 1) do all the necessary research yourself, 2) seek out the advice of a financial analysts, or:

A) put your money into a savings account.
B) buy into index funds.
C) buy stocks that you like.
D) buy into an investment fund that conducts fundamental analysis.

Question 57

If unexpected news raised people's expectations of a corporation's future dividends and price, then before the price changes this corporation's stock would be

A) overvalued, so its price would rise.
B) overvalued, so its price would fall.
C) undervalued, so its price would rise.
D) undervalued, so its price would fall.