Deck 14: Risk Analysis

Question 1

Use the following to answer questions below:


-Graphs of utility of income represent four different individuals. Which of them would reflect the attitude of an individual who is risk averse at all levels of income?

A) Individual A
B) Individual B
C) Individual C
D) Individual D

Answer 1

Individual C

Question 2

Use the following to answer questions below:


-Refer to the total utility graphs. Which graph would reflect the attitude of an individual who is risk neutral at all levels of income?

A) Individual A
B) Individual B
C) Individual C
D) Individual D

Answer 2

Individual B

Question 3

Use the following to answer questions below:


-Refer to the total utility graphs. Which graph would reflect the attitude of an individual who is a risk seeker at all levels of income?

A) Individual A
B) Individual B
C) Individual C
D) Individual D

Answer 3

Individual A

Question 4

Use the following to answer questions below:


-Refer to the total utility graphs. Which graph would reflect the attitude of an individual who might purchase insurance and gamble?

A) Individual A
B) Individual B
C) Individual C
D) Individual D

Question 5

An investment opportunity will pay $50 with a 10 percent probability and $20 with a 40 percent probability, and will result in a loss of $20 with a 50 percent probability. What is the expected value of the investment?

A) $3
B) $13
C) $23
D) None of the above is correct.

Question 6

An investment opportunity will pay $10 with a 20 percent probability, $20 with a 40 percent probability, $30 with a 30 percent probability, and $40 with a 10 percent probability. What is the standard deviation of the investment?

A) 3
B) 9
C) 81
D) None of the above is correct.

Question 7

An investment opportunity will pay $1 with a 20 percent probability, $2 with a 50 percent probability, and $6 with a 30 percent probability. What is the coefficient of variation of the investment?

A) 4/3
B) 3/4
C) 2/3
D) None of the above is correct.

Question 8

Investment A has an expected value of 5 and a standard deviation of 2. Investment B has an expected value of 10 and a standard deviation of 5. Using the coefficient of variation approach to comparing these two investments,

A) Investment A would be selected because it has the larger coefficient of variation.
B) Investment B would be selected because it has the larger coefficient of variation.
C) Investment A would be selected because it has the smaller coefficient of variation.
D) Investment B would be selected because it has the smaller coefficient of variation.

Question 9

The strategy selected on the basis of maximizing expected monetary value is the same as that selected on the basis of maximizing expected utility if

A) an individual is risk averse.
B) an individual is risk neutral.
C) an individual is risk seeking.
D) None of the above is necessarily correct.

Question 10

An individual is indifferent between a certain payment of $8 and a game that will pay $20 or nothing with equal probabilities. The individual has a certainty equivalent coefficient of

A) 0.40.
B) 0.50.
C) 0.80.
D) 1.25.

Question 11

An individual is indifferent between a certain payment of $20 and a game that will pay $50 or nothing with equal probabilities. The individual has a certainty equivalent coefficient of

A) 0.20.
B) 0.40.
C) 0.80.
D) 2.50.

Question 12

An individual has a certainty equivalent coefficient equal to 0.40. What is the most this individual would pay to play a game that pays $50 or $30 with equal probability?

A) $16
B) $32
C) $40
D) $100

Question 13

An individual must decide whether or not to pursue a business opportunity. If he does pursue the opportunity, then he will get a $20 profit if the business is successful and a $10 loss if the business fails. Apply the maximin and minimax regret criteria to this decision.

A) Maximin: Do not invest. Minimax regret: Do not invest.
B) Maximin: Do not invest. Minimax regret: Invest.
C) Maximin: Invest. Minimax regret: Do not invest.
D) Maximin: Invest. Minimax regret: Invest.

Question 14

An individual must decide whether or not to pursue a business opportunity. If he does pursue the opportunity, then he will get a $20 profit if the business is very successful and a $10 profit if the business is not very successful. Apply the maximin and minimax regret criteria to this decision.

A) Maximin: Do not invest. Minimax regret: Do not invest.
B) Maximin: Do not invest. Minimax regret: Invest.
C) Maximin: Invest. Minimax regret: Do not invest.
D) Maximin: Invest. Minimax regret: Invest.

Question 15

An individual must choose between two business opportunities. If he invests in A, then he will get a $20 profit if the economy is expanding and an $8 loss otherwise. If he invests in B, then he will get a $10 profit if the economy is expanding and break even otherwise. Apply the maximin and minimax regret criteria to this decision.

A) Maximin: Invest in A. Minimax regret: Invest in B.
B) Maximin: Invest in B. Minimax regret: Invest in B.
C) Maximin: Invest in A. Minimax regret: Invest in A.
D) Maximin: Invest in B. Minimax regret: Invest in A.

Question 16

A situation in which a decision maker knows all of the possible outcomes of a decision and also knows the probability associated with each outcome is referred to as

A) certainty.
B) risk.
C) uncertainty.
D) strategy.

Question 17

Which of the following methods of selecting a strategy is consistent with risk-averting behavior?

A) If two strategies have the same expected profit, select the one with the smaller standard deviation.
B) If two strategies have the same standard deviation, select the one with the smaller expected profit.
C) Select the strategy with the larger coefficient of variation.
D) All of the above are correct.

Question 18

Which one of the following does not measure risk?

A) Coefficient of variation
B) Standard deviation
C) Expected value
D) All of the above are measures of risk.

Question 19

If a person's utility doubles when his or her income doubles, then that person is risk

A) averse.
B) neutral.
C) seeking.
D) There is not enough information given in the question to determine an answer.

Question 20

Strategy A has an expected value of 10 and a standard deviation of 3. Strategy B has an expected value of 10 and a standard deviation of 5. Strategy C has an expected value of 15 and a standard deviation of 10. Which one of the following statements is true?

A) A risk-averse decision maker will always prefer A to B, but may prefer C to A.
B) A risk-neutral decision maker will always prefer C to A or B.
C) A risk-seeking decision maker will always prefer C to A or B.
D) All of the above are correct.

Question 21

The coefficient of variation measures

A) the risk per unit of expected payoff.
B) the risk-adjusted expected value.
C) the payoff per unit of risk.
D) a decision maker's risk-return trade-off.

Question 22

A situation in which a decision maker must choose between strategies that have more than one possible outcome when the probability of each outcome is unknown is referred to as

A) diversification.
B) certainty.
C) risk.
D) uncertainty.

Question 23

If a decision maker is risk averse, then the best strategy to select is the one that yields the

A) highest expected payoff.
B) lowest coefficient of variation.
C) highest expected utility.
D) lowest standard deviation.

Question 24

Circumstances that influence the profitability of a decision are referred to as

A) strategies.
B) a payoff matrix.
C) states of nature.
D) the marginal utility of money.

Question 25

The marginal utility of money diminishes for a decision maker who is

A) a risk seeker.
B) risk neutral.
C) a risk averter.
D) in a situation of uncertainty.

Question 26

A strategy that yields an expected monetary payoff of zero is called a

A) risk-neutral strategy.
B) fair game.
C) zero-sum game.
D) certainty equivalent.

Question 27

A risk-return trade-off function

A) shows the minimum expected return required to compensate an investor for accepting various levels of risk.
B) slopes upward for a risk-averse decision maker.
C) is horizontal for a risk-neutral decision maker.
D) All of the above are correct.

Question 28

If the market interest rate is 10 percent and a decision maker's risk-adjusted discount rate is 12 percent, then the decision maker

A) is risk averse.
B) has a certainty-equivalent coefficient that is greater than one.
C) is risk neutral.
D) None of the above is correct.

Question 29

Fred is willing to pay $1 for a lottery ticket that has an expected value of zero. This proves that Fred

A) is risk averse.
B) has a certainty-equivalent coefficient that is equal to one.
C) is risk neutral.
D) None of the above is correct.

Question 30

The analysis of a complex decision situation by constructing a mathematical model of the situation and then performing a large number of iterations in order to determine the probability distribution of outcomes is called

A) sensitivity analysis.
B) expected utility analysis.
C) simulation.
D) a decision tree.

Question 31

A payoff matrix presents all the information required to determine the optimal strategy using the

A) expected value criterion.
B) the maximin criterion.
C) the utility maximization criterion.
D) simulation criterion.

Question 32

Which of the following is not a way to deal with decision making under uncertainty?

A) Simulation
B) Diversification
C) Acquisition of additional information
D) Application of the maximin criterion

Question 33

A matrix that, for each state of nature and strategy, shows the difference between a strategy's payoff and the best strategy's payoff is called

A) a maximin matrix.
B) a minimax regret matrix.
C) a payoff matrix.
D) an expected utility matrix.

Question 34

The sequence of possible managerial decisions and their expected outcome under each set of circumstances can be represented and analyzed by using

A) the minimax regret criterion.
B) a decision tree.
C) a payoff matrix.
D) simulation.

Question 35

According to a survey carried out by Gitman and Forrester that was published in 1977, the most common way for businesses in the United States to deal with risk in capital budgeting decisions is by

A) ignoring it.
B) using the certainty-equivalent method.
C) using the risk-adjusted discount rate method.
D) using the expected utility method.

Question 36

The principal-agent problem may result if

A) a firm is owned and operated by the same person.
B) managers make decisions that are not in the best interest of owners.
C) a firm compensates managers based on the profitability of the firm.
D) All of these answers are correct.

Question 37

One way to correct a potential principal-agent problem is for stockholders to

A) offer managers "golden parachutes" in the event of a takeover.
B) empower managers to make the decisions they feel are best.
C) ensure that there is no explicit linkage between managers' compensation and the profitability of the firm.
D) All of these answers are correct.

Question 38

Which of the following is a sequential, ascending bid auction?

A) Dutch auction
B) First-price sealed bid auction
C) Second-price sealed bid auction
D) English auction

Question 39

Which of the following is a descending bid auction?

A) Dutch auction
B) First-price sealed bid auction
C) Second-price sealed bid auction
D) English auction

Question 40

The winner's curse refers to

A) the reaction of losers in an English auction to the winner.
B) a tax imposed on the winners of English auctions.
C) paying an amount that exceeds the true value of an item at auction.
D) a Dutch auction in which the winner is obliged, by tradition, to berate the auctioneer.

Question 41

Which of the following would suggest a decline in the level of risk in the U.S. financial markets

A) A rise in VIX
B) An increase in the interest rate spread between a AAA corporate bond and an equivalent in maturity U.S. Treasury bond
C) A decline in the U.S. Treasury bond yields
D) None of the above

Question 42

During the past decade the stock of Company A has been very stable with daily price changes staying under 1% more than 90% of the time. The stock of Company B has been less stable and daily price changes in excess of 1% tend to be observed more than 50% of the time. The standard deviation for daily price changes is higher for Company B. Based on this, we can conclude that

A) A daily return on the stock of company A is less risky
B) A daily return on the stock of company B is less risky
C) Both companies have the same level of risk about their daily stock returns
D) None of the above.

Question 43

If a project pays $1,000 with 40% probability and $0 with 60% probability, what is the expected return on this project?

A) $1,000
B) $600
C) $400
D) None of the above

Question 44

John is not willing to pay $2 for a lottery that has an expected value of $3 while Ben is willing to pay $4 for the same lottery. What can we tell about John and Ben?

A) John is risk-seeker, Ben is risk-averse
B) John is risk-averse, Ben is risk-seeking
C) Both, John and Ben, are risk-seeking
D) Both, John and Ben, are risk-averse

Question 45

The difference between the required rate of return on a risky investment and the rate of return on risk-free asset is known as

A) certainty equivalence.
B) certainty premium.
C) risk premium.
D) risk equivalence.

Question 46

The sum received with certainty that makes one indifferent to the expected return from risky lottery is known as

A) certainty equivalence.
B) certainty premium.
C) risk premium.
D) risk equivalence.

Question 47

Sequence of decisions and events can be best represented graphically by

A) uncertainty tree.
B) conditional probability tree.
C) risk sequence tree.
D) decision tree.

Question 48

If Firm A charges a high price for its product, the probability that a competitor will respond with a high price is 0.7. If the probability of an economy going to recession next year is 0.3, what is the probability of the competitor charging a high price and a recession starting next year if Firm A charges a high price?

A) 0.21
B) 0.3
C) 0.4
D) 0.7

Question 49

Assume, the exchange rate between the US dollar and the Euro right now is $1/€1. Which of the following is correct about the US dollar with respect to Euro if the next year the exchange rate becomes $1.1/€1.

A) US dollar appreciated
B) US dollar depreciated
C) US dollar neither appreciated, nor depreciated
D) US dollar both appreciated and depreciated

Question 50

An agreement to purchase or sell foreign security at a rate specified today for the delivery in the future is known as a

A) hedging contract.
B) forward contract.
C) future agreement.
D) forward agreement.

Question 51

After buying a used car, you find out that there were many hidden problems. If you knew these issues before, you would not have offered so much for it. This is a typical example of what economists call

A) people being people.
B) untrustworthy sellers.
C) asymmetric information.
D) adverse selection.

Question 52

People who have certain health conditions may be more likely to seek better health insurances with higher coverage driving up the costs while people who are healthy may not want to spend much for health insurance as they believe they will need less healthcare. This is a problem of

A) market for lemons.
B) adverse selection.
C) moral hazard.
D) all of the above.

Question 53

After John bought a more expensive car insurance, he started driving recklessly. This is an example of

A) market for lemons.
B) adverse selection.
C) moral hazard.
D) all of the above.

Question 54

The principal-agent problem can be best described as

A) owners and managers having different interests.
B) owners and managers not being able to work together productively.
C) managers not being accountable to owners.
D) owners not treating managers with respect.

Question 55

The firm has estimated the three different returns under different states of economy. The probabilities of each state and the returns are provided in the table below. What is the expected return for the firm?
$$\begin{array} { | l | l | l | l | } \hline \text { State of Economy } & \text { Recession } & \text { Normal } & \text { Boom } \\\hline \text { Probability } & 0.2 & 0.7 & 0.1 \\\hline \text { Return } & - 100,000 & 200,000 & 500,000 \\\hline\end{array}$$

A) 110,000
B) 130,000
C) 150,000
D) 170,000

Question 56

The firm has estimated the three different returns under different states of economy. The probabilities of each state and the returns are provided in the table below. What is the expected return for the firm?
$$\begin{array} { | l | l | l | l | } \hline \text { State of Economy } & \text { Recession } & \text { Normal } & \text { Boom } \\\hline \text { Probability } & 0.4 & 0.5 & 0.1 \\\hline \text { Return } & - 100,000 & 200,000 & 500,000 \\\hline\end{array}$$

A) 110,000
B) 130,000
C) 150,000
D) 170,000

Question 57

The firm has estimated the three different returns under different states of economy. The probabilities of each state and the returns are provided in the table below. What is the variance of the firm's returns?
$$\begin{array} { | l | l | l | l | } \hline \text { State of Economy } & \text { Recession } & \text { Normal } & \text { Boom } \\\hline \text { Probability } & 0.2 & 0.7 & 0.1 \\\hline \text { Return } & - 100 & 200 & 500 \\\hline\end{array}$$

A) 161.55
B) 192.09
C) 26100
D) 36900

Question 58

The firm has estimated the three different returns under different states of economy. The probabilities of economy reaching a particular state and the returns are provided in the table below. What is the variance of the firm's returns?
$$\begin{array} { | l | l | l | l | } \hline \text { State of Economy } & \text { Recession } & \text { Normal } & \text { Boom } \\\hline \text { Probability } & 0.4 & 0.5 & 0.1 \\\hline \text { Return } & - 100 & 200 & 500 \\\hline\end{array}$$

A) 161.55
B) 192.09
C) 26100
D) 36900

Question 59

The firm has estimated the three different returns under different states of economy. The probabilities of each state and the returns are provided in the table below. What is the standard deviation of the firm's returns?
$$\begin{array} { | l | l | l | l | } \hline \text { State of Economy } & \text { Recession } & \text { Normal } & \text { Boom } \\\hline \text { Probability } & 0.2 & 0.7 & 0.1 \\\hline \text { Return } & - 100 & 200 & 500 \\\hline\end{array}$$

A) 161.55
B) 192.09
C) 26100
D) 36900

Question 60

The firm has estimated the three different returns under different states of economy. The probabilities of economy reaching a particular state and the returns are provided in the table below. What is the standard deviation of the firm's returns?
$$\begin{array} { | l | l | l | l | } \hline \text { State of Economy } & \text { Recession } & \text { Normal } & \text { Boom } \\\hline \text { Probability } & 0.4 & 0.5 & 0.1 \\\hline \text { Return } & - 100 & 200 & 500 \\\hline\end{array}$$

A) 161.55
B) 192.09
C) 26100
D) 36900

Question 61

A payoff matrix shows the profit that would be earned under certainty, risk, and uncertainty so the decision maker can choose which is best.

Question 62

Decisions made under risk require a decision maker to choose both a strategy and a state of nature.

Question 63

A list of all possible states of nature and their probabilities is referred to as a probability distribution.

Question 64

If the probability that the economy will be in recession is 0.40, then the probability that the economy will not be in a recession must be 0.60.

Question 65

The expected profit of a strategy is equal to the level of profit realized from the outcome with the highest level of probability.

Question 66

The expected value of a strategy is a measure of risk.

Question 67

The normal probability distribution is an example of a discrete probability distribution.

Question 68

All normal distributions have a mean equal to zero.

Question 69

If a person's total utility more than doubles when his or her wealth doubles, then that person is a risk averter.

Question 70

The expected value of a fair game is zero.

Question 71

If a person is risk averse, then he or she will only play games that have an expected value that is negative.

Question 72

A lower risk-adjusted discount rate should be used to evaluate an investment project that involves a higher level of risk.

Question 73

The riskier a project is, the smaller its certainty equivalent will be.

Question 74

A decision tree shows a sequence of decisions and their outcomes under all states of nature.

Question 75

The maximin criterion is applied by first selecting the best outcome from each strategy and then identifying the strategy that has the lowest of the best outcomes.

Question 76

The maximin and minimax regret criteria always lead to the same conclusion, but they identify it using different methods.

Question 77

In general, uncertainty can be eliminated by gathering additional information.

Question 78

Diversification provides a way of reducing risk and uncertainty.

Question 79

Investments in foreign currency-denominated assets can be hedged by using the forward market in currencies.

Question 80

Hedging refers to the practice of making foreign investments.