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23. Refer to Figure 27-3. Suppose Paul begins with $900 in wealth. Starting from there,
a. Paul would be willing to accept a coin–flip bet that would result in him winning $200 if the result
was “heads” or losing $200 if the result was “tails.”
b. the pain of losing $200 of his wealth would equal the pleasure of adding $200 to his wealth.
c. the pain of losing $200 of his wealth would exceed the pleasure of adding $200 to his wealth.
d. the pleasure of adding $200 to his wealth would exceed the pain of losing $200 of his wealth.
6662 The Basic Tools of Finance
Figure 27-4. The figure shows a utility function for Alex.
24. Refer to Figure 27-4. From the appearance of Alex’s utility function, we know that
a. the pain that Alex would experience if he lost $500 of his wealth would exceed the pleasure that
he would experience if he added $500 to his wealth.
b. the pleasure that Alex would experience if he added $500 to his wealth would exceed the pain
that he would experience if he lost $500 of his wealth.
c. the property of increasing utility does not apply to Alex.
d. the property of diminishing marginal utility does not apply to Alex.
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25. Refer to Figure 27-4. From the appearance of Alex’s utility function, we know that
a. if Alex owns a house, then he definitely would buy fire insurance provided the cost of the
insurance was reasonable.
b. Alex would voluntarily exchange a portfolio of stocks with a high average return and a high
level of risk for a portfolio with a low average return and a low level of risk.
c. Alex is risk averse.
d. Alex is not risk averse.
26. Refer to Figure 27-4. If most people’s utility functions look like Alex’s utility function, then it is
easy to explain
why
a. people buy various types of insurance.
b. we observe a trade-off between risk and return.
c. most people prefer to hold diversified portfolios of assets to undiversified portfolios of assets.
d. None of the above are correct.
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Figure 27-5. The figure shows a utility function for Dexter.
27. Refer to Figure 27-5. In what way(s) does the graph differ from the usual case?
a. The utility function shown here is upward–sloping, whereas in the usual case the utility function
is downward– sloping.
b. The utility function shown here is bowed downward (convex), whereas in the usual case the
utility function is bowed upward (concave).
c. On the graph shown here, wealth is measured along the horizontal axis, whereas in the usual
case saving is measured along the horizontal axis.
d. On the graph shown here, utility is measured along the vertical axis, whereas in the usual case
satisfaction is measured along the vertical axis.
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28. Refer to Figure 27-5. From the appearance of the graph, we know that
a. Dexter’s level of satisfaction increases by more when his wealth increases from $1,001 to
$1,002 than it
does when his wealth increases from $1,000 to $1,001.
b. Dexter’s level of satisfaction increases by less when his wealth increases from $1,001 to $1,002
than it does
when his wealth increases from $1,000 to $1,001.
c. Dexter’s level of satisfaction increases by the same amount when his wealth increases from
$1,001 to
$1,002 as it does when his wealth increases from $1,000 to $1,001.
d. None of the above answers can be inferred from the appearance of the utility function.
29. Refer to Figure 27-5. From the appearance of the utility function, we know that
a. Dexter is risk averse.
b. Dexter gains less satisfaction when his wealth increases by X dollars than he loses in
satisfaction when his wealth decreases by X dollars.
c. the property of diminishing marginal utility does not apply to Dexter.
d. All of the above are correct.
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30. Refer to Figure 27-5. From the appearance of the utility function, we know that
a. Dexter is risk averse.
b. Dexter gains more satisfaction when his wealth increases by X dollars than he loses in
satisfaction when his wealth decreases by X dollars.
c. the property of decreasing marginal utility applies to Dexter.
d. All of the above are correct.
31. Refer to Figure 27-5. Suppose the vertical distance between the points (0, A) and (0, B) is 12.
If his wealth increased from $1,300 to $1,800, then
a. Dexter’s subjective measure of his well-being would increase by less than 12 units.
b. Dexter’s subjective measure of his well-being would increase by more than 12 units.
c. Dexter would change from being a risk-averse person into a person who is not risk averse.
d. Dexter would forgo the insurance he bought when his wealth was $1,300.
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32. Refer to Figure 27-5. Suppose Dexter begins with $1,300 in wealth. Starting from there,
a. the pain of losing $500 of his wealth would equal the pleasure of adding $500 to his wealth.
b. the pain of losing $500 of his wealth would exceed the pleasure of adding $500 to his wealth.
c. the pleasure of adding $500 to his wealth would exceed the pain of losing $500 of his wealth.
d. This cannot be determined from the graph.
33. From the standpoint of the economy as a whole, the role of insurance is
a. to entice risk-loving people to become risk averse.
b. to promote the phenomenon of adverse selection.
c. not to eliminate the risks inherent in life, but to spread them around more efficiently.
d. not to spread risks, but to eliminate them for individual policy holders.
34. The problem of moral hazard arises because
a. life is full of all sorts of risks.
b. after people buy insurance, they have less incentive to be careful about their risky behavior.
c. a high-risk person is more likely to apply for insurance than is a low-risk person.
d. insurance companies go to great effort to avoid paying claims to their policy holders.
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35. As the number of stocks in a person’s portfolio increases,
a. the risk of the portfolio increases, as indicated by the increasing value of the standard deviation
of the portfolio.
b. the risk of the portfolio increases, as indicated by the decreasing value of the standard deviation
of the portfolio.
c. the risk of the portfolio decreases, as indicated by the increasing value of the standard deviation
of the portfolio.
d. the risk of the portfolio decreases, as indicated by the decreasing value of the standard deviation
of the portfolio.
36. The largest reduction in a portfolio’s risk is achieved when the number of stocks in the portfolio is
increased from
a. 80 to 100.
b. 40 to 80.
c. 10 to 20.
d. 1 to 10.
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37. Diversification of a portfolio
a. can eliminate market risk, but it cannot eliminate firm-specific risk.
b. can eliminate firm-specific risk, but it cannot eliminate market risk.
c. increases the portfolio’s standard deviation.
d. is not necessary for a person who is risk averse.
38. Mary Beth is risk averse and has $1,000 with which to make a financial investment. She has three
options. Option A is a risk-free government bond that pays 5 percent interest each year for two
years. Option B is a low-risk stock that analysts expect to be worth about $1,102.50 in two years.
Option C is a high-risk stock that is expected to be worth about $1,200 in four years. Mary Beth
should choose
a. option A.
b. option B.
c. option C.
d. either A or B because they are the same to her.
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39. A measure of the volatility of a variable is its
a. present value.
b. future value.
c. return.
d. standard deviation.
40. A risk-averse person
a. has a utility curve where the slope increases with wealth, and might take a bet with a 80
percent chance of winning $300 and a 20 per chance of losing $300.
b. has a utility curve where the slope increases with wealth, and would never take a bet with a 80
percent chance of winning $300 and a 20 per cent chance of losing $300.
c. has a utility curve where the slope decreases with wealth, and might take a bet with a 80
percent chance of winning $300 and a 20 per chance of losing $300.
d. has a utility curve where the slope decreases with wealth, and would never take a bet with a 80
percent chance of winning $300 and a 20 per cent chance of losing $300.
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41. If a person is risk averse, then she has
a. diminishing marginal utility of wealth, implying that her utility function gets flatter as wealth
increases.
b. diminishing marginal utility of wealth, implying that her utility function gets steeper as wealth
increases.
c. increasing marginal utility of wealth, implying that her utility function gets flatter as wealth
increases.
d. increasing marginal utility of wealth, implying that her utility function gets steeper as wealth
increases.
42. If Alan is risk-averse, then he will always
a. choose not to play a game where he has a 50 percent chance of winning $5 and a 50 percent
chance of losing $5.
b. choose not to play a game where he has a 75 percent chance of winning $5 and a 25 percent
chance of losing $5.
c. choose to play a game where he has a 55 percent chance of winning $5 and a 45 percent
chance of losing
$5.
d. All of the above are correct.
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43. Which of the following games might a risk-averse person play?
a. a game where she has a 50 percent chance of winning $1 and a 50 percent chance of losing $1
b. a game where she has a 50 percent chance of winning $100 and a 50 percent chance of losing
$100
c. a game where she has a 60 percent chance of winning $1 and a 40 percent chance of losing $1
d. a game where she has a 40 percent chance of winning $1 and a 60 percent chance of losing $1
44. Which of the following games might a risk-averse person play?
a. a game where she has a 70 percent chance of winning $1 and a 30 percent chance of losing $1
b. a game where she has a 60 percent chance of winning $100 and a 40 percent chance of losing
$100
c. a game where she has a 60 percent chance of winning $2 and a 40 percent chance of losing $1
d. All of the above are correct.
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45. Which of the following is correct concerning a risk-averse person?
a. She would not play games where the probability of winning and losing a dollar are the same.
b. She might not buy health insurance if she thinks her risks are low.
c. Her marginal utility of wealth decreases as her income increases.
d. All of the above are correct.
46. Svetlana is risk averse. Which of the following is correct about Svetlana?
a. Her marginal utility of wealth increases as her income increases.
b. She will always accept a bet if the probability of winning a dollar is the same as the probability
of losing a dollar.
c. Her utility function is a straight line.
d. None of the above are correct.
47. The utility function of a risk-averse person has a
a. positive slope and gets steeper as wealth increases.
b. positive slope but gets flatter as wealth increases.
c. negative slope but gets steeper as wealth increases.
d. negative slope and gets flatter as wealth increases.
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48. A risk-averse person has
a. utility and marginal utility curves that slope upward.
b. utility and marginal utility curves that slope downward.
c. a utility curve that slopes down and a marginal utility curve that slopes upward.
d. a utility curve that slopes upward and a marginal utility curve that slopes downward.
49. Diminishing marginal utility of wealth implies that the utility function is
a. upward-sloping and has decreasing slope.
b. upward-sloping and has increasing slope.
c. downward-sloping and has decreasing slope.
d. downward-sloping and has increasing slope.
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50. If a person is risk averse, then as wealth increases, total utility of wealth
a. increases at an increasing rate.
b. increases at a decreasing rate.
c. decreases at an increasing rate.
d. decreases at a decreasing rate.
51. Given that Tamar is a risk-averse person, she might accept a bet with a 50 percent chance of
losing $100 today if she had a 50 percent
a. chance of winning $120 in two years and the interest rate was 11%.
b. chance of winning $114 in two years and the interest rate was 7%.
c. chance of winning $110 in two years and the interest rate was 3%.
d. None of the above are correct; a risk averse person would not accept any of the above bets.
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52. Risk
a. can be reduced by placing a large number of small bets rather than a small number of large
bets.
b. can be reduced by increasing the number of stocks in a portfolio.
c. Both A and B are correct.
d. Neither A nor B are correct.
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53. The last $2,000 of Rolanda‘s wealth adds less to her utility than the previous $2,000. Based on this
information,
Rolanda has
a. increasing marginal utility of wealth and is risk averse.
b. increasing marginal utility of wealth and is not risk averse.
c. decreasing marginal utility of wealth and is risk averse.
d. decreasing marginal utility of wealth and is not risk averse.
54. Recently, Lisa’s wealth increased by $500. If her wealth were to increase by another $500 in the
near future, then her utility would increase, but not by as much as it increased with the recent
increase to her wealth. Based on this information, Lisa‘s utility function
a. and marginal utility function are both upward sloping.
b. and marginal utility function are both downward sloping.
c. is upward sloping and her marginal utility function is downward sloping.
d. is downward sloping and her marginal utility function is upward sloping.
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55. Suppose that Thom experiences a greater loss in utility if he loses $50 than he would gain in utility
if he wins $50.
This implies that Thom’s
a. marginal utility diminishes as wealth rises, so he must be risk averse.
b. marginal utility diminishes as wealth rises, but we can’t tell from this if he is risk averse.
c. marginal utility increases as wealth rises, so he must be risk averse.
d. marginal utility increases as wealth rises, but we can’t tell from this if he is risk averse.
56. Which of the following defines an annuity?
a. For a fee, an insurance company provides you with regular income until you die.
b. A surcharge is added to life-insurance premiums paid by persons in dangerous occupations.
c. Annuity is another name for stock funds managed by mutual fund managers.
d. Annuity is another name for any diversified portfolio.
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57. Rory receives, from an insurance company, a payment of $5,000 each year, and he will continue
to receive these payments until he dies. This series of payments is called a(n)
a. portfolio.
b. bond.
c. dividend.
d. annuity.
58. In effect, an annuity provides insurance
a. against the risk of dying and leaving one’s family without a regular income.
b. against the risk of living too long.
c. to people who are not risk-averse.
d. to people whose utility functions do not display the usual properties.
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59. Which of the following actions best illustrates adverse selection?
a. A person adds risky stock to his portfolio.
b. A person who has narrowly avoided many accidents applies for automobile insurance.
c. A person is unwilling to buy a stock when she believes its price has an equal chance of rising or
falling $10.
d. A person purchases homeowners insurance and then checks his smoke detector batteries less
frequently.
60. Which of the following actions best illustrates moral hazard?
a. A person adds risky stock to his portfolio.
b. A person who has narrowly avoided many accidents applies for automobile insurance.
c. A person is unwilling to buy a stock when she believes its price has an equal chance of rising or
falling $10.
d. A person purchases homeowners insurance and then checks his smoke detector batteries less
frequently.