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61. Tami knows that people in her family die young, and so she buys life insurance. Preston knows he
is a reckless driver and so he applies for automobile insurance.
a. These are both examples of adverse selection.
b. These are both examples of moral hazard.
c. The first example illustrates adverse selection, and the second illustrates moral hazard.
d. The first example illustrates moral hazard, and the second illustrates adverse selection.
62. Abby buys health insurance because she knows that she has health risks that wouldn’t be obvious
to an insurance company. Brad buys home owners insurance and then is less careful to make
sure he’s put out his cigarettes. The example with Abby
a. and the example with Brad illustrate adverse selection.
b. and the example with Brad illustrate moral hazard.
c. illustrates adverse selection; the example with Brad illustrates moral hazard.
d. illustrates moral hazard; the example with Brad illustrates adverse selection.
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63. Which of the following is adverse selection?
a. the risk associated with selecting stocks in only a few specific companies
b. the risk that a person will become overconfident in his ability to select stocks
c. a high-risk person being more likely to apply for insurance
d. after obtaining insurance a person having less incentive to be careful
64. Which of the following best illustrates moral hazard?
a. After a person obtains life insurance, she takes up skydiving.
b. A person obtains insurance knowing he is in poor health.
c. A person holds stock only in very risky corporations.
d. A person holds stocks from only a few corporations.
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65. When you rent a car, you might treat it with less care than you would if it were your own. This is
an example of
a. market risk.
b. moral hazard.
c. adverse selection.
d. risk aversion.
66. Financial intermediaries typically require mortgage borrowers to have homeowner’s insurance and
do credit checks before making the loan.
a. The insurance requirement and the credit check are both designed primarily to reduce adverse
selection.
b. The insurance requirement and the credit check are both designed primarily to reduce the risk
of moral hazard.
c. The insurance requirement is designed primarily to reduce adverse selection; the credit check is
designed primarily to reduce the risk of moral hazard.
d. The insurance requirement is designed primarily to reduce the risk of moral hazard; the credit
check is designed primarily to reduce adverse selection.
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67. You may be unwilling to buy a used car because you suspect the last owner found out the car was
a lemon. You may treat a car you rented with a little less care than you would use on your own
car.
a. Both examples primarily illustrate adverse selection.
b. Both examples primarily illustrate moral hazard.
c. The first example primarily illustrates adverse selection; the second primarily illustrates moral
hazard.
d. The first example primarily illustrates moral hazard; the second primarily illustrates adverse
selection.
68. Over the past two centuries, the average annual rates of return were about
a. 5 percent for stocks and about 1.5 percent for short-term government bonds.
b. 6 percent for stocks and about 2.5 percent for short-term government bonds.
c. 8 percent for stocks and about 3 percent for short-term government bonds.
d. None of the above is correct.
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69. Risk-averse people will choose different asset portfolios than people who are not risk averse. Over
a long period of time, we would expect that
a. every risk-averse person will earn a higher rate of return than every non-risk-averse person.
b. every risk-averse person will earn a lower rate of return than every non-risk-averse person.
c. the average risk-averse person will earn a higher rate of return than the average non-risk-
averse person.
d. the average risk-averse person will earn a lower rate of return than the average non-risk-
averse person.
70. Which of the following is not correct?
a. The higher average return on stocks than on bonds comes at the price of higher risk.
b. Risk–averse persons will take the risks involved in holding stocks if the average return is high
enough to compensate for the risk.
c. Insurance markets reduce risk, but not by diversification.
d. Risk can be reduced by placing a large number of small bets, rather than a small number of
large bets.
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71. Shawn determines that if Lexall Corporation has high revenues, then Waters Corporation will
have low revenues, and that if Lexall Corporation has low revenues, then Waters Corporation will
have high revenues. Shawn buys stock in both corporations.
a. He has reduced firm-specific risk but not market risk.
b. He has reduced market risk, but not firm-specific risk.
c. He had reduce both firm-specific risk and market risk.
d. He has reduced neither firm-specific risk nor market risk.
72. Amanda talks with several different brokers at a social gathering. She hears the following advice
from brokers A, B, and C. Which broker, if any, gave her incorrect advice?
a. Broker A: “There are risks in holding stocks, even in a highly diversified portfolio.”
b. Broker B: “Portfolios with smaller standard deviations have lower risk.”
c. Broker C: “Stocks with greater risks offer lower average returns.”
d. They all gave her correct advice.
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73. Chloe talked to several stockbrokers and made the following conclusions. Which, if any, of
Chloe’s conclusions are
correct?
a. It is relatively easy to reduce firm-specific risk by increasing the number of companies one
holds stock in.
b. Stock prices, even if not exactly a random walk, are very close to it.
c. Some people have made a lot of money in the stock market by using insider information, but
these cases are not contrary to the efficient markets hypothesis.
d. All of Chloe’s conclusions are correct.
74. Other things the same, as the number of stocks in a portfolio rises,
a. risk increases and the standard deviation of the return rises.
b. risk increases and the standard deviation of the return falls.
c. risk decreases and the standard deviation of the return rises.
d. risk decreases and the standard deviation of the return falls.
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75. 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.
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Figure 27-6. On the graph, x represents risk and y represents return.
76. 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.
77. 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.
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78. 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.
79. 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.
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80. 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
81. 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.
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82. 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.
83. 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.
84. 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.
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85. 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.
86. 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.
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87. 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.
88. 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.
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89. 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.
90. 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.
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91. 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. firm-specific risk, which will likely raise shareholders’ demand for higher return.
b. firm-specific 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.
92. 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.
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93. The idea of insurance
a. would not appeal to a risk-averse person.
b. is, other things the same, to reduce the probability of a fire, accident, or death.
c. is to share risk.
d. is to provide a sure thing, not a gamble.
94. 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.
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95. 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.
96. As the number of stocks in a portfolio rises,
a. both firm-specific risks and market risk fall.
b. firm-specific risks fall; market risk does not.
c. market risk falls; firm-specific risks do not.
d. neither firm-specific risks nor market risk falls.
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97. In general, as a person includes fewer stocks and more bonds in his portfolio,
a. both risk and expected return rise.
b. risk rises but expected return falls.
c. risk falls, but expected return rises.
d. both risk and expected return fall.
98. People who hold well-diversified portfolios of stocks have greatly reduced or eliminated
a. firm-specific risk, and so they do not need to worry about their wealth decreasing as a result of
recessions.
b. market risk, and so they do not need to worry about their wealth decreasing as a result of
recessions.
c. firm-specific risk, but still they have reason to worry about their wealth decreasing as a result of
recessions.
d. market risk, but still they have reason to worry about their wealth decreasing as a result of
recessions.
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99. If Cara’s utility falls more by losing $600 than it rises by gaining $600, she has
a. increasing marginal utility of wealth and is risk averse.
b. increasing marginal utility of wealth but is not risk averse.
c. decreasing marginal utility of wealth and is risk averse.
d. decreasing marginal utility of wealth but is not risk averse.
100. Diversifying
a. increases the standard deviation of the value of a portfolio indicating its risk has increased.
b. increases the standard deviation of the value of a portfolio indicating its risk has decreased.
c. decreases the standard deviation of the value of a portfolio indicating its risk has increased.
d. decreases the standard deviation of the value of a portfolio indicating its risk has decreased.
101. A person who is risk averse might accept a 50% chance of losing $100 today in exchange for a
50% chance of winning $125 in two years if the interest rate was
a. 9% but not 10%
b. 10% but not 11%
c. 11% but not 12%
d. None of the above is correct; a risk averse person would not accept any of the above bets.