Chapter 05
Understanding Risk
Multiple-Choice Questions
1. Which of the following would not be included in a definition of risk?
a. Risk is a measure of uncertainty.
b. Risk can always be avoided at no cost.
c. Risk has a time horizon.
d. Risk usually involves some future payoff.
2. All other factors held constant, an investment:
a. with more risk should offer a lower return and sell for a higher price.
b. with less risk should sell for a lower price and offer a higher expected
ret
urn.
c
. with more risk should sell for a lower price and offer a higher expected return.
d. with less risk should sell for a lower price and offer a lower return.
3. Uncertainties that are not quantifiable:
a. are what we define as risk.
b. are factored into the price of an asset.
c. cannot be priced.
d. are benchmarks against which quantifiable risks can be assessed.
4. When measuring the risk of an asset:
a. one must measure the uncertainty about the size of future payoffs.
b. it is necessary to incorporate uncertainties that are not quantifiable.
c. one must remember that the concept of risk applies only to financial markets, not to financial
intermediaries.
d. one cannot use other investments to evaluate the asset’s risk.
5. Which of the following is true?
a. Investments with higher risk generally have a higher expected return than risk-free
investments.
b. Investments that pay a return over a longer time horizon generally have less risk.
c. Investments with a greater variance in the size of the future payoff generally pay a lower
expected return.
d. Risk-free investments are the best benchmark for measuring the risk of all investment
strategies.
6. Inflation presents risk because:
a. inflation is always present.
b. inflation cannot be measured.
c. there are different ways to measure it.
d. there is no certainty regarding what inflation will be in the future.
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7. If the probability of an outcome equals one, the outcome:
a. is more likely to occur than the others listed.
b. is certain to occur.
c. is certain not to occur.
d. has unquantifiable risk.
8. If a fair coin is tossed, the probability of coming up with either a head or a tail is:
a. ½ or 50 percent.
b. Zero.
c. 1 or 100 percent.
d. Unquantifiable.
9. If the probability of an outcome is zero, you know the outcome is:
a. more likely to occur.
b. certain to occur.
c. less likely to occur.
d. certain not to occur.
10. The expected value of an investment:
a. is what the owner will receive when the investment is sold.
b. is the sum of the payoffs.
c. is the probability-weighted sum of the possible outcomes.
d. cannot be determined in advance.
11. If an investment will return $1,500 half of the time and $700 half of the time, the expected
value of the investment is:
a. $1,250.
b. $1,050.
c. $1,100.
d. $2,200.
12. Another name for the expected value of an investment would be the:
a. mean value.
b. upper-end value.
c. certain value.
d. risk-free value.
13. If an investment has a 20% (0.20) probability of returning $1,000; a 30% (0.30) probability
of returning $1,500; and a 50% (0.50) probability of returning $1,800; the expected value of the
investment is:
a. $1,433.33
b. $1,550.00
c. $2,800.00
d. $1,600.00
14. Suppose that Fly–By–Night Airlines, Inc. has a return of 5% twenty percent of the time and
0% the rest of the time. The expected return from Fly-By-Night is:
a. 10%.
b. 0.1%.
c. 0.2%.
d. 1.0%.
15. An investor puts $1,000 into an investment that will return $1,250 one-half of the time and
$900 the remainder of the time. The expected return for this investor is:
a. $1,075
b. 5.0%
c. 7.5%
d. 15.0%
16. An investor puts $2,000 into an investment that will pay $2,500 one-fourth of the time;
$2,000 one-half of the time, and $1,750 the rest of the time. What is the investor’s
expected return?
a. 12.5%
b. $250.00
c. 6.25%
d. 3.125%
17. Risk-free investments have rates of return:
a. equal to zero.
b. with a standard deviation equal to zero.
c. that are uncertain, but have a certain time horizon.
d. that exhibit a large spread of potential payoffs.
18. An investment with a large spread between possible payoffs will generally have:
a. a low expected return.
b. a high standard deviation.
c. a low value at risk.
d. both a low expected return and a low value at risk.
19. An investment pays $1,500 half of the time and $500 half of the time. Its expected value
and variance respectively are:
a. $1,000; 500,000
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rs
b. $2,000; (250,000 dollars)2
c. $1,000; 250,000
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rs
d. $1,000; 250,000 dollars2
20. An investment pays $1,200 a quarter of the time; $1,000 half of the time; and $800 a
quarter of the time. Its expected value and variance respectively are:
a. $1,000; 20,000 dollars2
b. $1,050; 20,000 dollars2
c. $1,000; 40,000 dollars2
d. $1,000; 80,000 dollars2
21. An investment pays $1,000 three quarters of the time, and $0 the remaining time.
Its expected value and variance respectively are:
a. $1,000: 62,500 dollars2
b. $750; 46,875 dollars
c. $750; 62,500 dollars
d. $750; 187,500 dollars2
22. The standard deviation is generally more useful than the variance because:
a. it is easier to calculate.
b. variance is a measure of risk, where standard deviation is a measure of return.
c. standard deviation is calculated in the same units as payoffs and variance isn’t.
d. it can measure unquantifiable risk.
23. Given a choice between two investments with the same expected payoff most people will:
a. choose the one with the lower standard deviation.
b. opt for the one with the higher standard deviation.
c. be indifferent since the expected payoffs are the same.
d. calculate the variance to assess the relative risks of the two choices.
24. An investment will pay $2,000 half of the time and $1,400 half of the time. The standard
deviation for this investment is:
a. $90,000.
b. $300.
c. $1,700.
d. $30.
25. An investment will pay $2,000 a quarter of the time; $1,600 half of the time and $1,400
a quarter of the time. The standard deviation of this asset is:
a. $600
b. $1,650
c. $47,500
d. $217.94
26. Investment A pays $1,200 half of the time and $800 half of the time. Investment B pays
$1,400 half of the time and $600 half of the time. Which of the following statements is correct?
a. Investment A and B have the same expected value, but A has greater risk.
b. Investment B has a higher expected value than A, but also greater risk.
c. Investment A and B have the same expected value, but A has lower risk than B.
d. Investment A has a greater expected value than B, but B has less risk.
27. Investment A pays $1,200 half of the time and $800 half of the time. Investment B pays
$1,400 half of the time and $600 half of the time. Which of the following statements is correct?
a. Investment A and B have the same expected value, but A has greater risk.
b. Investment B has a higher expected value than A, but also greater risk.
c. Investment A has a greater expected value than B, but B has less risk.
d. None of the statements are correct
28. The greater the standard deviation of an investment the:
a. lower the return.
b. greater the risk.
c. lower the risk.
d. lower the risk and return.
29. The difference between standard deviation and value at risk is:
a. nothing, they are two names for the same thing.
b. value at risk is a more common measure in financial circles than is standard deviation.
c. standard deviation reflects the spread of possible outcomes where value at risk focuses on the
value of the worst outcome.
d. value at risk is expected value times the standard deviation.
30. A $600 investment has the following payoff frequency: a quarter of the time it will be $0;
three quarters of the time it will pay off $1000. Its standard deviation and value at risk
respectively are:
a. $750; $600
b. $433; $600
c. $0; $1,000
d. $433; $1,000
31. A $500 investment has the following payoff frequency: half of the time it will pay $350 and the
other half of the time it will pay $900. Its standard deviation and value at risk respectively are:
a. $275; $150
b. $625; $275
c. $275; $350
d. $125; $500
32. The measure of risk that focuses on the worst possible outcome is called:
a. expected rate of return.
b. risk-free rate of return.
c. standard deviation of return.
d. value at risk.
33. Leverage:
a. reduces risk.
b. is synonymous with risk-free investment.
c. increases expected rate of return.
d. leads to smaller changes in the investment’s price.
34. Which of the following individuals is least likely to use value at risk as an important factor in
his/her investment decision?
a. An individual considering a mortgage to buy his first home.
b. A family considering purchasing health insurance.
c. A policy maker considering regulation of depository institutions.
d. A mutual fund manager choosing the allocation of investments in the fund’s portfolio.
35. Comparing a lottery where a $1 ticket purchases a chance to win $1 million with another
lottery in which a $5,000 ticket purchases a chance to win $5 billion, we notice many people
would participate in the first but not the second, even though the odds of winning both lotteries
are the same. We can perhaps best explain this outcome by:
a. higher expected value for the lottery paying $1 million.
b. higher expected value for the lottery paying $5 billion. c.
lower value at risk for the lottery paying $1 million.
d. higher value at risk for the lottery paying $1 million.
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36. Which of the following statements is true?
a. Leverage increases expected return while lowering risk.
b. Leverage increases risk.
c. Leverage lowers the expected return and lowers risk.
d. Leverage lowers the expected return and increases risk.
37. Which of the following statements is true?
a. Leverage increases expected return and increases risk.
b. Leverage increases expected return and reduces risk.
c. Leverage decreases expected return but has no effect on risk.
d. Leverage decreases expected return and increases risk.
38. Which of the following investment strategies involves generating a higher expected rate of
return through increasing risk?
a. Diversifying b.
Hedging risk c.
Leverage
d. Value at risk
39. A risk-averse investor versus a risk-neutral investor:
a. will never take a risk, while the risk neutral investor will.
b. needs greater compensation for the same risk versus the risk neutral investor.
c. will take the same risks as the risk neutral investor if the expected returns are equal.
d. needs less compensation for the same risk versus the risk neutral investor.
40. A risk-averse investor will:
a. always accept a greater risk with a greater expected return.
b. only invest in assets providing certain returns.
c. never accept lower risk if it means accepting a lower expected return.
d. sometimes accept a lower expected return if it means less risk.
41. A risk-averse investor will:
a. never prefer an investment with a lower expected return.
b. always prefer an investment with a certain return to one with the same expected return but
that has any amount of uncertainty.
c. always require a certain return.
d. always focus exclusively on the expected return.
42. Up to what amount would a risk-neutral gambler pay to enter a game where on the flip of a
fair coin, if you call the correct outcome the payoff is $2,000?
a. More than $1000 but less than $2000.
b. Up to $2,000.
c. Up to $1,000.
d. More than $1,500.
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43. Professional gamblers know that the odds are always in favor of the house (casinos). The
fact that they gamble says they are:
a. irrational.
b. risk-neutral.
c. risk-averse.
d. risk seekers.
44. The risk premium for an investment:
a. is negative for U.S. treasury securities.
b. is a fixed amount added to the risk-free return, regardless of the level of risk.
c. increases with risk.
d. is zero (0) for risk-averse investors.
45. A risk-averse investor compared to a risk-neutral investor would:
a. offer the same price for an investment as the risk-neutral investor.
b. require a higher risk premium for the same investment as a risk-neutral investor.
c. place more focus on expected return and less on return than the risk-neutral investor.
d. place less focus on expected return than the risk-neutral investor.
46. When considering different investments, a risk-averse investor is most likely to focus on
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purchasing:
a. investments with the greatest spread in the expected rate of return.
b. investments that offer the lowest standard deviation in the investments’ expected rates of
return for any given expected rate of return.
c. only risk-free investments.
d. investments with the lowest risk premium, regardless of the expected rate of return.
47. Which of the following statements is most correct?
a. Usually higher expected returns are associated with higher risk premiums.
b. Usually higher risk premiums are associated with lower expected returns.
c. Usually lower expected returns are associated with higher risk premiums.
d. Usually expected returns are not associated with risk premiums.
48. The fact that over the long run the return on common stocks has been higher than that on
long-term U.S. Treasury bonds is partially explained by the fact that:
a. A lot more money is invested in common stocks than U.S. Treasury bonds.
b. There are regulations on the interest rates U.S. Treasury bonds can offer.
c. The risk premium is higher on common stocks.
d. Risk-averse investors buy more common stock.
49. When the home construction industry does poorly due to a recession, this is an example of:
a. systematic risk.
b. idiosyncratic risk.
c. risk premium.
d. unique risk.
50. Unique risk is another name for:
a. market risk.
b. systematic risk.
c. the risk premium.
d. idiosyncratic risk.
51. High oil prices tend to harm the auto industry and benefit oil companies; therefore, high oil
prices are an example of:
a. systematic risk.
b. idiosyncratic risk.
c. neither systematic nor idiosyncratic risk.
d. both systematic and idiosyncratic risk.
52. Changes in general economic conditions usually produce:
a. systematic risk.
b. idiosyncratic risk.
c. risk reduction.
d. lower risk premiums.
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53. Unexpected inflation can benefit some people/firms and harm others. This is an example of:
a. systematic risk.
b. unmeasured risk.
c. idiosyncratic risk.
d. zero risk since the effects balance.
54. Diversification is the principle of:
a. eliminating risk.
b. reducing the risk we carry to just two.
c. holding more than one asset to reduce risk.
d. eliminating investments from our portfolio that have idiosyncratic risk.
55. Diversification can eliminate:
a. all risk in a portfolio.
b. risk only if the investor is risk averse.
c. the systematic risk in a portfolio.
d. the idiosyncratic risk in a portfolio.
56. An investor practicing hedging would be most likely to:
a. avoid the stock market and focus on bonds.
b. purchase shares in general motors and buy U.S. treasury bonds.
c. purchase shares in general motors and Amoco oil.
d. put his/her invested funds in CDs.
57. Hedging is possible only when investments have:
a. opposite payoff patterns.
b. the same payoff patterns.
c. payoffs that are independent of each other.
d. the same risk premiums.
58. An investor who diversifies by purchasing a 50-50 mix of two stocks that are not perfectly
positively correlated will find that the standard deviation of the portfolio is:
a. the sum of the standard deviations of the two individual stocks.
b. greater than the sum of the standard deviations of the individual stocks.
c. greater than the standard deviation from holding the same balance in only one of these stocks.
d. less than the standard deviation from holding the same balance in only one of these stocks.
59. Which of the following statements is false?
a. Diversification can reduce risk.
b. Diversification can reduce risk but only by reducing the expected return.
c. Diversification reduces idiosyncratic risk.
d. Diversification allocates savings across more than one asset.