Ch26-Basic Tools of Finance

1. The future value of a deposit in a savings account will be larger a. the longer a person waits to withdraw the funds. b. the higher the interest rate is. c. the larger the initial deposit is. d. All of the above are correct.

2. Edgar has four savings accounts. Which one has the most in it? a. $100 deposited 1 year ago at an 8% interest rate. b. $100 deposited 2 years ago at a 4% interest rate. c. $100 deposited 4 years ago at a 2% interest rate. d. $100 deposited 8 years ago at a 1% interest rate.

3. Suppose that the price of a bond is equal to the sum of the present value of its future payments. Suppose further that this bond pays $50 in one year and $1,050 in two years. What is the price of the bond if the interest rate is 5 percent? a. $1,050.00 b. $1,045.35 c. $1,000.00 d. $945.35

4. Prospect theory says that a. people should follow their gut feelings and purchase stocks they think have good prospects. b. people will tend to sell off winning investments too quickly and hold onto losing ones too long. c. people tend to be overly pessimistic about developments in the stock market. d. during a speculative bubble most people are thinking that they won’t be able to get out of the market before the bubble bursts.

5. Al, Ralph, and Stan are all intending to retire. Each currently has $1 million in assets. Al will earn 16% interest and retire in two years. Ralph will earn 8% interest and retire in four years. Stan will earn 4% interest and retire in eight years. Who will have the most dollars when he retires? a. Al b. Ralph c. Stan d. They all retire with the same amount.

6. Which of the following is the correct expression for finding the present value of a $1,000 payment one year from today if the interest rate is 6 percent? a. $1,000 ( (1.06) b. $1,000(1.06) c. $1,000/(1.06) d. None of the above is correct.

7. Which of the following changes would increase the present value of a future payment? a. a decrease in the size of the payment b. an increase in the time until the payment is made c. a decrease in the interest rate d. All of the above are correct.

8. You are expecting to receive $1,000 at some time in the future. Which of the following would unambiguously decrease the present value of this future payment? a. Interest rates rise and you get the payment sooner. b. Interest rates rise and you have to wait longer for the payment. c. Interest rates fall and you get the payment sooner. d. Interest rates fall and you have to wait longer to get the payment.

9. Suppose that the price of a bond is equal to the sum of the present value of its future payments. Suppose further that the bond pays $50 today, $50 one year from today, and $1,050 two years from today. What is the price of this bond if the interest rate is 5 percent? a. $1,000 b. $1,050 c. $1,100 d. None of the above is correct.

10. A judge requires Harry to make a payment to Sally. The judge says that Harry can pay her either $10,000 today or $11,000 two years from today. Of the following interest rates, which is the highest one at which Harry would be better off paying the money today? a. 3% b. 4% c. 5% d. 6%

11. Mixster Concrete Company is considering buying a new cement truck. The owners and their accountants decide that this is the profitable thing to do. Before they can buy the truck, the interest rate and price of trucks change. In which case do these changes both make them less likely to buy the truck? a. both interest rates and price of trucks rise b. both interest rates and the price of trucks fall c. the interest rate rises and the price of trucks fall d. the interest rate falls and the price of trucks rises

12. A firm has three different investment options. Option A will give the firm $10 million at the end of one year, $10 million at the end of two years, and $10 million at the end of three years. Option B will give the firm $15 million at the end of one year, $10 million at the end of two years, and $5 million at the end of three years. Option C will give the firm $30 million at the end of one year, and nothing thereafter. Which of these options has the highest present value? a. Option A b. Option B c. Option C d. All have the same present value

13. Other things the same, an increase in the interest rate makes the quantity of loanable funds demanded a. rise, and investment spending rise. b. rise, and investment spending fall. c. fall, and investment spending rise. d. fall, and investment spending fall.

14. A measure of the volatility of a variable is its a. present value. b. future value. c. return. d. standard deviation.

15. A risk averse person a. has a utility curve where the slope increases with wealth, and might take a bet with a 60 percent chance of wining $100 and a 40 per chance of losing $100. b. has a utility curve where the slope increases with wealth, and would never take a bet with a 60 percent chance of wining $100 and a 40 per cent chance of losing $100. c. has a utility curve where the slope decreases with wealth, and might take a bet with a 60 percent chance of wining $100 and a 40 per chance of losing $100. d. has a utility curve where the slope decreases with wealth, and would never take a bet with a 60 percent chance of wining $100 and a 40 per cent chance of losing $100.

16. 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.

17. Which of the following games might a risk-averse person be willing to 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 60 percent chance of winning $1 and a 40 percent chance of losing $1. c. Both A and B. d. Neither A nor B

18. 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.

19. Eddie is risk averse. Which of the following is correct about Eddie? a. His marginal utility of wealth increases as his income increases. b. He will not accept bets where his probability of winning and losing a dollar are the same. c. Both A and B are correct. d. Neither A nor B are correct.

20. A risk averse person might accept a bet with a 50% chance of losing $100 today if they had a 50% chance of winning a. of winning $120 in two years and the interest rate was 11%. b. of winning $114 in two years and the interest rate was 7%. c. of winning $110 and two years and the interest rate was 3%. d. A risk averse person would not accept any of the above bets.

21. 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.

22. Suppose that Rupert’s utility drops more if he loses $50 than if he gains $50. This implies that Rupert’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.

23. Which of the following best illustrates adverse selection? a. A person adds risky stock to their 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 gets homeowners insurance and then checks their smoke detector batteries less frequently.

24. Annie knows that people in her family die young, and so she buys life insurance. Harry 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.

25. Sally buys health insurance because she knows that she has health risks that wouldn’t be obvious to an insurance company. Edward buys homeowners insurance and then is less careful to make sure he’s put out his cigarettes. The example with Sally a. and the example with Edward illustrate adverse selection. b. and the example with Sally illustrate moral hazard. c. best illustrates adverse selection, the example with Edward best illustrates moral hazard. d. best illustrates moral hazard, the example with Edward best illustrates adverse selection.

26. 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

27. 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.

28. 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'd 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.

29. 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.

30. 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.

31. Roger determines that if Aim Corporation has high revenues, then Zest Corporation will have low revenues, and that if Aim Corporation has low revenues, Zest Corporation will have high revenues. He 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.

32. 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. There are risks in holding stocks, even in a highly diversified portfolio. b. Portfolios with smaller standard deviations have lower risk. c. Stocks with greater risks offer lower average returns. d. They all gave her correct advice.

33. Mary talked to several stockbrokers and made the following conclusions. Which, if any, of her 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 Mary’s conclusions are correct.

34. 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.

35. Marcus puts a greater proportion of his portfolio into government bonds. This 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

36. 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.

37. Dividends a. are the rates of return on mutual funds. b. are cash payments that companies make to shareholders. c. are the difference between the price and present value per share of a stock. d. are the rates of return on a company’s capital stock.

38. Fundamental analysis is a. the study of the relation between risk and return of stock portfolios. b. the determination of the allocation of savings between stocks and bonds based on a person’s degree of risk aversion. c. the study of a company’s accounting statements and future prospects to determine its value. d. a method used to determine how adding stocks to a portfolio will change the risk of the portfolio.

39. Fundamental analysis determines the value of a stock based on a. dividends. b. the expected final sale price. c. the ability of the corporation to earn profits. d. all of the above.

40. If stock prices follow a random walk, it means a. long periods of declining prices are followed by long periods of rising prices. b. the greater the number of consecutive days of price declines, the greater the probability prices will increase the following day. c. stock prices are unrelated to random events that shock the economy. d. stock prices are just as likely to rise as to fall at any given time.

41. If stock prices follow a random walk, then stock investors can make large profits by a. buying stocks whose prices have been falling for several days. b. buying stocks whose prices have been rising for several days. c. performing fundamental analysis of stocks using data contained in annual reports. d. using inside information.

42. According to the efficient market hypothesis, which of the following is not correct? a. Stock market prices tend to rise today if they rose yesterday. b. As judged by the typical person in the market, all stocks are fairly valued all the time. c. At the market price, the number of shares being offered for sale matches the number of shares people want to buy. d. All of the above are incorrect.

43. According to the efficient markets hypothesis, better than expected news about a corporation will a. have no effect on it's stock price. b. raise the price of the stock. c. lower the price of the stock. d. change the price of the stock in a random direction.

44. If the efficient market hypothesis is correct, then a. index funds should typically beat managed funds, and usually do. b. index fund should typically beat managed funds, but usually do not. c. mutual funds should typically beat index funds, and usually do. d. mutual funds should typically bet index funds, but usually do not.

45. Research studies have shown that a. the correlation between how well a stock does one year and how well it does the next is significantly greater than zero. b. managed mutual funds generally outperform indexed mutual funds. c. people tend to be overconfident when making investment decisions. d. All of the above are correct.

46. Suppose that interest rates unexpectedly rise and that Carter Corporation announces that revenues from last quarter were down but not as much as the public had anticipated they would be down. According to the efficient markets hypothesis which of the these things make the price of Carter Corporation Stock fall? a. both the interest rate rising and the revenue announcement b. neither the interest rate rising nor the revenue announcement c. only the interest rate rising d. only the revenue announcement

47. Which of the following is correct concerning stock market irrationality? a. Bubbles could arise, in part, because the price that people pay for stock depends on what they think someone else will pay for it in the future. b. Economists almost all agree that the evidence for stock market irrationality is convincing and the departures from rational pricing are important. c. Some evidence for the existence of market irrationality is that informed and presumably rational managers of mutual funds generally beat the market. d. All of the above are correct.

48. 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?

49. Give two conditions that are important to the efficient market theory. List one implication of the efficient market theory.

Answers

1. D 2. D 3. C 4. B 5. C 6. C 7. C 8. B 9. B
10. B
11. A
12. C
13. D
14. D
15. C
16. A
17. B
18. D
19. B
20. C
21. C
22. A
23. B
24. A
25. C
26. C
27. D
28. C
29. D
30. C
31. A
32. C
33. D
34. B
35. B
36. A
37. B
38. C
39. D
40. D
41. D
42. A
43. B
44. A
45. C
46. C
47. A
48. There are several possibilities. The first is that they had very high expectations for corporations that weren't doing well at the time to do very well in the future. The second is that in evaluating the value of stocks they took into account what others might be willing to pay for them in the future. Even if they thought that the corporation might never be profitable, they might have believed that other people would be willing to pay a lot for it in the future. Another possibility is that people became overconfident in their ability to pick stocks in a rising stock market. This overconfidence may have led buyers to bid up prices.
49. Efficient market theory says that it should be very difficult to beat the market by finding undervalued stocks. The first condition is that lots of people are following the stock exchange closely, so that any new information will be quickly reflected in a change in the stock price. The second condition is that supply and demand determine the price. Thus, the market will balance the number of people who think the stock is overvalued with those who think it is undervalued. Consequently, it should be difficult to consistently beat the market.