Chapter 7

The Pricing of Risky Financial Assets

D1Factual
1. If the interest rate on a security consists only of the riskless rate, then A) there is no uncertainty. B) velocity is constant. C) the money supply is fixed. D) the price level is fixed. Answer A

D2Applied
!. "he current price of a #overnment $ond is %&!'. "he $ond pays %&' in interest this year. At the end of the current year, the $ond matures, and the principal of %1,''' is repaid. (hat is the return to the holder of this $ond) A) 1 percent B) * percent C) & percent D) 1+ percent Answer D

D2Interpretive
,. In a world of certainty, the interest rate reflects A) the de#ree of risk. B) differin# time patterns of individuals- consumption preferences. C) economic #rowth. D) .ualifications of $orrowers. Answer B

D2Interpretive
/. In a world of certainty, the key decisions influenced $y the riskless interest rate are A) risk premiums demanded $y investors. B) portfolio decisions. C) diversification decisions. D) consumption versus savin# decisions. Answer D

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730itter12il$er13dell Money, Banking, and Financial Markets , 4leventh 4dition

D2Interpretive
5. 0isk aversion implies that A) individuals will not take on risk. B) investors must $e compensated for a$out half of the risk they take on. C) investors must $e compensated for the risk they take on. D) 6one of the a$ove Answer C

D1Factual
7. 8ost people are A) risk lovers. B) risk averters. C) indifferent toward risk. D) 6one of the a$ove Answer B

D2Factual
!!. If a person prefers a #am$le with an expected value of %1'' to a sure %1'' that person is A) irrational. B) a risk lover. C) nonsystematic. D) mana#in# a portfolio. Answer B

D1Factual
+. "he expected yield on an asset with two possi$le outcomes is e.ual to the A) difference $etween the two outcomes. B) sum of the possi$le outcomes multiplied $y their respective pro$a$ilities. C) standard deviation of the two outcomes. D) product of the two outcomes. Answer B

D1Interpretive
*. 4vidence that most investors are risk averse is that they A) $uy a diversified portfolio. B) $uy different $onds with the same yield and maturity. C) put most of their funds in one company9s stock. D) like to #am$le. Answer A

Chapter +"he :ricin# of 0isky ;inancial Assets 74

D3Applied
&. Assume that a security has two possi$le outcomes. "here is a 5' percent chance that the yield will e.ual 1! percent and a 5' percent chance that the yield will e.ual / percent. "he expected yield for this security is A) 17 percent. B) 1! percent. C) * percent. D) / percent. Answer C

D3Applied
1'. If an asset has a '.+ pro$a$ility of yieldin# 1' percent and a '., pro$a$ility of yieldin# !' percent, the expected yield of the asset is A) ,' percent. B) !' percent. C) 1, percent. D) 1' percent. Answer C

D3Applied
11. Assume that the yield on a security has two possi$le outcomes. "here is a 7' percent chance it will yield 1' percent and a /' percent chance it will yield 5 percent. "he expected yield for this security is A) 1'.' percent. B) *.' percent. C) +.5 percent. D) 7.' percent. Answer B

D2Applied
1!. If asset A is a ,'<year 3.2. "reasury $ond yieldin# & percent and asset B is a ,'<year corporate $ond issued $y =eneral 8otors that also yields & percent, risk averse investors would A) prefer asset A. B) prefer asset B. C) $e indifferent $etween the two assets. D) differ accordin# to their rate of time preference. Answer A

D2Applied
1,. If asset A is a risky asset yieldin# 1' percent and asset B is a riskless asset with the same maturity with a yield of * percent, investors would A) prefer asset A. B) prefer asset B. C) $e indifferent $etween the two assets. D) 6one of the a$ove Answer D

750itter12il$er13dell Money, Banking, and Financial Markets , 4leventh 4dition

D2Factual
1/. "he standard deviation around an expected value is a useful measure of A) expected value of an asset. B) economic value of an asset. C) the difference $etween the $est<case return of an asset and its worst<case return. D) deviation of an asset-s actual returns from its expected returns. Answer D

D2Interpretive
15. A potential draw$ack of usin# the standard deviation to measure risk is that A) positive and ne#ative deviations from the mean cancel each other out. B) $oth positive and ne#ative deviations are included to compute deviations around the mean. C) the pro$a$ility distri$ution of returns is symmetrical. D) 6one of the a$ove Answer B

D1Factual
17. 8odern portfolio analysis assumes that individuals A) are risk<averse. B) attempt to maximi>e li.uidity. C) attempt to maximi>e returns re#ardless of risk. D) never take risks. Answer A

D3Applied
1+. Assume that a security has e.ually possi$le outcomes of yieldin# * percent and / percent. "he standard deviation of the pro$a$ility distri$ution of returns for this security is A) 7 percent. B) / percent. C) , percent. D) ! percent. Answer D

D3Applied
1*. Assume an asset has a 5' percent pro$a$ility of yieldin# 1' percent and an e.ual pro$a$ility of yieldin# 7 percent, the standard deviation for this asset is A) 1' percent. B) * percent. C) 7 percent. D) ! percent. Answer D

Chapter +"he :ricin# of 0isky ;inancial Assets 76

D2Interpretive
1&. "he most fundamental proposition of modern portfolio theory is that A) investment risk is reduced $y investin# in on security. B) the smaller the standard deviation is, the lar#er is the risk of a portfolio. C) even thou#h an asset is risky in isolation, when com$ined with other assets the risk of the portfolio is less, perhaps even >ero. D) uncertain outcomes make for risky investments. Answer C

D2Factual
!'. 4mpirical evidence indicates that security returns have A) #reater pro$a$ility of exceedin# expected value yields. B) #reater pro$a$ility of yieldin# $elow expected value returns. C) a symmetrical pro$a$ility distri$ution. D) a pro$a$ility distri$ution that cannot $e measured. Answer C

D2Interpretive
!1. If an investor holds two risky assets with a perfect ne#ative correlation, then risk A) falls to >ero. B) is increased. C) is unaffected. D) is reduced $y 5' percent. Answer A

D2Interpretive
!!. :ortfolio diversification is ineffective when A) assets in the portfolio have precisely the same pattern of returns. B) assets in the portfolio have ne#ative correlations. C) assets in the portfolio are uncorrelated. D) :ortfolio diversification is ineffective in each of the a$ove scenarios. Answer A

D2Interpretive
!,. If two risky assets, A and B, have ne#ative correlation, then when A9s yield increases A) B9s yield increases. B) B9s yield decreases. C) B9s yield can increase or decrease. D) "here is not enou#h information to determine what B9s yield will do. Answer B

D2Interpretive
!/. ?oldin# a #roup of assets reduces risk relative to holdin# a sin#le asset as lon# as the assets A) are dependent on each other. B) are positively correlated. C) are uncorrelated. D) do not have precisely the same pattern of returns. Answer D

770itter12il$er13dell Money, Banking, and Financial Markets , 4leventh 4dition

D3Applied
!5. Assume a portfolio in which there is e.ual investment in two assets that are perfectly positively correlated, with e.ually expected returns of 1' percent and 7 percent for asset A and * percent and / percent for asset B. "he expected yield on this portfolio is A) * percent. B) + percent. C) 7 percent. D) 5 percent. Answer B

D3Applied
!7. Assume a portfolio in which there is e.ual investment in two assets that are perfectly ne#atively correlated, with e.ually expected returns of 1' percent and 7 percent for asset A and * percent and / percent for asset B. "he expected yield on this portfolio is A) * percent. B) + percent. C) 7 percent. D) 5 percent. Answer B

D2Interpretive
!+. Because most asset yields are affected in a systematic way $y economic conditions, most securities in portfolios A) have a covariance #reater than >ero. B) have ne#ative yields. C) have covariance #reater than one. D) increase in risk as new assets are added. Answer A

D2Interpretive
!*. If asset returns are less than perfectly correlated, portfolio diversification A) reduces systematic risk. B) reduces nonsystematic risk. C) increases systematic yields. D) reduces systematic yields. Answer B

D2Factual
!&. Assets with >ero covariance have yields that are A) inversely related. B) positively correlated. C) ne#atively correlated. D) independent. Answer D

Chapter +"he :ricin# of 0isky ;inancial Assets 78

D2Interpretive
,'. A mutual fund that purchases a wide variety of stocks will A) eliminate systematic risk. B) minimi>e nonsystematic risk. C) minimi>e market risk. D) minimi>e default risk. Answer B

D1Factual
,1. 2ome amount of every security in existence is held in the hypothetical @@@@@@@@@@@@@@@@@@ portfolio. A) perfect B) market C) systematic D) nonsystematic Answer B

D2Interpretive
,!. "he risk premium that risk averse investors will demand on a security will $e in proportion to the @@@@@@@@@@@@@@@@@@ of the portfolio. A) systematic risk B) nonsystematic risk C) risk of the worst case return D) diversification Answer A

D2Interpretive
,,. "he @@@@@@@@@@@@@@@@@@ the nonsystematic risk of a portfolio, the @@@@@@@@@@@@@@@@@@ the risk premium will $e. A) hi#herA lower B) hi#herA hi#her C) lowerA lower D) 6one of the a$ove Answer D

D3Interpretive
,/. (e can $e more confident that standard deviation is a #ood measure of the risk of an asset Bheld in isolation) when A) the num$er of different possi$le returns on the asset rises. B) the pro$a$ilities attached to the possi$le returns on the asset are less e.ual. C) the possi$le returns on the asset are distri$uted symmetrically around the mean. D) the asset has a lon#er maturity. Answer C

790itter12il$er13dell Money, Banking, and Financial Markets , 4leventh 4dition

D2Applied
,5. A venture capital fund wants to invest %1''' in each of one thousand mad scientists. "he first scientist applyin# to the fund is workin# on the le#endary pill that turns water into #asoline, and the second scientist is workin# on the even more le#endary perpetual motion machine. "he smart venture capitalist here will A) $ack the pill and look for &&& other scientists workin# on the same pill. B) $ack the machine and look for &&& other scientists workin# on the same machine. C) look for 5'' scientists workin# on the pill and 5'' workin# on the machine. D) $ack the pill, the machine, and &&* other different proCects. Answer D

D2Interpretive
,7. (hich of the followin# statements is not true) A) :ortfolio diversification implies that investors earn a return a$ove the risk<free rate that compensates for the risk inherent in each and every security. B) "he risk of the market portfolio is less than the sum of each security9s risk. C) "he risk premium depends the systematic risk of securities. D) All of the statements a$ove are true. Answer A