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Studocu is not sponsored or endorsed by any college or university Chapter 6 - risks International Financial Management (Caucasus University) Studocu is not sponsored or endorsed by any college or university Chapter 6 - risks International Financial Management (Caucasus University) Downloaded by Johnny He (johnnyhe2017@gmail.com) lOMoARcPSD|7048616

Chapter 6 Risk Aversion and Capital Allocation to Risky Assets Multiple Choice Questions 1. Which of the following statements regarding risk-averse investors is true ? A) They only care about the rate of return. B) They accept investments that are fair games. C) They only accept risky investments that offer risk premiums over the risk-free rate. D) They are willing to accept lower returns and high risk. E) A and B. Answer: C Difficulty: Moderate 2. Which of the following statements is (are) true ? I)Risk-averse investors reject investments that are fair games. II) Risk-neutral investors judge risky investments only by the expected returns. III) Risk-averse investors judge investments only by their riskiness. IV) Risk-loving investors will not engage in fair games. A) I only B) II only C) I and II only D) II and III only E) II, III, and IV only Answer: C Difficulty: Moderate Rationale: Risk-averse investors consider a risky investment only if the investment offers a risk premium. Risk-neutral investors look only at expected returns when making an investment decision. 3. In the mean-standard deviation graph an indifference curve has a ________ slope. A) negative B) zero C) positive D) northeast E) cannot be determined Answer: C Difficulty: Easy Rationale: The risk-return trade-off is one in which greater risk is taken if greater returns can be expected, resulting in a positive slope. 1 Downloaded by Johnny He (johnnyhe2017@gmail.com) lOMoARcPSD|7048616

Chapter 6 Risk Aversion and Capital Allocation to Risky Assets 4. In the mean-standard deviation graph, which one of the following statements is true regarding the indifference curve of a risk-averse investor? A) It is the locus of portfolios that have the same expected rates of return and different standard deviations. B) It is the locus of portfolios that have the same standard deviations and different rates of return. C) It is the locus of portfolios that offer the same utility according to returns and standard deviations. D) It connects portfolios that offer increasing utilities according to returns and standard deviations. E) none of the above. Answer: C Difficulty: Moderate Rationale: Indifference curves plot trade-off alternatives that provide equal utility to the individual (in this case, the trade-offs are the risk-return characteristics of the portfolios). 5. In a return-standard deviation space, which of the following statements is (are) true for risk-averse investors? (The vertical and horizontal lines are referred to as the expected return-axis and the standard deviation-axis, respectively.) I)An investor's own indifference curves might intersect. II) Indifference curves have negative slopes. III) In a set of indifference curves, the highest offers the greatest utility. IV) Indifference curves of two investors might intersect. A) I and II only B) II and III only C) I and IV only D) III and IV only E) none of the above Answer: D Difficulty: Moderate Rationale: An investor's indifference curves are parallel, and thus cannot intersect and have positive slopes. The highest indifference curve (the one in the most northwestern position) offers the greatest utility. Indifference curves of investors with similar risk- return trade-offs might intersect. 2 Downloaded by Johnny He (johnnyhe2017@gmail.com) lOMoARcPSD|7048616

Chapter 6 Risk Aversion and Capital Allocation to Risky Assets 6. Elias is a risk-averse investor. David is a less risk-averse investor than Elias. Therefore, A) for the same risk, David requires a higher rate of return than Elias. B) for the same return, Elias tolerates higher risk than David. C) for the same risk, Elias requires a lower rate of return than David. D) for the same return, David tolerates higher risk than Elias. E) cannot be determined. Answer: D Difficulty: Moderate Rationale: The more risk averse the investor, the less risk that is tolerated, given a rate of return. 7. When an investment advisor attempts to determine an investor's risk tolerance, which factor would they be least likely to assess? A) the investor's prior investing experience B) the investor's degree of financial security C) the investor's tendency to make risky or conservative choices D) the level of return the investor prefers E) the investor's feeling about loss Answer: D Difficulty: Moderate Use the following to answer questions 8-9: Assume an investor with the following utility function: U = E(r) - 3/2(s 2 ). 8. To maximize her expected utility, she would choose the asset with an expected rate of return of _______ and a standard deviation of ________, respectively. A) 12%; 20% B) 10%; 15% C) 10%; 10% D) 8%; 10% E) none of the above Answer: C Difficulty: Moderate Rationale: U = 0.10 - 3/2(0.10) 2 = 8.5%; highest utility of choices. 3 Downloaded by Johnny He (johnnyhe2017@gmail.com) lOMoARcPSD|7048616

Chapter 6 Risk Aversion and Capital Allocation to Risky Assets 9. To maximize her expected utility, which one of the following investment alternatives would she choose? A) A portfolio that pays 10 percent with a 60 percent probability or 5 percent with 40 percent probability. B) A portfolio that pays 10 percent with 40 percent probability or 5 percent with a 60 percent probability. C) A portfolio that pays 12 percent with 60 percent probability or 5 percent with 40 percent probability. D) A portfolio that pays 12 percent with 40 percent probability or 5 percent with 60 percent probability. E) none of the above. Answer: C Difficulty: Difficult Rationale: U(c) = 9.02%; highest utility of possibilities. 10. A portfolio has an expected rate of return of 0.15 and a standard deviation of 0.15. The risk-free rate is 6 percent. An investor has the following utility function: U = E(r) - (A/2)s 2 . Which value of A makes this investor indifferent between the risky portfolio and the risk-free asset? A) 5 B) 6 C) 7 D) 8 E) none of the above Answer: D Difficulty: Difficult Rationale: 0.06 = 0.15 - A/2(0.15) 2 ; 0.06 - 0.15 = -A/2(0.0225); -0.09 = -0.01125A; A = 8; U = 0.15 - 8/2(0.15) 2 = 6%; U(R f ) = 6%. 11. According to the mean-variance criterion, which one of the following investments dominates all others? A) E(r) = 0.15; Variance = 0.20 B) E(r) = 0.10; Variance = 0.20 C) E(r) = 0.10; Variance = 0.25 D) E(r) = 0.15; Variance = 0.25 E) none of these dominates the other alternatives. Answer: A Difficulty: Difficult Rationale: A gives the highest return with the least risk; return per unit of risk is .75, which dominates the reward-risk ratio for the other choices. 4 Downloaded by Johnny He (johnnyhe2017@gmail.com) lOMoARcPSD|7048616

Chapter 6 Risk Aversion and Capital Allocation to Risky Assets 12. Consider a risky portfolio, A, with an expected rate of return of 0.15 and a standard deviation of 0.15, that lies on a given indifference curve. Which one of the following portfolios might lie on the same indifference curve? A) E(r) = 0.15; Standard deviation = 0.20 B) E(r) = 0.15; Standard deviation = 0.10 C) E(r) = 0.10; Standard deviation = 0.10 D) E(r) = 0.20; Standard deviation = 0.15 E) E(r) = 0.10; Standard deviation = 0.20 Answer: C Difficulty: Difficult Rationale: Portfolio A has a reward to risk ratio of 1.0; portfolio C is the only choice with the same risk-return tradeoff. Use the following to answer questions 13-15: 13. Based on the utility function above, which investment would you select? A) 1 B) 2 C) 3 D) 4 E) cannot tell from the information given Answer: C Difficulty: Difficult Rationale: U(c) = 0.21 - 4/2(0.16) 2 = 15.88 (highest utility of choices). 14. Which investment would you select if you were risk neutral? A) 1 B) 2 C) 3 D) 4 E) cannot tell from the information given Answer: D Difficulty: Difficult Rationale: If you are risk neutral, your only concern is with return, not risk. 5 Downloaded by Johnny He (johnnyhe2017@gmail.com) lOMoARcPSD|7048616

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