Professional Documents
Culture Documents
In Class Problem Solving 3 With Answers
In Class Problem Solving 3 With Answers
3. Which of the following statements best describes the economist’s view of finance and the financial system?
a. The financial system is very important to the functioning of the economy, and the tools of finance
are often helpful to us as individuals when we find ourselves making certain decisions.
b. The financial system, while interesting, is not very important to the functioning of the economy;
however, the tools of finance are often helpful to us as individuals when we find ourselves making
certain decisions.
c. The financial system is very important to the functioning of the economy; however, the tools of
finance are not particularly helpful to us as individuals since we seldom make decisions for which
those tools are useful.
d. The field of finance is intimately concerned with the financial system and the tools of finance, and
financial economists see great importance in them; however, the “mainstream” economist sees
little value in studying financial markets or the tools of finance.
ANS: A
4. Suppose you put $350 into a bank account today. Interest is paid annually and the annual interest rate is 6
percent. The future value of the $350 after 4 years is
a. $414.09.
b. $434.00.
c. $441.87.
d. $481.24.
ANS: C
5. Suppose you put $500 into a bank account today. Interest is paid annually and the annual interest rate is 5.5
percent. The future value of the $500 is
a. $637.50 after 5 years and $822.09 after 10 years.
b. $637.50 after 5 years and $775.00 after 10 years.
c. $653.48 after 5 years and $854.07 after 10 years.
d. $688.36 after 5 years and $915.56 after 10 years.
ANS: C
6. If the interest rate is 7.5 percent, then what is the present value of $4,000 to be received in 6 years?
a. $2,420.68
b. $2,591.85
c. $2,996.33
d. $3,040.63
ANS: B
7. Suppose you will receive $500 at some point in the future. If the annual interest rate is 7.5 percent, then the
present value of the $500 is
a. $411.26 if the $500 is to be received in 5 years and $338.95 if the $500 is to be received in 10
years.
b. $348.28 if the $500 is to be received in 5 years and $242.60 if the $500 is to be received in 10
1
.
years.
c. $291.11 if the $500 is to be received in 5 years and $272.89 if the $500 is to be received in 10
years.
d. $291.11 if the $500 is to be received in 5 years and $236.49 if the $500 is to be received in 10
years.
ANS: B
10. A manufacturing company is thinking about building a new factory. The factory, if built, will yield the compa-
ny $300 million in 7 years, and it would cost $220 million today to build. The company will decide to build
the factory if the interest rate is
a. no less than 4.53 percent.
b. no greater than 4.53 percent.
c. no less than 5.81 percent.
d. no greater than 5.81 percent.
ANS: B
11. Which of the following is the correct way to compute the future value of $X that earns r percent interest for
N years?
a. $X(1 + rN)N
b. $X(1 + r)N
c. $X(1 + rN)
d. $X(1 + r/N)N
ANS: B
12. Which of the following is the correct way to compute the future value of $1 put into an account that earns 5
percent interest for 16 years?
a. $1(1 + .05)16
b. $1(1 + .05 16) 16
c. $1(1 + .05 16)
d. $1(1 + 16/.05)16
ANS: A
13. Which of the following is the correct way to compute the future value of $100 put into an account that
earns 4 percent interest for 10 years?
a. $100(1 + .0410)
b. $100(1 + .04 10)
c. $100 10 (1 + .04)
d. $100(1 + .04)10
ANS: D
15. Toni put $500 into an account and one year later she had $534. What interest rate was paid on Toni’s de-
posit?
a. 7.1 percent
b. 5.9 percent
c. 6.8 percent
d. None of the above is correct.
ANS: C
16. Bert put $75 into an account and one year later had $100. What interest rate was paid on Bert’s deposit?
a. 20 percent
b. 25 percent
c. 28 percent
d. None of the above is correct.
ANS: D
17. Susan put $375 into an account and one year later had $405. What interest rate was paid on Susan’s depos-
it?
a. 5 percent
b. 7 percent
c. 8 percent
d. 10 percent
ANS: C
18. Hector puts $150 into an account when the interest rate is 4 percent. Later he checks his balance and finds
he has about $168.73. How long did Hector wait to check his balance?
a. 3 years
b. 3.5 years
c. 4 years
d. 4.5 years
ANS: A
19. Marcia has four savings accounts. Which account has the largest balance?
a. $100 deposited 1 year ago at an 8 percent interest rate
b. $100 deposited 2 years ago at a 4 percent interest rate
c. $100 deposited 4 years ago at a 2 percent interest rate
d. $100 deposited 8 years ago at a 1 percent interest rate
ANS: D
20. Which, if any, of the present values below are computed correctly?
a. A payment of $100 to be received one year from today, with a 2 percent interest rate, has a
present value of $98.81.
b. A payment of $200 to be received two years from today, with a 3 percent interest rate, has a
present value of $188.52.
c. A payment of $300 to be received three years from today, with a 4 percent interest rate, has a
present value of $234.34.
d. None of the above are correct to the nearest cent.
ANS: B
21. Risk aversion helps to explain various things we observe in the economy, including
a. adherence to the old adage, “Don’t put all your eggs in one basket.”
b. insurance.
c. the risk-return trade-off.
d. All of the above are correct.
ANS: D
22. Economists have developed models of risk aversion using the concept of
a. utility and the associated assumption of diminishing marginal utility.
b. utility and the associated assumption of increasing marginal utility.
c. income and the associated assumption of diminishing marginal wealth.
d. income and the associated assumption of increasing marginal wealth.
ANS: A
C
B
26. Refer to Figure 1. The utility function that is shown exhibits the property of diminishing
a. wealth.
b. utility.
c. marginal wealth.
d. marginal utility.
ANS: D
27. Refer to Figure 1. Which distance along the vertical axis represents the marginal utility of an increase in
wealth from $600 to $800?
a. the distance between the origin and point B
b. the distance between the origin and point C
c. the distance between point A and point C
d. the distance between point B and point C
ANS: D
28. Refer to Figure 1. Let 0A represent the distance between the origin and point A; let AB represent the
distance between point A and point B; etc. Which of the following ratios best represents the marginal utility
per dollar when wealth increases from $400 to $600?
a.
b.
c.
d.
ANS: D
29. Refer to Figure 1. For the person to whom this utility function applies,
a. the more wealth she has, the less utility she gets from an additional dollar of wealth.
b. the more wealth she has, the more utility she gets from an additional dollar of wealth.
c. her level of satisfaction will be enhanced more by an increase in wealth from $600 to $800 than it
would be by an increase in wealth from $400 to $600.
d. her level of satisfaction will be enhanced equally by an increase in wealth from $600 to $800 or by
an increase in wealth from $400 to $600.
ANS: A
30. Refer to Figure 1. Suppose the person to whom this utility function applies begins with $600 in wealth.
Starting from there,
a. she would be willing to accept a coin-flip bet that would result in her winning $200 if the result
was “heads” or losing $200 if the result was “tails.”
b. the pain of losing $200 of her wealth would equal the pleasure of adding $200 to her wealth.
c. the pain of losing $200 of her wealth would exceed the pleasure of adding $200 to her wealth.
d. the pleasure of adding $200 to her wealth would exceed the pain of losing $200 of her wealth.
ANS: C
31. Refer to Figure 14-1. The properties exhibited by this utility function help to explain various things we
observe in the economy, including
a. the risk-return tradeoff.
b. insurance.
c. diversification.
d. All of the above are correct.
ANS: D
Figure 2. The figure shows a utility function for Mary Ann.
Utility
C
B
A
32. Refer to Figure 2. From the appearance of the utility function, we know that
a. Mary Ann is risk averse.
b. Mary Ann gains less satisfaction when her wealth increases by X dollars than she loses in
satisfaction when her wealth decreases by X dollars.
c. the property of diminishing marginal utility applies to Mary Ann.
d. All of the above are correct.
ANS: D
33. Refer to Figure 2. From the appearance of the utility function, we know that
a. Mary Ann is risk averse.
b. Mary Ann gains more satisfaction when her wealth increases by X dollars than she loses in
satisfaction when her wealth decreases by X dollars.
c. the property of increasing marginal utility applies to Mary Ann.
d. All of the above are correct.
ANS: A
34. Refer to Figure 2. Suppose the vertical distance between the points (0, A) and (0, B) is 5. If her wealth
increased from $1,050 to $1,350, then
a. Mary Ann’s subjective measure of her well-being would increase by less than 5 units.
b. Mary Ann’s subjective measure of her well-being would increase by more than 5 units.
c. Mary Ann would change from being a risk-averse person into a person who is not risk averse.
d. Mary Ann would change from being a person who is not risk averse into a risk-averse person.
ANS: A
35. Refer to Figure 2. From the appearance of the utility function, we know that
a. if Mary Ann owns a house, she would not consider buying fire insurance.
b. Mary Ann would prefer to hold a portfolio of stocks with an average return of 8 percent and a
standard deviation of 2 percent to a portfolio of stocks with an average return of 8 percent and a
standard deviation of 5 percent.
c. Mary Ann would prefer to hold a portfolio of stocks with an average return of 8 percent and a
standard deviation of 5 percent to a portfolio of stocks with an average return of 6 percent and a
standard deviation of 3 percent.
d. All of the above are correct.
ANS: B
36. Refer to Figure 2. Suppose Mary Ann begins with $1,050 in wealth. Starting from there,
a. she would be willing to accept a coin-flip bet that would result in her winning $300 if the result
was “heads” or losing $300 if the result was “tails.”
b. the pain of losing $300 of her wealth would equal the pleasure of adding $300 to her wealth.
c. the pain of losing $300 of her wealth would exceed the pleasure of adding $300 to her wealth.
d. the pleasure of adding $300 to her wealth would exceed the pain of losing $300 of her wealth.
ANS: C
37. Refer to Figure 2. Suppose Mary Ann begins with $1,050 in wealth. Which of the following coin-flip bets
would she definitely not be willing to accept?
a. If it is “heads,” she wins $100; if it is tails, she loses $95.
b. If it is “heads,” she wins $150; if it is tails, she loses $150.
c. If it is “heads,” she wins $150; if it is tails, she loses $140.
d. She definitely would not accept any of these bets.
ANS: B
Figure 3. The figure shows a utility function for Rob.
Utility
38. Refer to Figure 3. From the appearance of Rob’s utility function, we know that
a. the pain that Rob would experience if he lost $200 of his wealth would exceed the pleasure that
he would experience if he added $200 to his wealth.
b. the pleasure that Rob would experience if he added $200 to his wealth would exceed the pain
that he would experience if he lost $200 of his wealth.
c. the property of increasing utility does not apply to Rob.
d. the property of diminishing marginal utility does not apply to Rob.
ANS: D
39. Refer to Figure 3. From the appearance of Rob’s utility function, we know that
a. if Rob owns a house, then he definitely would buy fire insurance provided the cost of the
insurance were reasonable.
b. Rob would voluntarily exchange a portfolio of stocks with a high average return and a high level of
risk for a portfolio with a low average return and a low level of risk.
c. Rob is risk averse.
d. Rob is not risk averse.
ANS: D
40. Refer to Figure 3. If most people’s utility functions look like Rob’s utility function, then it is easy to explain
why
a. people buy various types of insurance.
b. we observe a trade-off between risk and return.
c. most people prefer to hold diversified portfolios of assets to undiversified portfolios of assets.
d. None of the above are correct.
ANS: D
Figure 4. The figure shows a utility function for Dexter.
Utility
41. Refer to Figure 4. In what way(s) does the graph differ from the usual case?
a. The utility function shown here is upward-sloping, whereas in the usual case the utility function is
downward-sloping.
b. The utility function shown here is bowed downward (convex), whereas in the usual case the utility
function is bowed upward (concave).
c. On the graph shown here, wealth is measured along the horizontal axis, whereas in the usual case
saving is measured along the horizontal axis.
d. On the graph shown here, utility is measured along the vertical axis, whereas in the usual case
satisfaction is measured along the vertical axis.
ANS: B
42. Refer to Figure 4. From the appearance of the graph, we know that
a. Dexter’s level of satisfaction increases by more when his wealth increases from $1,001 to $1,002
than it does when his wealth increases from $1,000 to $1,001.
b. Dexter’s level of satisfaction increases by less when his wealth increases from $1,001 to $1,002
than it does when his wealth increases from $1,000 to $1,001.
c. Dexter’s level of satisfaction increases by the same amount when his wealth increases from
$1,001 to $1,002 as it does when his wealth increases from $1,000 to $1,001.
d. None of the above answers can be inferred from the appearance of the utility function.
ANS: A
43. Refer to Figure 4. From the appearance of the utility function, we know that
a. Dexter is risk averse.
b. Dexter gains less satisfaction when his wealth increases by X dollars than he loses in satisfaction
when his wealth decreases by X dollars.
c. the property of diminishing marginal utility does not apply to Dexter.
d. All of the above are correct.
ANS: C
44. Refer to Figure 4. From the appearance of the utility function, we know that
a. Dexter is risk averse.
b. Dexter gains more satisfaction when his wealth increases by X dollars than he loses in satisfaction
when his wealth decreases by X dollars.
c. the property of decreasing marginal utility applies to Dexter.
d. All of the above are correct.
ANS: B
45. Refer to Figure 4. Suppose the vertical distance between the points (0, A) and (0, B) is 12. If his wealth
increased from $1,300 to $1,800, then
a. Dexter’s subjective measure of his well-being would increase by less than 12 units.
b. Dexter’s subjective measure of his well-being would increase by more than 12 units.
c. Dexter would change from being a risk-averse person into a person who is not risk averse.
d. Dexter would forgo the insurance he bought when his wealth was $1,300.
ANS: B
46. Refer to Figure 4. Suppose Dexter begins with $1,300 in wealth. Starting from there,
a. the pain of losing $500 of his wealth would equal the pleasure of adding $500 to his wealth.
b. the pain of losing $500 of his wealth would exceed the pleasure of adding $500 to his wealth.
c. the pleasure of adding $500 to his wealth would exceed the pain of losing $500 of his wealth.
d. This cannot be determined from the graph.
ANS: C
47. From the standpoint of the economy as a whole, the role of insurance is
a. to entice risk-loving people to become risk averse.
b. to promote the phenomenon of adverse selection.
c. not to eliminate the risks inherent in life, but to spread them around more efficiently.
d. not to spread risks, but to eliminate them for individual policy holders.
ANS: C
50. The largest reduction in a portfolio’s risk is achieved when the number of stocks in the portfolio is increased
from
a. 80 to 100.
b. 40 to 80.
c. 10 to 20.
d. 1 to 10.
ANS: D
52. Mary Beth is risk averse and has $1,000 with which to make a financial investment. She has three options.
Option A is a risk-free government bond that pays 5 percent interest each year for two years. Option B is a
low-risk stock that analysts expect to be worth about $1,102.50 in two years. Option C is a high-risk stock
that is expected to be worth about $1,200 in four years. Mary Beth should choose
a. option A.
b. option B.
c. option C.
d. either A or B because they are the same to her.
ANS: A
53. A measure of the volatility of a variable is its
a. present value.
b. future value.
c. return.
d. standard deviation.
ANS: D
63. Diminishing marginal utility of wealth implies that the utility function is
a. upward-sloping and has decreasing slope.
b. upward-sloping and has increasing slope.
c. downward-sloping and has decreasing slope.
d. downward-sloping and has increasing slope.
ANS: A
64. If a person is risk averse, then as wealth increases, total utility of wealth
a. increases at an increasing rate.
b. increases at a decreasing rate.
c. decreases at an increasing rate.
d. decreases at a decreasing rate.
ANS: B
65. Given that Tamar is a risk-averse person, she might accept a bet with a 50 percent chance of losing $100
today if she had a 50 percent
a. chance of winning $120 in two years and the interest rate was 11%.
b. chance of winning $114 in two years and the interest rate was 7%.
c. chance of winning $110 in two years and the interest rate was 3%.
d. None of the above are correct; a risk averse person would not accept any of the above bets.
ANS: C
66. 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.
ANS: C
Figure 5. On the graph, x represents risk and y represents return.
10 y
9
8
D
7
6 C
5 B
4
A
3
2
1
5 10 15 20 x
71. 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 pro-
duced 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
ANS: B
74. 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.
ANS: B
75. Ben decided to increase the number of stocks in his portfolio. In doing so, Ben 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.
ANS: B
77. Which of the following pairs of portfolios exemplifies the risk-return tradeoff?
a.
For Portfolio A, the average return is 6 percent and the standard deviation is 15 percent; for
Portfolio B, the average return is 6 percent and the standard deviation is 25 percent.
b. For Portfolio A, the average return is 5 percent and the standard deviation is 15 percent; for
Portfolio B, the average return is 8 percent and the standard deviation is 15 percent.
c. For Portfolio A, the average return is 5 percent and the standard deviation is 25 percent; for
Portfolio B, the average return is 8 percent and the standard deviation is 15 percent.
d. For Portfolio A, the average return is 5 percent and the standard deviation is 15 percent; for
Portfolio B, the average return is 8 percent and the standard deviation is 25 percent.
ANS: D
80. 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
ANS: C