Chapter 17/Uncertainty
Chapter 17 Uncertainty
MULTIPLE CHOICE
Choose the one alternative that best completes the statement or answers the question.
1) Although he is very poor, Al plays the million-dollar lottery everyday because he is certain that one day he will win. Al makes this calculation based upon
A) the frequency of past outcomes.
B) subjective probability.
C) knowledge of all possible outcomes.
D) tossing a coin.
Answer: B
Diff: 0
Topic: Degree of Risk
2) If there are 10,000 people in your age bracket, and 10 of them died last year, an insurance company believes that the probability of someone in that age bracket dying this year would be
A) 0.
B) .001.
C) .0001.
D) 1,000.
Answer: B
Diff: 0
Topic: Degree of Risk
3) People in a certain group have a 0.3% chance of dying this year. If a person in this group buys a life insurance policy for $3,300 that pays $1,000,000 to her family if she dies this year and $0 otherwise, what is the expected value of a policy to the insurance company?
A) $0
B) $300
C) $3,000
D) $3,300
Answer: B
Diff: 1
Topic: Degree of Risk
4) Expected value represents
A) the actual payment one expects to receive.
B) the average of all payments one would receive if one undertook the risky event many times.
C) the payment one receives if he or she makes the correct decision.
D) the payment that is most likely to occur.
Answer: B
Diff: 2
Topic: Degree of Risk
5) On any given day, a salesman can earn $0 with a 20% probability, $100 with a 40% probability, or $300 with a 20% probability. His expected earnings equal
A) $0.
B) $100 because that is the most likely outcome.
C) $100 because that is what he will earn on average.
D) $200 because that is what he will earn on average.
Answer: C
Diff: 2
Topic: Degree of Risk
6) On any given day, a salesman can earn $0 with a 30% probability, $100 with a 20% probability, or $300 with a 50% probability. His expected earnings equal
A) $0.
B) $100.
C) $150.
D) $170.
Answer: D
Diff: 1
Topic: Degree of Risk
7) Sarah buys little stuffed animals for $5 each. They come in different varieties. If the producer stops making (retires) a certain variety, a stuffed animal of that variety will be worth $100; otherwise it is worth $0. There is 50% chance that any variety will be retired. When Sarah buys her next stuffed animal, the expected profit is
A) $50.
B) $47.50.
C) $45.00.
D) $0.
Answer: C
Diff: 1
Topic: Degree of Risk
8) Sarah buys little stuffed animals for $5 each. They come in different varieties. If the producer stops making (retires) a certain variety, a stuffed animal of that variety will be worth $100; otherwise it is worth $0. There is 50% chance that any variety will be retired. What is the value to Sarah of knowing ahead of time whether a variety will be retired?
A) $50
B) $5
C) $2.50
D) $0
Answer: C
Diff: 2
Topic: Degree of Risk
9) If a payout is certain to occur, then the variance of that payout equals
A) zero.
B) one.
C) the expected value.
D) the expected value squared.
Answer: A
Diff: 1
Topic: Degree of Risk
10) A lottery game pays $500 with .001 probability and $0 otherwise. The variance of the payout is
A) 15.8.
B) 249.50.
C) 249.75.
D) 499.
Answer: C
Diff: 1
Topic: Degree of Risk
11) All else held constant, as the variance of a payoff increases, the
A) expected value of the payoff increases.
B) risk of the payoff increases.
C) expected value of the payoff decreases.
D) risk of the payoff decreases.
Answer: B
Diff: 1
Topic: Degree of Risk
Figure 17.1
12) Figure 17.1 shows Bob's utility function. He currently has $100 of wealth, but there is a 50% chance that it could all be stolen. The midpoint of the chord that runs from zero and intersects the utility function where wealth is 100, represents Bob's
A) risk premium.
B) expected utility of receiving $50 with certainty.
C) expected utility of receiving $0 50% of the time and $100 50% of the time.
D) risk neutrality.
Answer: C
Diff: 1
Topic: Decision Making Under Uncertainty
13) Figure 17.1 shows Bob's utility function. He currently has $100 of wealth, but there is a 50% chance that it could all be stolen. Bob's expected utility is
A) a.
B) b.
C) c.
D) d.
Answer: A
Diff: 1
Topic: Decision Making Under Uncertainty
14) Figure 17.1 shows Bob's utility function. He currently has $100 of wealth, but there is a 50% chance that it could all be stolen. Bob is
A) risk averse.
B) risk neutral.
C) risk loving.
D) risk premium.
Answer: A
Diff: 1
Topic: Decision Making Under Uncertainty
15) Figure 17.1 shows Bob's utility function. He currently has $100 of wealth, but there is a 50% chance that it could all be stolen. Bob's expected wealth is
A) $0.
B) $50.
C) $75.
D) $100.
Answer: B
Diff: 1
Topic: Decision Making Under Uncertainty
16) Figure 17.1 shows Bob's utility function. He currently has $100 of wealth, but there is a 50% chance that it could all be stolen. To reduce the chance of theft to zero, Bob is willing to pay
A) $20.
B) $50.
C) $70.
D) $80.
Answer: C
Diff: 1
Topic: Decision Making Under Uncertainty
17) Figure 17.1 shows Bob's utility function. He currently has $100 of wealth, but there is a 50% chance that it could all be stolen. Over and above the price of fair insurance, what is the risk premium Bob would pay to eliminate the chance of theft?
A) $0
B) $20
C) $30
D) $50
Answer: B
Diff: 1
Topic: Decision Making Under Uncertainty
18) Figure 17.1 shows Bob's utility function. He currently has $100 of wealth, but there is a 50% chance that it could all be stolen. Living with this risk gives Bob the same expected utility as if there was no chance of theft and his wealth was
A) $0.
B) $20.
C) $30.
D) $50.
Answer: C
Diff: 1
Topic: Decision Making Under Uncertainty
19) Figure 17.1 shows Bob's utility function. He currently has $100 of wealth, but there is a 50% chance that it could all be stolen. What is the most Bob would pay for insurance that would replace his $100 should it be stolen?
A) $30
B) $50
C) $70
D) $75
Answer: C
Diff: 1
Topic: Decision Making Under Uncertainty
20) Figure 17.1 shows Bob's utility function. He currently has $100 of wealth, but there is a 50% chance that it could all be stolen. If Bob could keep $50 with certainty, his utility would be
A) a.
B) b.
C) c.
D) d.
Answer: B
Diff: 1
Topic: Decision Making Under Uncertainty
21) Figure 17.1 shows Bob's utility function. He currently has $100 of wealth, but there is a 50% chance that it could all be stolen. Bob is risk averse because
A) his utility function is concave.
B) he has diminishing marginal utility of wealth.
C) he is willing to pay a premium to avoid a risky situation.
D) All of the above.
Answer: D
Diff: 1
Topic: Decision Making Under Uncertainty
22) Figure 17.1 shows Bob's utility function. He currently has $100 of wealth, but there is a 50% chance that it could all be stolen. Bob is risk averse because
A) his utility function is convex.
B) he has negative marginal utility of wealth.
C) he is willing to pay a premium to avoid a risky situation.
D) All of the above.
Answer: C
Diff: 1
Topic: Decision Making Under Uncertainty
23) Figure 17.1 shows Bob's utility function. He currently has $100 of wealth, but there is a 50% chance that it could all be stolen. Bob will buy theft insurance to cover the full $100
A) as long as it does not cost more than $25.
B) as long as it does not cost more than $50.
C) as long as it does not cost more than $70.
D) at any price.
Answer: C
Diff: 1
Topic: Decision Making Under Uncertainty
24) If a person is entertained by gambling, then
A) she is not risk averse.
B) does not understand the concept of a fair game.
C) she may gamble even if it is an unfair game.
D) she will definitely not buy automobile insurance.
Answer: C
Diff: 1
Topic: Decision Making Under Uncertainty
25) If a person is risk neutral, then she
A) is indifferent about playing a fair game.
B) will pay a premium to avoid a fair game.
C) has a horizontal utility function.
D) has zero marginal utility of wealth.
Answer: A
Diff: 1
Topic: Decision Making Under Uncertainty
26) John derives more utility from having $1,000 than from having $100. From this, we can conclude that John
A) is risk averse.
B) is risk loving.
C) is risk neutral.
D) has a positive marginal utility of wealth.
Answer: D
Diff: 1
Topic: Decision Making Under Uncertainty
27) John's utility from an additional dollar increases more when he has $1,000 than when he has $10,000. From this, we can conclude that John
A) is risk averse.
B) is risk loving.
C) is risk neutral.
D) has a negative marginal utility of wealth.
Answer: A
Diff: 1
Topic: Decision Making Under Uncertainty
28) Bob invests $50 in an investment that has a 50% chance of being worth $100 and a 50% chance of being worth $0. From this information we can conclude that Bob is not
A) risk loving.
B) risk neutral.
C) risk averse.
D) rational.
Answer: C
Diff: 1
Topic: Decision Making Under Uncertainty
29) Bob invests $75 in an investment that has a 50% chance of being worth $100 and a 50% chance of being worth $0. From this information we can conclude that Bob is
A) risk loving.
B) risk neutral.
C) risk averse.
D) irrational.
Answer: A
Diff: 1
Topic: Decision Making Under Uncertainty
30) Bob invests $25 in an investment that has a 50% chance of being worth $100 and a 50% chance of being worth $0. From this information we can conclude that Bob is
A) risk loving.
B) risk neutral.
C) risk averse.
D) Any one of the three above.
Answer: D
Diff: 1
Topic: Decision Making Under Uncertainty
31) The Friedman-Savage utility function can explain why
A) people buy automobile insurance.
B) somebody becomes addicted to gambling.
C) people become more risk averse as their wealth increases.
D) people place small bets to have a chance at winning a large amount.
Answer: D
Diff: 2
Topic: Decision Making Under Uncertainty
32) Buying a diversified mutual stock fund allows you to
A) completely avoid all types of risk.
B) avoid only random, unsystematic risk.
C) avoid only systematic risk.
D) avoid risk only when all the stock prices are perfectly correlated.
Answer: B
Diff: 1
Topic: Avoiding Risk
33) The ability of diversification to reduce risk
A) is greater the more negatively correlated the two events are.
B) is greater the more positively correlated the two events are.
C) is greater the more uncorrelated the two events are.
D) is greater the more risk averse the individual is.
Answer: A
Diff: 2
Topic: Avoiding Risk
34) If two events are perfectly positively correlated, then
A) diversification is not necessary since there is no risk.
B) diversification eliminates all risk.
C) diversification does not reduce risk at all.
D) diversification only cuts the risk in half.
Answer: C
Diff: 2
Topic: Avoiding Risk
35) Many people do not fully insure against risk because
A) they are risk averse.
B) the insurance companies are all crooks.
C) the insurance offered is less than fair.
D) the insurance offered is more than fair.
Answer: C
Diff: 1
Topic: Avoiding Risk
36) If fair insurance is offered to a risk-averse person, she will
A) buy enough insurance to eliminate all risk.
B) not buy any insurance because it is overpriced.
C) not buy any insurance since the marginal utility of the amount of the payment is positive.
D) buy enough insurance to cover about half of the possible loss.
Answer: A
Diff: 1
Topic: Avoiding Risk
37) Which of the following losses to an individual would an insurance company NOT cover?
A) The person's automobile is stolen.
B) Fire destroys the person's home.
C) The person's father dies.
D) The person's country is invaded.
Answer: D
Diff: 1
Topic: Avoiding Risk
38) Insurance companies do not cover losses that would
A) happen to all of the policyholders at once.
B) happen with a very low probability.
C) happen to just a handful of policyholders.
D) happen with uncertainty.
Answer: A
Diff: 1
Topic: Avoiding Risk
39) Risk-averse individuals make risky investments
A) never.
B) when the investment's return exceeds the return on a nonrisky investment.
C) when the investment's return adequately compensates for the risk.
D) only when they are feeling irrational.
Answer: C
Diff: 1
Topic: Investing Under Uncertainty
40) If an individual makes her investment decisions based solely on the Net Present Value criterion, one can conclude that she is
A) risk averse.
B) risk neutral.
C) risk loving.
D) extremely wealthy.
Answer: B
Diff: 1
Topic: Investing Under Uncertainty
41) The rate of return on bonds is lower than on stocks over time because
A) bond holders cannot diversify.
B) bonds have a lower standard deviation in returns.
C) stocks have less nondiversifiable risks than bonds.
D) bonds are subject to more random risks than stocks.
Answer: B
Diff: 0
Topic: Investing Under Uncertainty
42) Empirical evidence suggests that usury laws
A) help poor consumers by lowering the interest rate they pay.
B) hurt poor consumers by limiting their ability to borrow.
C) keep interest rates low.
D) limit the amount borrowed by wealthier consumers.
Answer: B
Diff: 1
Topic: Investing Under Uncertainty
43) Usury laws result in banks making less credit available to lower-income households because
A) higher-income households will pay a higher interest rate than lower-income households.
B) loans made to higher-income households have no risk.
C) loans to lower-income households are riskier than loans to higher-income households.
D) the regulated interest rate does not adequately compensate the bank for the risk of