Econ 50 Fall 16 Review Questions

1. Explain the relationship between the concept of diversification and the concepts
of systematic risk and non-systematic risk.
2. Explain in what sense an investor who purchases a single stock is behaving
irrationally. Has she overpaid or underpaid for the stock? How do you reconcile
your answer to the last question with the fact that she paid exactly the same price
for the stock as thousands of other people who purchased the stock at the same
time she did? OVERPAID. HER STOCK IS RISKIER THAN IT NEEDS
TO BE, THEREFORE RISK-Er RATIO IS UNFAVORABLE.
3. Which systematic risk is the most inescapable? That is, which systematic risk
remains even for the investment that comes closest to being risk free?
INFLATION. US INFLATION-INDEXED BONDS ESSENTIALLY
ELIMINATE THIS RISK AS WELL.
4. If a gambling wheel is fair and has the following values: 0, 2, 3, 4, 0, 6, 7, 0, 8,
& 40. What is the Ev? WHATEVER THE AVERAGE OF THOSE
NUMBERS IS.
5. The expected value of a fair wheel with 50 slots is 25. The number 25 must
appear somewhere on the wheel. FALSE. A WHEEL AS DESCRIBED WITH
ZERO IN TWENTY-FIVE SLOTS AND 50 IN TWENTY-FIVE SLOTS
WOULD HAVE AN Er OF 25.
6. You get an email from a friend telling you about a fundraiser her charity is doing.
They are selling rubber ducks. Each duck is numbered and each is associated
with its owner. All the ducks will be put into a local stream at the same time. The
first duck to cross the finish line gets $100, the second duck to cross the line gets
$75, the third duck gets $50 and the fourth gets $25. The prize money has been
donated by an anonymous donor. Each duck costs a $1.00. You ask your friend
how many ducks are being sold and she says, We limit it to 100, but we seldom
manage to sell that many. Im on the fundraising committee so Im expected to
find buyers for the ducks; I really hope we can sell them all this year. You pause
for a few minutes, and then make an offer to your friend. Assuming you are a
cold-hearted capitalist who hates to part with a nickel, let alone a dollar, which of
the following offers is the most logical? Why?
a. Offer to buy a duck for a dollar and hope you win.
b. Offer to buy 10 ducks for $10 dollars and hope you win.
c. Find an excuse to not buy a duck.
d. Offer to buy all the ducks for $100.
7. When we say that investors do not care about non-systematic risk, that implies
that a major positive, firm-specific (non-systematic) event at a company has no
effect on the stock price of that company. FALSE. WE EXPECT THESE
EVENTS ALL THE TIME, BUT WE EXPECT THEY WILL BE RANDOM
AND DIVERSIFIABLE.

8. All other things being equal, if the nominal risk-free rate of return were to
increase significantly, we should expect the nominal stock market rate of return
would
a. Increase
b. Decrease
c. Not change
d. Cant predict
9. T/F: It is unlikely that any individual stock lies on the SML. Explain your
answer. TRUE. SEE THE SLIDE THAT TALKS ABOUT IBM. UNLESS A
STOCK HAD NO DIVERSIFIABLE RISK (NON-SYSTEMATIC RISK) IT
COULD NOT LIE ON THE SML.
10. All other things being equal, if we observed a long-term increase in the so-called
risk premium for stocks, the best possible explanation is:
a. Investors were becoming less risk averse
b. Investors were becoming more risk averse
c. Inflation was increasing
d. Inflation was decreasing
11. You are talking to your doctor about investments. She says that she owns only
one stock. You explain to her the benefits of diversification. She says, I get it!
Diversification works like sample size in a medical trial. The more patients we
treat, the more certain we can be that the observed results are attributable to the
treatment. Does she get it? Why or why not? YES.
12. We have said that investors care about Risk and Return. Explain how the concept
of an investors time horizon relates to one or both of those concepts.
EXPECTED RETURN IS A STATISTICAL CONCEPT. THE MORE
TRIES OR EVENTS IN THE SAMPLE SIZE, THE MORE CONFIDENT
WE BECOME THAT THE ACTUAL RESULT WILL COME CLOSE TO
THE EXPECTED RESULT. WITH THE STOCK MARKET, EVENTS
ARE ANNUAL RETURNS, SO WE NEED QUITE A FEW YEARS TO
HAVE CONFIDENCE THAT ACTUAL WILL COME CLOSE TO
PREDICTED (MANY USE THE RULE OF THUMB OF 10 YEARS OR
MORE).
13. If you are convinced that stocks as an investment class have a higher expected
return than government bonds, explain why stocks may not be the right
investment for everybody. DIFFERENT WAYS TO ANSWER THIS, BUT
ALL SHOULD TOUCH ON RISK i.e. VARIANCE IN RETURN. SEE
#12.
14. What systematic risk factor are you inevitably exposed to when you make a
foreign investment? CURRENCY EXCHANGE RISK.

15. Your portfolio contains a large amount of stock from a company you once worked
for. You have not rebalanced your portfolio to better ensure diversification as you
are concerned about the taxes that will be due when you sell the stock. As a result
you follow the price of this stock Company X fairly closely. Driving home
from work one day you were wondering how Company Xs stock did that day as
you knew they were going to announce their quarterly sales and earnings that
morning before the market opened. Unfortunately you missed the announcement
and your iPhone was dead. As you were thinking these thoughts a genie
magically appeared and said, You can ask me two questions to help you figure
out if Company Xs stock price rose or fell today, but you cannot ask me anything
about the stock price specifically. Which of the following two questions would
be the most useful for you to ask?
a. What were Company Xs earnings?
b. What were Company Xs sales?
c. Did the overall market go up or down today?
d. What happened in the bond market today?
e. Were Company Xs earnings above or below expectations?
f. Were Company Xs sales above or below expectations?
g. Were any management changes at Company X announced today with the
earnings report?
16. An insurance company offers two retirement products, each is an annuity. The
first one pays a guaranteed annual amount for as long as the annuity holder is
alive. The second product is a variable annuity that pays a guaranteed
minimum annual amount (which is less than the first product), but in addition, it
pays a variable payment tied to changes in the S&P 500 index. When the market
goes up, the payment will increase. When the market declines, the payment will
decrease. You are told that the price to purchase either annuity is $100,000.
Assuming the annuities are fairly priced, what can you expect regarding the
amount of money you will receive over the course of your life?
a. The fixed annuity will pay you more.
b. The variable annuity will pay you more.
c. Both annuities will pay you the same.
d. Cant tell
17. All other things being equal, the fall of Apples stock price will:
a. Increase the value of Apple puts
b. Decrease the value of Apple calls
c. A & B
d. None of the above
18. If Apples share price remained unchanged since the day that a call option was
sold, all other things (except the passage of time) being constant, the value of that
call option has likely:
a. Fallen
b. Increased
c. Remained the same

d. Cannot tell from the information given.

19. If an investor owned a large number of Apple shares, and that investor regularly
wrote call options on Apple and sold them, and if we consider his investment in
Apple and his practice of writing call options as the totality of his investments,
which of the following best describes the expected economic outcome of his
behavior.
a. He will lower the overall expected return of his total investments, but
will also lower the expected risk.
b. He will raise the overall risk of his investment activity.
c. He will lower the amount of current cash income he receives from his
investments
d. None of the above.
20. If I purchased a large number of put options on Apple, but I also own a sizable
number of shares of Apple, which general description best describes my position:
a. I have lowered the overall risk of my position, but I have lowered the
expected return as well.
b. I have raised the expected return from my portfolio.
c. I have perfectly insured my position in Apple
d. None of the above.
21. The fact that price changes for both individual stocks and market indices can be
well modeled as a random walk; that is, successive price changes are nearly as
likely to be up as down, implies that investment in the stock market is
essentially a gamble, not an investment.
a. True, because if prices move randomly with regard to sign (up vs.
down) the expected return from such an investment must be close to zero,
indicating the investment is actually a gamble.
b. False, because while it is generally true that stock prices follow a random
walk, investors can choose to invest in quality stocks whose price changes
are not random and therefore represent an actual investment.
c. False, because while the overall changes in price are well modeled as
random walks, professionals have a much better than average ability to
find growth stocks whose prices do not follow a random walk.
Therefore investing with professional advice is not a gamble, but an
investment.
d. False, because although price changes are well modeled as a random
walk, there is a slight positive bias towards increases in stock prices
over time which match investors expected return.
22. Which of the following is a reasonable restatement of some feature of financial
markets if you are an adherent of the CAPM view of the world and also believe
that markets are semi-strong efficient? Circle all that apply.
a. Risk and return are negatively correlated.
b. All risks matter.
c. The existence of insider trading is evidence against EMH

d. There is no such thing as a free lunch, with expected return comes

expected risk.
e. Current stock prices are the best predictor of future stock prices.
f. Financial assets are priced based on their expected return and their
diversifiable risk factors.
23. If you observed that on the day that a company announced its quarterly results,
that the stock price declined significantly, what is the likely explanation(s)?
a. Earnings declined versus the previous quarter
b. Earnings increased versus the previous quarter
c. Sales declined versus the previous quarter
d. Earnings increased versus the previous quarter, but not as much as
expected
e. a. & c.
24. As the writer of put options, you most hope that the market price of the
underlying asset:
a. Increases
b. Decreases
c. Indifferent between the two
25. Which of the following is the best plain-language statement of MM proposition
#1?
a. If the size of the pie doesnt change, the value of the pie doesnt
change, no matter how many slices you make.
b. If a pie grows in proportion to the number of slices, then the value of the
pie doesnt change.
c. Taxes result in the pie being effectively larger, because the government
lets you sell some slices without sales taxes being paid, which is a subsidy
of pie.
d. Pie is very tasty and not unhealthy if eaten in moderation.
26. Which of the following is the best plain-language statement of the key concept
underlying MM proposition #2?
a. Corporations earnings are effectively taxed twice: once within the firm
and once more when paid out to shareholders.
b. Corporations can give a bondholder $100 of income, but it only
costs the corporation $65 to do so.
c. Corporations can give a bondholder $100 of income, but it only costs
the corporation $35 to do so.
d. Corporations that make pie are nice places to work.
27. Which of the following facts is inconsistent with MM proposition #2 being
completely (or largely) correct?
a. Interest rates rise during periods of inflation.
b. Firms prefer to issue long-term debt
c. Average D/E ratios that are between 1 and 2

28. If you believe that markets are efficient, and the day after Tim Cook announces
the new iPhone 32 can not only make phone calls, but clean your house as well,
however, over the next two days the stock price doesnt change a bit, you might
conclude which of the following? More than one may be true.
a. The market does not believe the iPhone 32 will meaningfully change
Apples earnings.
b. The market believes that the iPhone 32 will meaningfully change
Apples earnings, but they have thought that for a long time.
c. The experts who follow Apple believes that the iPhone 32 will
meaningfully change Apples earnings, but the market hasnt caught up to
the news yet.
d. The experts dont believe Tim Cook is telling the truth.
29. Assume it is generally true that the Federal Reserve bank can, through the actions
of its open market committee, change expectations about inflation in future
periods. You are driving home and hear on the radio that the Fed met yesterday
and made an important announcement. Just then someone honks at you and you
miss the next few words of the report. When you return to paying attention, you
hear the announcer say, .and bond prices fell dramatically today. What can
you assume about the Feds actions?
a. They changed perceptions about future inflation, making the market
believe inflation would be less than expected.
b. They changed perceptions about future inflation, making the market
believe inflation would be more than expected.
c. Cant conclude anything from the facts given.
30. As an adherent to the teachings of EMH, why do you support the effort that was
made several years ago to have the FED be more explicit in their announcements
about what they planned to do, but were not yet actually doing? THE POLICY
ALLOWS THE FED TO MORE PRECISELY GUIDE EXPECTATIONS
AND THE MARKET WILL ACT ACCORDINGLY. If the FED consistently
failed to do what they told the markets they planned to do, what do you imagine
would be the effect of the FEDs announcements? MARKETS WOULD COME
TO SEE THAT THE EXPECTATIONS WERE UNWARRANTED AND
STOP RESPONDING. THE TOOL OF MAKING ANNOUNCEMENTS
WOULD LOSE POWER/VALUE.
31. An article in a financial magazine stated that The market has rewarded firms that
have increased their leverage (debt), as stocks in those companies have seen their
returns increase in the period following the increase in debt levels.
a. Using your understanding of MM proposition #2, explain why this
observation was to be expected and not at all surprising. THE RISK OF
LEVERAGED FIRMS (FROM A STOCKHOLDERS POV) GOES
UP. WITH RISK COMES RETURN (MARKET DEMANDS IT) SO
RETURN MUST INCREASE AS LEVERAGE INCREASES.