CH 17 FINAL

Question 1

Your friend Dimitre tells you that he thinks that his favorite basketball team has a 70% chance
of winning the next game. This is an example of a(n)
A) objective probability.
B) subjective probability.
C) risk-averse statement.
D) Friedman-Savage preference.

Answer 1

B) subjective probability.

Question 2

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 2

B) the average of all payments one would receive if one undertook the risky event many times.

Question 3

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 3

C) $100 because that is what he will earn on average.

Question 4

On any given day we know a salesman can earn $0 with a 40% probability, $100 with a 20%
probability or $300 with 40% probability. His expected earnings equal
A) $0.
B) $140.
C) $300.
D) It cannot be determined from the available information.

Answer 4

B) $140.

Question 5

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 5

C) 249.75.

Question 6

A risk-preferring person is willing to pay
A) a risk premium.
B) a fee to make a fair bet.
C) to obtain decreasing marginal utility.
D) None of the above.

Answer 6

B) a fee to make a fair bet.

Question 7

For a risk-neutral person, the expected utility associated with various levels of wealth
A) is above the person’s utility function.
B) is below the person’s utility function.
C) is equal to the person’s utility function.
D) does not exist.

Answer 7

C) is equal to the person’s utility function.

Question 8

Which of the following games involving the roll of a single die is a fair bet?
A) Bet $1 and receive $1 if 3 or 4 comes up.
B) Bet $1 and receive $1 if 3, 4, or 5 comes up.
C) Bet $1 and receive $4 if 6 comes up.
D) None of the bets is a fair bet.

Answer 8

B) Bet $1 and receive $1 if 3, 4, or 5 comes up.

Question 9

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 9

C) risk averse.

Question 10

Catherine is risk averse. When faced with a choice between a gamble and a certain level of
wealth she will
A) always prefer the gamble.
B) always prefer the certain level of wealth.
C) prefer the gamble if the expected utility from it is higher than the utility from the certain level
of wealth.
D) prefer the certain level of wealth if the expected utility from the gamble is higher than the
utility of the certain level of wealth.

Answer 10

C) prefer the gamble if the expected utility from it is higher than the utility from the certain level
of wealth.

Question 11

Which of the following is a fair bet based on the toss of an unbiased coin?
A) head: receive $5, tail: lose $5
B) head: receive $2, tail: lose $3
C) head: receive $0.5, tail: lose $1
D) head: lose $3, tail: lose $3

Answer 11

A) head: receive $5, tail: lose $5

Question 12

Risk premium is the ________ amount that a ________ person would pay to avoid
________.
A) maximum; risk-averse; taking a risk
B) maximum; risk-neutral; losing everything
C) minimum; risk-averse; taking a risk
D) minimum; risk-loving; losing everything

Answer 12

A) maximum; risk-averse; taking a risk

Question 13

Which of the following helps to reduce risk?
A) Abstain from risk taking.
B) Obtain more information.
C) Diversify.
D) All of the above.

Answer 13

D) All of the above.

Question 14

In terms of the stock market, systematic risk refers to the fact that
A) some stocks have higher returns than others.
B) some stocks’ returns have a higher variance than others.
C) all stock prices are correlated with the health of the economy.
D) most stock prices are perfectly negatively correlated.

Answer 14

C) all stock prices are correlated with the health of the economy.

Question 15

A person is betting a coin will come up heads or tails. The coin always lands on one of these
two outcomes. This person can bet to
A) eliminate only the systematic risk.
B) eliminate only the random risk.
C) eliminate all risk.
D) All of the above

Answer 15

C) eliminate all risk.

Question 16

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 16

A) buy enough insurance to eliminate all risk.

Question 17

After Hurricane Katrina, there was considerable public outrage that many of the properties
were not insured against flooding although they were insured against wind damage. What might
explain these different approaches to insurance?
A) The risk of wind damage is potentially diversifiable, but the risk of flooding is not.
B) The risk of flood damage is potentially diversifiable, but the risk of wind damage is not.
C) predatory insurance policies
D) Neither the risk of wind damage nor the risk of flooding is diversifiable.

Answer 17

A) The risk of wind damage is potentially diversifiable, but the risk of flooding is not.

Question 18

Suppose a senior college football player approaches an insurance company and seeks to
purchase an insurance policy against him receiving a career-ending injury. The insurance
company
A) will sell him an insurance policy because the proposal entails uncertainty not risk.
B) will sell him an insurance policy because the proposal entails risk not uncertainty.
C) will not sell him an insurance policy because the proposal entails uncertainty not risk.
D) will not sell him an insurance policy because the proposal entails risk not uncertainty.

Answer 18

B) will sell him an insurance policy because the proposal entails risk not uncertainty.

Question 19

Risk-averse individuals make risky investments
A) never.
B) when the investment’s expected return exceeds the return on a non-risky investment.
C) when the investment’s expected return adequately compensates for the risk.
D) only when they are feeling irrational.

Answer 19

C) when the investment’s expected return adequately compensates for the risk

Question 20

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 20

B) risk neutral.

Question 21

Michelle invested $50 in a project that has a 40% chance of being worth $80 and a 60%
chance of being worth $20. One can conclude that Michelle is
A) risk averse.
B) risk neutral.
C) risk loving.
D) extremely wealthy.

Answer 21

C) risk loving.

Question 22

The gambler’s fallacy suggests that what happened in the past will influence the present. This
is most likely true in which of the following situations?
A) flipping cards from a single deck
B) tossing a fair coin
C) the quality of play of a baseball team
D) horse racing

Answer 22

B) tossing a fair coin

Question 23

Behavioral economics under uncertainty documents that
A) people’s behavior often differs from what standard expected utility theory predicts.
B) people’s behavior can change with their circumstances.
C) people might put considerable weight on certain outcomes.
D) All of the above.

Answer 23

D) All of the above.

Question 24

Prospect theory can explain why
A) people tend to gamble on long odds with small expected utility.
B) people tend to sell their losing stocks and keep their winning stocks.
C) people should only sell their losing stocks.
D) people should never play the lottery.

Answer 24

B) people tend to sell their losing stocks and keep their winning stocks.

Question 25

According to prospect theory,
A) people are concerned with wealth levels only.
B) people are concerned with changes in wealth levels only.
C) people never use a reference level when making their decisions.
D) everybody is risk-neutral.

Answer 25

B) people are concerned with changes in wealth levels only.

Question 26

Which of the following evidence does NOT support the expected utility theory?
A) People assign disproportionately high weights to rare events.
B) Risk-averse people do not engage in fair bets.
C) Risk-loving people do not purchase insurance policies.
D) Risk-neutral people engage in fair bets.

Answer 26

A) People assign disproportionately high weights to rare events.

Question 27

The certainty effect occurs when people put ________ weight on outcomes that they
consider to be ________ relative to ________ outcomes.
A) excessive; certain; risky.
B) low; certain; risky.
C) low; recurring; rare.
D) excessive; risky, certain.

Answer 27

A) excessive; certain; risky.