Week 1 revision questions + answers

Question 1

Although Jack is very poor, Jack plays the million-dollar lottery every day because he is certain that one day he will win. Jack makes this calculation based upon:

1. The frequency of past outcomes
2. Tossing a coin
3. Subjective probability
4. Knowledge of all possible outcomes

Answer 1

3. Subjective probability

Question 2

Your friend Nia tells you that she thinks that her favourite basketball team has a 70% chance of winning the next game. This is an example of a(n)

1. Friedman-Savage preference
2. Subjective probability
3. Risk-averse statement
4. Objective probability

Answer 2

2. Subjective probability

Question 3

Your friend Diana tells you that she thinks that her favourite football team has a 70% chance of winning the next game because that is exactly the winning rate of her team in the last two seasons. This is an example of a(n)

1. Subjective probability
2. Risk-averse statement
3. Friedman-Savage preference
4. Objective probability

Answer 3

4. Objective probability

Question 4

All else held constant, as the variance of a payoff increases, the

1. Risk of the payoff increase
2. The expected value of the payoff decreases
3. Expected value of the payoff increases
4. Risk of the payoff decreases

Answer 4

1. Risk of the payoff increases

Question 5

A share of a restaurant chain can be worth SGD2 with a probability of 0.40 and SGD10 with a probability of 0.60. What is the expected value a of the price of this share?

1. 6.8
2. 5
3. 6
4. 8.5

Answer 5

1. 6.8

Question 6

Use the figure below to answer the question. In the diagram wealth, W, is measured along the horizontal axis and utility, U, is measured along the vertical axis.

The figure shows Bob’s utility function. He currently has SGD100 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

1. SGD80
2. SGD20
3. SGD50
4. SGD70

Answer 6

4. SGD70

Question 7

John derives more utility from having SGD1,000 than from having SGD100. From this, we can conclude that John

1. Is risk loving
2. Is risk neutral
3. Is risk averse
4. Has a positive marginal utility of wealth

Answer 7

4. Has a positive marginal utility of wealth

Question 8

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?

1. Neither the risk of wind damage nor the risk of flooding is diversifiable
2. The risk of wind damage is potentially diversifiable, but the risk of flooding is not
3. The risk of flood damage is potentially diversifiable, but the risk of wind damage is not
4. Predatory insurance policies

Answer 8

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

Question 9

Farmers who purchase insurance against crop failures tend to be pooled with farmers far away. Why might this be the case?

1. The weather in a single geographic area represents idiosyncratic risk, which is diversifiable
2. The weather in a single geographic area represents systematic risk, which is not diversifiable
3. The weather in far-flung geographic areas represents systematic risk, which is not diversifiable
4. The weather in far-flung geographic areas are commonly positively correlated

Answer 9

1. The weather in a single geographic area represents idiosyncratic risk, which is diversifiable

Question 10

What is one reason the federal government might “bail out” farmers in flood prone areas of the country?

1. Such flooding is not diversifiable and therefore only non-profit entities, such as the federal government, can cover the risks
2. Such flooding is diversifiable, but the market for such insurance policies cannot clear without the assistance of the International Community.
3. Such flooding is diversifiable, but insurance company CEOs are more concerned with their stockholder wealth than the well-being of farmers.
4. Such flooding is known to happen on a regular basis and therefore there is no “risk” to be insured against.

Answer 10

1. Such flooding is not diversifiable and therefore only non-profit entities, such as the federal government, can cover the risks

Question 11

Suppose a football player approaches an insurance company and seeks to purchase an insurance policy against him receiving a career-ending injury. The insurance company

1. will not sell him an insurance policy because the proposal entails uncertainty not risk.
2. will not sell him an insurance policy because the proposal entails risk not uncertainty.
3. will sell him an insurance policy because the proposal entails uncertainty not risk.
4. will sell him an insurance policy because the proposal entails risk not uncertainty

Answer 11

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

Question 12

What is one reason car insurance seems much cheaper than health insurance?

1. Health insurance entails more idiosyncratic than systematic risk, and therefore the gains to diversification are more dramatic.
2. Health insurance entails more systematic than idiosyncratic risk, and therefore there are fewer gains to diversification.
3. Car insurance entails more systematic than idiosyncratic risk, and therefore the gains to diversification are more dramatic.
4. Health insurance is manipulated through market power, and car insurance is not.

Answer 12

2. Health insurance entails more systematic than idiosyncratic risk, and therefore there are fewer gains to diversification

Question 13

If a person is entertained by gambling then,

1. She does not understand the concept of a fair game
2. She may gamble even if it is an unfair game
3. She is risk averse
4. She will definitely not buy automobile insurance

Answer 13

2. She may gamble even if it is an unfair game

Question 14

Experimental evidence that people prefer to avoid risk in gain scenarios but seek risk in loss scenarios is attributed to:

1. the Allais paradox
2. Violation of the independene axiom
3. The common consequence effect
4. Loss aversion

Answer 14

4. Loss aversion

Question 15

If Sue’s utility for money function is U(M) is M1/2 where M is the sum of money, her expected utility for a gamble that has a 50% chance of winning $100 and 50% chance of winning nothing is:

1. 10 and she is risk neutral
2. 5 and she is risk averse
3. 5 and she is risk loving
4. None of the suggested alternatives

Answer 15

2. 5 and she is risk averse

Question 16

Sue’s utility for money function is U(M) is M1/2 where M is the sum of money.

She is choosing between:

A. Investing in a risky project that has a 50% chance of earning $100 and 50% chance of zero earnings.

or;

B. Leaving her money where it is, in which case she earns £36.

Which option will she choose? Will she invest in the risky project (option A) or leave her money where it is (option B)?

1. None of the suggested alternatives
2. She is indifferent between the two options
3. Option A, she will invest
4. Option B, she will leave her money where it is

Answer 16

4. Option B, she will leave her money where it is