Chapter 06 - Risk Aversion and Capital Allocation to Risky Assets
16. The variable (A) in the utility function represents the: A. investor's return requirement. B. investor's aversion to risk.
C. certainty-equivalent rate of the portfolio. D. minimum required utility of the portfolio. E. the security's variance.
A is an arbitrary scale factor used to measure investor risk tolerance. The higher the value of A, the more risk averse the investor.
AACSB: Analytic Bloom's: Understand Difficulty: Intermediate Topic: Risk Aversion
17. The exact indifference curves of different investors A. cannot be known with perfect certainty.
B. can be calculated precisely with the use of advanced calculus. C. allow the advisor to create more suitable portfolios for the client.
D. cannot be known with perfect certainty but they do allow the advisor to create more suitable portfolios for the client. E. None of these is correct.
Indifference curves cannot be calculated precisely, but the theory does allow for the creation of more suitable portfolios for investors of differing levels of risk tolerance.
AACSB: Analytic Bloom's: Understand Difficulty: Basic
Topic: Risk Tolerance
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Chapter 06 - Risk Aversion and Capital Allocation to Risky Assets
18. The riskiness of individual assets
A. should be considered for the asset in isolation.
B. should be considered in the context of the effect on overall portfolio volatility.
C. should be combined with the riskiness of other individual assets in the proportions these assets constitute the entire portfolio.
D. should be considered in the context of the effect on overall portfolio volatility and should be combined with the riskiness of other individual assets in the proportions these assets constitute the entire portfolio.
E. is irrelevant to the portfolio decision.
The relevant risk is portfolio risk; thus, the riskiness of an individual security should be considered in the context of the portfolio as a whole.
AACSB: Analytic Bloom's: Understand Difficulty: Basic
Topic: Portfolio Risk Allocation
19. A fair game
A. will not be undertaken by a risk-averse investor. B. is a risky investment with a zero risk premium. C. is a riskless investment.
D. will not be undertaken by a risk-averse investor and is a risky investment with a zero risk premium.
E. will not be undertaken by a risk-averse investor and is a riskless investment.
A fair game is a risky investment with a payoff exactly equal to its expected value. Since it offers no risk premium, it will not be acceptable to a risk-averse investor.
AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Risk Aversion
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Chapter 06 - Risk Aversion and Capital Allocation to Risky Assets
20. The presence of risk means that A. investors will lose money.
B. more than one outcome is possible.
C. the standard deviation of the payoff is larger than its expected value. D. final wealth will be greater than initial wealth. E. terminal wealth will be less than initial wealth.
The presence of risk means that more than one outcome is possible.
AACSB: Analytic Bloom's: Understand Difficulty: Basic Topic: Risk Aversion
21. The utility score an investor assigns to a particular portfolio, other things equal, A. will decrease as the rate of return increases.
B. will decrease as the standard deviation decreases. C. will decrease as the variance decreases. D. will increase as the variance increases. E. will increase as the rate of return increases.
Utility is enhanced by higher expected returns and diminished by higher risk.
AACSB: Analytic Bloom's: Understand Difficulty: Basic Topic: Risk Aversion
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Chapter 06 - Risk Aversion and Capital Allocation to Risky Assets
22. The certainty equivalent rate of a portfolio is
A. the rate that a risk-free investment would need to offer with certainty to be considered equally attractive as the risky portfolio.
B. the rate that the investor must earn for certain to give up the use of his money. C. the minimum rate guaranteed by institutions such as banks.
D. the rate that equates \all risk-averse investors.
E. represented by the scaling factor \?.005\
The certainty equivalent rate of a portfolio is the rate that a risk-free investment would need to offer with certainty to be considered equally attractive as the risky portfolio.
AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Risk Aversion
23. According to the mean-variance criterion, which of the statements below is
correct? A. Investment B dominates Investment A. B. Investment B dominates Investment C.
C. Investment D dominates all of the other investments. D. Investment D dominates only Investment B. E. Investment C dominates investment A.
Investment B dominates investment C because investment B has a higher return and a lower standard deviation (risk) than investment C.
AACSB: Analytic Bloom's: Understand Difficulty: Intermediate Topic: Risk Aversion
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Chapter 06 - Risk Aversion and Capital Allocation to Risky Assets
24. Steve is more risk-averse than Edie. On a graph that shows Steve and Edie's indifference curves, which of the following is true? Assume that the graph shows expected return on the vertical axis and standard deviation on the horizontal axis. I) Steve and Edie's indifference curves might intersect.
II) Steve's indifference curves will have flatter slopes than Edie's. III) Steve's indifference curves will have steeper slopes than Edie's. IV) Steve and Edie's indifference curves will not intersect.
V) Steve's indifference curves will be downward sloping and Edie's will be upward sloping. A. I and V B. I and III C. III and IV D. I and II E. II and IV
This question tests whether the student understands the graphical properties of indifference curves and how they relate to the degree of risk tolerance.
AACSB: Analytic Bloom's: Understand Difficulty: Intermediate Topic: Risk Tolerance
25. The Capital Allocation Line can be described as the
A. investment opportunity set formed with a risky asset and a risk-free asset. B. investment opportunity set formed with two risky assets.
C. line on which lie all portfolios that offer the same utility to a particular investor.
D. line on which lie all portfolios with the same expected rate of return and different standard deviations.
E. investment opportunity set formed with multiple risky assets.
The CAL has an intercept equal to the risk-free rate. It is a straight line through the point representing the risk-free asset and the risky portfolio, in expected-return/standard deviation space.
AACSB: Analytic Bloom's: Understand Difficulty: Intermediate
Topic: Portfolio Risk Allocation
6-35