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Matty and Rudy are the same age,live in the same town,and hold similar jobs a similar distance from their respective homes.They are so similar,in fact,that to the insurance company,they look the same and are offered the same insurance options.However,Matty has never been a particularly good driver and so buys a lot of auto insurance.Rudy,on the other hand,takes pride in being an excellent driver and so only carries the minimum insurance required.This example illustrates the potential for :


A) risk pooling.
B) risk aversion.
C) adverse selection.
D) diversification.

E) A) and C)
F) A) and B)

Correct Answer

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Diversification involves:


A) investing all your money in one company.
B) investing all your money in the same type of financial assets, with the same amount of risk.
C) investing all your money in a variety of financial assets, with varying amounts of risk.
D) None of these statements is true.

E) A) and B)
F) A) and C)

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Evaluating risk requires that:


A) we think about different possible outcomes.
B) we accept that our best guess about future costs and benefits could be wrong.
C) we consider uncertain costs or benefits of an event or choice.
D) All of these statements are true.

E) C) and D)
F) None of the above

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In the context of insurance,everyone typically has to pay a higher premium because of:


A) risk pooling.
B) diversification.
C) risk aversion.
D) adverse selection.

E) B) and C)
F) A) and B)

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Which of the following is closest to the future value of a $4,000 deposit earning 2 percent interest annually after 10 years?


A) $4,122
B) $4,876
C) $5,025
D) $4,805

E) B) and D)
F) A) and D)

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If you knew that an investment was going to pay you $215,892.50 in 10 years,and you knew that the annual interest rate over that time would be 8 percent,you could calculate the present value to be:


A) $80,000.
B) $100,000.
C) $150,000.
D) $125,000.

E) A) and B)
F) A) and C)

Correct Answer

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The present value of $300,000 in 12 years at 4 percent interest is approximately:


A) $312,451.
B) $187,379.
C) $427,126.
D) None of these statements is true.

E) A) and B)
F) B) and C)

Correct Answer

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B

Diversification:


A) reduces the likelihood that bad things will happen.
B) means you're not likely going to be completely ruined by a single unfortunate event.
C) increases the likelihood that bad things will happen.
D) None of these statements is true.

E) A) and B)
F) A) and C)

Correct Answer

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Risk pooling occurs when:


A) people organize themselves in a group to collectively absorb the cost of the risk faced by each individual.
B) people organize themselves in groups according to how risk-averse they are.
C) people organize themselves in groups according to recognizable characteristics.
D) companies organize individuals into groups according to how risk-averse they are.

E) B) and D)
F) B) and C)

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If you want to own $1 million when you retire in 45 years,how much should you put into your retirement fund now,given the interest rate is 3 percent?


A) $250,005.
B) $436,770.
C) $264,439.
D) $275,389.

E) A) and B)
F) A) and C)

Correct Answer

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When people are deciding whether to deposit money in a bank:


A) everyone will respond exactly the same to any given interest rate.
B) some people will require a higher interest rate to deposit the same amount of money.
C) people don't accurately account for the risk of losing savings.
D) they will deposit the same amount in response to any given interest rate.

E) B) and C)
F) A) and D)

Correct Answer

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Insurance premiums represent:


A) the expected value of the payout the company will give to individuals who are insured.
B) more than the expected value of the payout the company will give to individuals who are insured.
C) less than the expected value of the payout the company will give to individuals who are insured.
D) peace of mind and are unrelated to the expected value of the payout the company will give to individuals who are insured.

E) None of the above
F) A) and B)

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Suppose Jack and Kate are at the town fair and are choosing which game to play.The first game has a bag with four marbles in it-1 red marble and 3 blue ones.The player draws one marble from the bag; if it is red,they win $20 and if it is blue,they win $1.The second game has a bag with 10 marbles in it-1 red,4 blue,and 5 green.The player draws one marble from the bag; if it is red,they win $20; if it is blue,they win $5; and if it is green,they win $1.Both games cost $5 to play.What is the probability of drawing a red marble in each game?


A) 10 percent in both games
B) 10 percent in the first game and 25 percent in the second game
C) 25 percent in the first game and 10 percent in the second game
D) 25 percent in both games

E) C) and D)
F) A) and B)

Correct Answer

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Which of the following is closest to the future value of a $40,000 deposit earning 3 percent interest annually after 5 years?


A) $41,282
B) $46,021
C) $46,371
D) $41,150

E) A) and D)
F) A) and C)

Correct Answer

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John is trying to decide whether to expand his business or not.If he continues his business as it is,with no expansion,there is a 50 percent chance he will earn $100,000 and a 50 percent chance he will earn $300,000.If he does expand,there is a 30 percent chance he will earn $100,000,a 30 percent chance he will earn $300,000 and a 40 percent chance he will earn $500,000.It will cost him $150,000 to expand.If John were to expand,which of the following is true?


A) John's expected earnings are $50,000 less than if he didn't expand.
B) John can expect to earn $120,000 more by expanding, but that is less than the cost of expansion, $150,000.
C) John can expect to earn $120,000 more by expanding and therefore made the most profitable decision.
D) All of these statements are true.

E) B) and C)
F) A) and C)

Correct Answer

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A mechanism for reallocating risk is:


A) risk premiums.
B) dividend pooling.
C) diversification.
D) All of these are mechanisms for reallocating risk.

E) None of the above
F) B) and C)

Correct Answer

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Someone who is risk-averse is likely to:


A) buy a government bond instead of a stock.
B) invest in a start-up company instead of putting her money under her mattress.
C) buy company stock instead of putting money in a savings account.
D) All of these statements are true.

E) None of the above
F) A) and C)

Correct Answer

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A

Buying insurance and then never making a claim:


A) is considered by economists to be irrational behavior.
B) means buying the insurance was a bad decision.
C) does not mean buying the insurance was a bad decision.
D) is a poor use of money.

E) A) and B)
F) A) and C)

Correct Answer

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Suppose Jack and Kate are at the town fair and are choosing which game to play.The first game has a bag with four marbles in it-1 red marble and 3 blue ones.The player draws one marble from the bag; if it is red,they win $20 and if it is blue,they win $1.The second game has a bag with 10 marbles in it-1 red,4 blue,and 5 green.The player draws one marble from the bag; if it is red,they win $20; if it is blue,they win $5; and if it is green,they win $1.Both games cost $5 to play.The expected value of the payoff is _____ for the first game and _____ for the second game.


A) $5.00; $4.50
B) $5.75; $4.50
C) $4.50; $5.75
D) $5.75; $5.25

E) None of the above
F) A) and D)

Correct Answer

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Suppose Jack and Kate are at the town fair and are choosing which game to play.The first game has a bag with four marbles in it-1 red marble and 3 blue ones.The player draws one marble from the bag; if it is red,they win $20 and if it is blue,they win $1.The second game has a bag with 10 marbles in it-1 red,4 blue,and 5 green.The player draws one marble from the bag; if it is red,they win $20; if it is blue,they win $5; and if it is green,they win $1.Both games cost $5 to play.Kate is considering whether to play the second game.If Kate only cares about the expected value of the outcome and does not care about risk,she should:


A) not play since she never wins anything.
B) play if the cost of playing the game is greater than the expected value of the payoff.
C) compare the cost of playing the game with the value of her time.
D) play if the cost of playing the game is less than the expected value of the payoff.

E) A) and C)
F) None of the above

Correct Answer

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D

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