FINA-7001 Business Finance 1 Week 6: Assignment 2 – MC#1

FINA-7001 Business Finance 1 Week 6: Assignment 2 – MC#1 Page 1 | 14 1. Which of the following is NOT a correct statement? a) Risk-averse investors will not willingly undertake fair gambles. b) Risk-averse investors prefer to gamble on a risky situation where there is an equal probability of winning or losing the same amount of money. c) Risk-averse investors require a risk premium to bear risk; the more risk averse they are, the higher the risk premium they require. d) Risk-averse investors are willing to pay an insurance premium to get out of a risky situation. Answer: b 2. Which of the following investments would a risk-averse investor prefer if the risk-free rate is zero? Value of Investment if: Investment Cost Today Market Return 0% Probability: 40% Market Return 0% Probability: 60% I $20 $20 $20 II $15 $30 $0 III $0 -$10 $10 a) I only b) II only c) III only d) I and III only Answer: c, Investment E(Value) E(Payoff) I $20*40% + $20*60% = $20 $20 – $20 = $0 II $30*40% + $0*60% = $12 $12 – $15 = –$3 III –$10*40% + $10*60% = $2 $2 – $0 = $2 A risk-averse investor prefers investment III because to be induced to enter a risky situation, (s)he needs a risk premium. FINA-7001 Business Finance 1 Week 6: Assignment 2 – MC#1 Page 2 | 14 3. Given the following information, which investment(s) would risk-averse investors prefer if the riskfree rate is 5 percent? Value of Investment after one year if: Investment Cost Today Market Return 0% Probability: 40% Market Return 0% Probability: 60% I $18 $36 $8 II $14 $12 $16 III $15 $30 $5 a) I only b) II only c) III only d) I and II only Answer: a, Investment E0(Value) E(Payoff) I ($36*40% + $8*60%)/1.05 = $18.29 $18.29 – $18 = $0.29 II ($12*40% + $16*60%)/1.05 = $13.71 $13.71 – $14 = –$0.29 III ($30*40% + $5*60%)/1.05 = $14.29 $14.29 – $15 = –$0.71 A risk-averse investor prefers investment I because to be induced to enter a risky situation, he needs a risk premium. 4. A portfolio consists of two securities: a 90-day T-bill and the S&P/TSX Composite. The expected return on the T-bill is 4.5 percent. The expected return on the S&P/TSX Composite is 12 percent with a standard deviation of 20 percent. What is the portfolio standard deviation if the expected return for this portfolio is 15 percent? a) 8.13% b) 12.00% c) 16.80% d) 28.00% Answer: d, Weight in S&P/TSX, 15% 4.5% 1.4 12% 4.5% w − = = − , weight in risk-free asset = 1 – 1.4 = –0.4 σ P = = 20%*1.4 28% 5. Which one of the following is NOT true? a) The separation theorem states that the borrowing decision and investment decision are separate. b) Investors should look at investments in terms of their prospective return, not their cost c) The separation theorem states that you cannot separate your risk-free and stock investments. d) The market portfolio is the tangent line that goes through the risk free rate.