FIn 470 - Midterm 1 Exam Questions and Answers

FIn 470 - Midterm 1 Exam Questions and Answers Risk - Ans:-numerical measure about the future payoff to an investment assessed over some time horizon Risk vs uncertainty - Ans:-risk can be quantified (measured) uncertainty can not 5 characteristics of Risk - Ans:-1. risk can be quantified - the riskier an investment the less desirable and the lower the price 2. risk arises because the future outcomes are unknown - we do not know which of many possible outcomes will follow in the future 3. risk has to do with the future payoff of an investment ©GRACEAMELIA 2024/2025 ACADEMIC YEAR. ALL RIGHTS RESERVED FIRST PUBLISH OCTOBER 2024 Page 2/18 - we Mesut imagine all the possible payoffs and the likelihood of each 4. risk must be assessed over some time horizon - in general, risk over shorter periods is lower 5. risk usually measured relative to some benchmark, not in isolation - frequently investments are compare to a "risk free rate" like US treasury bonds if an investment will return $1600, 25% of the time and $700, 75% of the time what is the expected value of the investment - Ans:-.25 x 1600 = 400 .75 x 700 = 525 EV = 925 a risk free asset is - Ans:-an investment whose future value is known with certainty and whose return is the risk free rate of return - the payoff you receive is guaranteed and cannot vary ©GRACEAMELIA 2024/2025 ACADEMIC YEAR. ALL RIGHTS RESERVED FIRST PUBLISH OCTOBER 2024 Page 3/18 variance - Ans:-average of the square deviations of the possible outcomes from their expected value, weighted by their probabilities 1. compute expected value 2. subtract expected value from each of the possible payoffs and square the results 3. multiply each result by the probability 4. add up the results *** compute variance and SD - investment return $500 75% of the time and $2000 25% of the time - Ans:-1. (500 x .75) + (2000 x . .25) = $875 = EV 2. (2,000 - 875 ) = (1125)^2 = 1,265,625 (500 - 875) = (-375) ^2 = 140625 3. .75 (140,625) + .25 (1,265,625) = 421,875= VAR 4. Sq rt 421,875 = 649.52 = Standar Dev standard deviation - Ans:-the std dev is more useful because it deals in normal units, not squared units (dollars sq) ©GRACEAMELIA 2024/2025 ACADEMIC YEAR. ALL RIGHTS RESERVED FIRST PUBLISH OCTOBER 2024 Page 4/18 - we can compare other investments - given a choice between two investments with equal expected payoffs, most will choose the one with the lower standard deviation. - the greater the standard deviation the higher the risk *** risk free investments have rates of return a. equal to zero b. with a std dev equal to zero c. that are uncertain but have a time horizon d. exhibit a large spread of potential payoffs (super risky) - Ans:-B. with standard deviations