Basic Finance
Name:____________________________
____ 1.
Most financial decisions involve two related elements:
a. advice and consent.
b. investment and taxes.
c. time and risk.
d. saving and consumption.
____ 2.
The field of finance primarily studies
a. how society manages its scarce resources.
b. the implications of time and risk for allocating resources over time.
c. firms’ decisions concerning how much to produce and what price to charge.
d. how society can reduce market risk.
____ 3.
Which of the following statements best describes the economist’s view of finance and the
financial system?
a. The financial system is very important to the functioning of the economy, and the tools of
finance are often helpful to us as individuals when we find ourselves making certain
decisions.
b. The financial system, while interesting, is not very important to the functioning of the
economy; however, the tools of finance are often helpful to us as individuals when we find
ourselves making certain decisions.
c. The financial system is very important to the functioning of the economy; however, the
tools of finance are not particularly helpful to us as individuals since we seldom make
decisions for which those tools are useful.
d. The field of finance is intimately concerned with the financial system and the tools of
finance, and financial economists see great importance in them; however, the
“mainstream” economist sees little value in studying financial markets or the tools of
finance.
____ 4.
Compounding refers directly to
a. finding the present value of a future sum of money.
b. finding the future value of a present sum of money.
c. changes in the interest rate over time on a bank account or a similar savings vehicle.
d. interest being earned on previously-earned interest.
____ 5.
Discounting refers directly to
a. finding the present value of a future sum of money.
b. finding the future value of a present sum of money.
c. calculations that ignore the phenomenon of compounding for the sake of ease and
simplicity.
d. decreases in interest rates over time, while compounding refers to increases in interest
rates over time.
____ 6.
Other things the same, an increase in the interest rate makes the quantity of loanable funds
demanded
a. rise, and investment spending rise.
b. rise, and investment spending fall.
c. fall, and investment spending rise.
d. fall, and investment spending fall.
____ 7.
Other things the same, an increase in the interest rate makes the quantity of loanable funds
supplied
a. rise, and investment spending rise.
b. rise, and investment spending fall.
c. fall, and investment spending rise.
d. fall, and investment spending fall.
____ 8.
Albert Einstein once referred to compounding as
a. “an obsession among economists that defies explanation.”
b. “the greatest mathematical discovery of all time.”
c. his own discovery.
d. John Maynard Keynes’s greatest contribution.
____ 9.
Risk aversion helps to explain various things we observe in the economy, including
a. adherence to the old adage, “Don’t put all your eggs in one basket.”
b. insurance.
c. the risk-return trade-off.
d. All of the above are correct.
____ 10.
Economists have developed models of risk aversion using the concept of
a. utility and the associated assumption of diminishing marginal utility.
b. utility and the associated assumption of increasing marginal utility.
c. income and the associated assumption of diminishing marginal wealth.
d. income and the associated assumption of increasing marginal wealth.
____ 11.
For a risk averse person,
a. the pleasure of winning $1,000 on a bet exceeds the pain of losing $1,000 on a bet.
b. the pain of losing $1,000 on a bet exceeds the pleasure of winning $1,000 on a bet.
c. the utility function exhibits the property of increasing marginal utility.
d. the utility function gets steeper as wealth increases.
____ 12.
From the standpoint of the economy as a whole, the role of insurance is
a. to entice risk-loving people to become risk averse.
b. to promote the phenomenon of adverse selection.
c. not to eliminate the risks inherent in life, but to spread them around more efficiently.
d. not to spread risks, but to eliminate them for individual policy holders.
____ 13.
The problem of moral hazard arises because
a. life is full of all sorts of risks.
b. after people buy insurance, they have less incentive to be careful about their risky
behavior.
c. a high-risk person is more likely to apply for insurance than is a low-risk person.
d. insurance companies go to great effort to avoid paying claims to their policy holders.
____ 14.
As the number of stocks in a person’s portfolio increases,
a. the risk of the portfolio increases, as indicated by the increasing value of the standard
deviation of the portfolio.
b. the risk of the portfolio increases, as indicated by the decreasing value of the standard
deviation of the portfolio.
c. the risk of the portfolio decreases, as indicated by the increasing value of the standard
deviation of the portfolio.
d. the risk of the portfolio decreases, as indicated by the decreasing value of the standard
deviation of the portfolio.
____ 15.
The largest reduction in a portfolio’s risk is achieved when the number of stocks in the
portfolio is increased from
a. 80 to 100.
b. 40 to 80.
c. 10 to 20.
d. 1 to 10.
____ 16.
Diversification of a portfolio
a. can eliminate market risk, but it cannot eliminate firm-specific risk.
b. can eliminate firm-specific risk, but it cannot eliminate market risk.
c. increases the portfolio’s standard deviation.
d. is not necessary for a person who is risk averse.
____ 17.
A measure of the volatility of a variable is its
a. present value.
b. future value.
c. return.
d. standard deviation.
____ 18.
If Robert is risk-averse, then he will always
a. choose not to play a game where he has a 50 percent chance of winning $1 and a 50
percent chance of losing $1.
b. choose not to play a game where he has a 75 percent chance of winning $1 and a 25
percent chance of losing $1.
c. choose to play a game where he has a 52 percent chance of winning $1 and a 48 percent
chance of losing $1.
d. All of the above are correct.
____ 19.
If a person is risk averse, then as wealth increases, total utility of wealth
a. increases at an increasing rate.
b. increases at a decreasing rate.
c. decreases at an increasing rate.
d. decreases at a decreasing rate.
____ 20.
Risk
a. can be reduced by placing a large number of small bets rather than a small number of large
bets.
b. can be reduced by increasing the number of stocks in a portfolio.
c. Both A and B are correct.
d. Neither A nor B are correct.
____ 21.
Which of the following defines an annuity?
a. For a fee, an insurance company provides you with regular income until you die.
b. A surcharge is added to life-insurance premiums paid by persons in dangerous
occupations.
c. Annuity is another name for stock funds managed by mutual fund managers.
d. Annuity is another name for any diversified portfolio.
____ 22.
In effect, an annuity provides insurance
a. against the risk of dying and leaving one’s family without a regular income.
b. against the risk of living too long.
c. to people who are not risk-averse.
d. to people whose utility functions do not display the usual properties.
____ 23.
Which of the following actions best illustrates adverse selection?
a. A person adds risky stock to his portfolio.
b. A person who has narrowly avoided many accidents applies for automobile insurance.
c. A person is unwilling to buy a stock when she believes its price has an equal chance of
rising or falling $10.
d. A person purchases homeowners insurance and then checks his smoke detector batteries
less frequently.
____ 24.
Which of the following actions best illustrates moral hazard?
a. A person adds risky stock to his portfolio.
b. A person who has narrowly avoided many accidents applies for automobile insurance.
c. A person is unwilling to buy a stock when she believes its price has an equal chance of
rising or falling $10.
d. A person purchases homeowners insurance and then checks his smoke detector batteries
less frequently.
____ 25.
Tami knows that people in her family die young, and so she buys life insurance. Preston
knows he is a reckless driver and so he applies for automobile insurance.
a. These are both examples of adverse selection.
b. These are both examples of moral hazard.
c. The first example illustrates adverse selection, and the second illustrates moral hazard.
d. The first example illustrates moral hazard, and the second illustrates adverse selection.
____ 26.
Which of the following is adverse selection?
a. the risk associated with selecting stocks in only a few specific companies
b. the risk that a person will become overconfident in his ability to select stocks
c. a high-risk person being more likely to apply for insurance
d. after obtaining insurance a person having less incentive to be careful
____ 27.
Which of the following best illustrates moral hazard?
a. After a person obtains life insurance, she takes up skydiving.
b. A person obtains insurance knowing he is in poor health.
c. A person holds stock only in very risky corporations.
d. A person holds stocks from only a few corporations.
____ 28.
When you rent a car, you might treat it with less care than you would if it were your own.
This is an example of
a. market risk.
b. moral hazard.
c. adverse selection.
d. risk aversion.
____
29.
Over the past two centuries, the average annual rates of return were about
a.
b.
c.
d.
5 percent for stocks and about 1.5 percent for short-term government bonds.
6 percent for stocks and about 2.5 percent for short-term government bonds.
8 percent for stocks and about 3 percent for short-term government bonds.
None of the above is correct.
____ 30.
Risk-averse people will choose different asset portfolios than people who are not risk averse.
Over a long period of time, we would expect that
a. every risk-averse person will earn a higher rate of return than every non-risk-averse
person.
b. every risk-averse person will earn a lower rate of return than every non-risk-averse person.
c. the average risk-averse person will earn a higher rate of return than the average non-riskaverse person.
d. the average risk-averse person will earn a lower rate of return than the average non-riskaverse person.
____ 31.
Roger determines that if Aim Corporation has high revenues, then Zest Corporation will have
low revenues, and that if Aim Corporation has low revenues, Zest Corporation will have high revenues. He
buys stock in both corporations.
a. He has reduced firm-specific risk but not market risk.
b. He has reduced market risk, but not firm-specific risk.
c. He had reduce both firm-specific risk and market risk.
d. He has reduced neither firm-specific risk nor market risk.
____ 32.
Amanda talks with several different brokers at a social gathering. She hears the following
advice from brokers A, B, and C. Which broker, if any, gave her incorrect advice?
a. Broker A: “There are risks in holding stocks, even in a highly diversified portfolio.”
b. Broker B: “Portfolios with smaller standard deviations have lower risk.”
c. Broker C: “Stocks with greater risks offer lower average returns.”
d. They all gave her correct advice.
____ 33.
Mary talked to several stockbrokers and made the following conclusions. Which, if any, of
her conclusions are correct?
a. It is relatively easy to reduce firm-specific risk by increasing the number of companies one
holds stock in.
b. Stock prices, even if not exactly a random walk, are very close to it.
c. Some people have made a lot of money in the stock market by using insider information,
but these cases are not contrary to the efficient markets hypothesis.
d. All of Mary’s conclusions are correct.
____ 34.
Other things the same, as the number of stocks in a portfolio rises,
a. risk increases and the standard deviation of the return rises.
b. risk increases and the standard deviation of the return falls.
c. risk decreases and the standard deviation of the return rises.
d. risk decreases and the standard deviation of the return falls.
____ 35.
Diversification reduces
a. only market risk.
b. only firm-specific risk.
c. neither market or firm-specific risk.
d. both market and firm-specific risk.
____ 36.
Which of the following is a source of market risk?
a. Holding stocks in many companies carries the risk of a reduced average return.
b. Real GDP varies over time and sales and profits move with real GDP.
c. When a paper producer has declining sales, it is likely that so will other paper producers.
d. If stockholders become aggravated with the way a CEO runs a company, the price of that
company’s stock might fall in the stock market.
____ 37.
Angela reads financial advice columns and concludes the following. Which, if any, of her
conclusions are incorrect?
a. Higher average returns come at the price of higher risk.
b. People who are risk averse should never hold stock.
c. Diversification cannot eliminate all of the risk in stock portfolio.
d. None of her conclusions are incorrect.
____ 38.
Ben decided to increase the number of stocks in his portfolio. In doing so, Ben reduced
a. both the firm-specific risk and the market risk of his portfolio.
b. the firm-specific risk, but not the market risk of his portfolio.
c. the market risk, but not the firm-specific risk of his portfolio.
d. neither the market risk nor the firm-specific risk of his portfolio.
____ 39.
To diversify, a homeowner with a variable-rate mortgage should choose investments that
a. pay higher returns when interest rates rise and lower returns when interest rates fall.
b. pay lower returns when interest rates rise and higher returns when interest rates fall.
c. provide a higher return than the market average.
d. provide a lower return than the market average.
____ 40.
Marcus puts a greater proportion of his portfolio into government bonds. Marcus’s action
a. increases both risk and the average rate of return.
b. decreases both risk and the average rate of return.
c. increases risk, but decreases the average rate of return.
d. decreases risk, but increases the average rate of return.
____ 41.
Suppose that fundamental analysis indicates a particular company’s stock is overvalued.
a. This means its present value is less than its price. You should consider adding the stock to
your portfolio.
b. This means its present value is less than its price. You shouldn’t consider adding the stock
to your portfolio.
c. This means its present value is more than its price. You should consider adding the stock
to your portfolio.
d. This means its present value is more than its price. You shouldn’t consider adding the
stock to your portfolio.
____ 42.
The idea of insurance
a. would not appeal to a risk-averse person.
b. is, other things the same, to reduce the probability of a fire, accident, or death.
c. is to share risk.
d. is to provide a sure thing, not a gamble.
____ 43.
Which of the following actions best illustrates adverse selection?
a. A person purposely chooses bonds of corporations with high default risk because of the
high returns.
b. A person dislikes losing $400 more than he likes winning $400.
c. After obtaining automobile insurance a person drives less carefully than before.
d. A person intending to take up dangerous hobbies applies for life insurance.
____ 44.
In general, as a person includes fewer stocks and more bonds in his portfolio,
a. both risk and expected return rise.
b. risk rises but expected return falls.
c. risk falls, but expected return rises.
d. both risk and expected return fall.
____ 45.
According to fundamental analysis, a saver should prefer to buy stocks that are
a. undervalued. This means the price of the stock is low given the value of the corporation.
b. undervalued. This means the value of the corporation is low given the price of stock.
c. overvalued. This means the price of the stock is high given the value of the corporation.
d. overvalued. This means the value of the corporation is high given the price of stock.
____ 46.
By diversifying, the risk of holding stock
a. can be eliminated. On average over the past two centuries stocks paid a higher average
real return than bonds.
b. can be eliminated. On average over the past two centuries stocks paid a lower average real
return than bonds.
c. can be reduced but not eliminated. On average over the past two centuries stocks paid a
higher average real return than bonds.
d. can be reduced but not eliminated. On average over the past two centuries stocks paid a
lower average real return than bonds.
____ 47.
If a stock or bond is risky
a. risk averse people may be willing to hold it as part of a diversified portfolio.
b. risk averse people may be willing to hold it if the expected return is high enough.
c. both A and B are correct.
d. risk averse people will not hold it.
____ 48.
When a person engages in detailed analysis of a company to determine its value, he or she is
engaging in
a. standard deviation analysis.
b. informational analysis.
c. fundamental analysis.
d. efficiency analysis.
____ 49.
By purchasing shares in a mutual fund that holds a portfolio of stocks, a person can
a. benefit from fundamental analysis, since the mutual fund requires its shareholders to
perform fundamental analysis on their own.
b. benefit from fundamental analysis, since the mutual fund hires one or more individuals to
perform fundamental analysis for the fund.
c. eliminate market risk.
d. reduce the standard deviation of his or her portfolio to zero.
____ 50.
If the efficient markets hypothesis is correct, then
a. the number of shares of stock offered for sale exceeds the number of shares of stock that
people want to buy.
b. the stock market is informationally efficient.
c. stock prices never follow a random walk.
d. All of the above are correct.
____
51.
If you believe that stock prices follow a random walk, then probably you
a.
b.
c.
d.
do not believe that there is positive relationship between risk and return.
do not believe that stock prices reflect all available information.
believe in the validity of the efficient markets hypothesis.
believe that it is a good idea to engage in fundamental analysis.
____ 52.
The performance of index funds
a. usually falls short of the performance of actively-managed funds.
b. provides evidence in support of the notion that stock prices do not depend upon supply
and demand.
c. provides evidence in support of the efficient markets hypothesis.
d. provides evidence in support of the notion that stock-market participants are irrational.
____ 53.
Which of the following is correct?
a. Risk-averse people will not hold stock.
b. Diversification cannot reduce firm-specific risk.
c. The larger the percentage of stock in a portfolio, the greater the risk, but the greater the
average return.
d. Stock prices are determined by fundamental analysis rather than by supply and demand.
____ 54.
Dividends
a. are the rates of return on mutual funds.
b. are cash payments that companies make to shareholders.
c. are the difference between the price and present value per share of a stock.
d. are the rates of return on a company’s capital stock.
____ 55.
Fundamental analysis is
a. the study of the relation between risk and return of stock portfolios.
b. the determination of the allocation of savings between stocks and bonds based on a
person’s degree of risk aversion.
c. the study of a company’s accounting statements and future prospects to determine its
value.
d. a method used to determine how adding stocks to a portfolio will change the risk of the
portfolio.
____ 56.
If stock prices follow a random walk, it means
a. long periods of declining prices are followed by long periods of rising prices.
b. the greater the number of consecutive days of price declines, the greater the probability
prices will increase the following day.
c. stock prices are unrelated to random events that shock the economy.
d. stock prices are just as likely to rise as to fall at any given time.
____ 57.
Some people claim that stocks follow a random walk. What does this mean?
a. The price of stock one day is about what it was on the previous day.
b. Changes in stock prices cannot be predicted from available information.
c. Stock prices are not determined by market fundamentals such as supply and demand.
d. Prices of stocks of different firms in the same industry show no or little tendency to move
together.
____
58.
If stock prices follow a random walk, then stock investors can make large profits by
a.
b.
c.
d.
buying stocks whose prices have been falling for several days.
buying stocks whose prices have been rising for several days.
performing fundamental analysis of stocks using data contained in annual reports.
using inside information.
____ 59.
The efficient markets hypothesis says that
a. only individual investors can make money in the stock market.
b. it should be easy to find stocks whose price differs from their fundamental value.
c. stock prices follow a random walk.
d. All of the above are correct.
____ 60.
An index fund
a. holds only stocks and bonds that are indexed to inflation.
b. holds all the stocks in a given stock index.
c. guarantees a return that follows the index of leading economic indicators.
d. typically has a lower return than a managed fund.
____ 61.
If the efficient market hypothesis is correct, then
a. index funds should typically beat managed funds, and usually do.
b. index fund should typically beat managed funds, but usually do not.
c. mutual funds should typically beat index funds, and usually do.
d. mutual funds should typically beat index funds, but usually do not.
____ 62.
Research studies have shown that
a. the correlation between how well a stock does one year and how well it does the next is
significantly greater than zero.
b. managed mutual funds generally outperform indexed mutual funds.
c. people tend to be overconfident when making investment decisions.
d. All of the above are correct.
____ 63.
Which of the following is correct?
a. Managed funds typically have a higher return than indexed funds. This tends to refute the
efficient market hypothesis.
b. Managed funds typically have a higher return than indexed funds. This tends to support
the efficient market hypothesis.
c. Index funds typically have a higher rate of return than managed funds. This tends to refute
the efficient market hypothesis.
d. Index funds typically have a higher rate of return than managed funds. This tends to
support the efficient market hypothesis.
____ 64.
In the 1990s, Fed Chairperson Alan Greenspan questioned whether the stock market
a. boom at that time reflected “irrational exuberance.”
b. decline at that time reflected “irrational funk.”
c. boom at that time reflected “rational exuberance.”
d. decline at that time reflected “rational funk.”
____ 65.
Which of the following is correct concerning stock market irrationality?
a. Bubbles could arise, in part, because the price that people pay for stock depends on what
they think someone else will pay for it in the future.
b. Economists almost all agree that the evidence for stock market irrationality is convincing
and the departures from rational pricing are important.
c. Some evidence for the existence of market irrationality is that informed and presumably
rational managers of mutual funds generally beat the market.
d. All of the above are correct.
____ 66.
Whenever the price of an asset rises above what appears to be its fundamental value, the
market is said to be experiencing a
a. conjectural mistake.
b. fundamental mishap.
c. speculative bubble.
d. temporary inefficiency.
____ 67.
Which of the following terms is used to describe a situation in which the price of an asset
rises above what appears to be its fundamental value?
a. “random walk”
b. “random bubble”
c. “speculative bubble”
d. “speculative hedge”
____ 68.
An asset market is said to experience a speculative bubble when
a. the price of the asset rises above what appears to be its fundamental value.
b. the price of the asset appears to follow a random walk.
c. the market cannot establish an equilibrium price for the asset.
d. the asset is a natural resource and its supply is manipulated by foreign nations and foreign
firms.
____ 69.
The possibility of speculative bubbles in the stock market arises in part because
a. stock prices may not depend at all on psychological factors.
b. fundamental analysis may be the correct way to evaluate the value of stocks.
c. future streams of dividend payments are very hard to estimate.
d. the value of shares of stock depends not only on the future stream of dividend payments
but also on the price at which the stock will be sold.
____ 70.
If asset markets are driven by the “animal spirits” of investors, then
a. those markets reflect rational behavior.
b. those markets reflect irrational behavior.
c. the efficient markets hypothesis is correct.
d. the stock market exhibits informational efficiency.
____ 71.
The value of a stock is based on the
a. present values of the dividend stream and final price. As a result, the value of a stock rises
when interest rates rise.
b. present values of the dividend stream and final price. As a result, the value of a stock falls
when interest rates rise.
c. future values of the dividend stream and final price. As a result, the value of a stock rises
when interest rates rises.
d. future values of the dividend stream and final price. As a result, the value of a stock falls
when interest rates rise.
____ 72.
The efficient markets hypothesis implies
a. that all stocks are fairly valued all the time and that no stock is a better buy than any other.
b. that all stocks are fairly valued all the time, but that some stocks may be better buys than
other.
c. that some stocks may be better buys than others and stock experts can determine which
ones.
d. that no stock is efficiently valued.
____ 73.
The efficient markets hypothesis says that beating the market consistently is
a. impossible. Many studies find that beating the market is, at best, extremely difficult.
b. impossible. Many studies find that beating the market is relatively easy.
c. relatively easy. Many studies find that beating the market is, at best, extremely difficult.
d. relatively easy. Many studies find that beating the market is relatively easy.
____ 74.
If you are convinced that stock prices are impossible to predict from available information,
then you probably also believe that
a. the efficient markets hypothesis is not a correct hypothesis.
b. the stock market is informationally efficient.
c. the stock market is informationally inefficient.
d. there is no reason to establish a diversified portfolio of stocks.
____ 75.
The available evidence indicates that
a. about one-half of all managers of active mutual funds consistently outperform index funds.
b. outperforming the market on a consistent basis is extremely difficult to do.
c. there is little truth to the notion that there is a trade-off between risk and return.
d. there is little truth to the efficient markets hypothesis.
____ 76.
According to the efficient market hypothesis
a. changes in the prices of stocks are predictable. Evidence shows that managed funds
typically do better than indexed funds.
b. changes in the prices of stocks are predictable. Evidence shows that indexed funds
typically do better than managed funds.
c. changes in the prices of stocks are not predictable. Evidence shows that managed funds
typically do better than indexed funds.
d. changes in the prices of stocks are not predictable. Evidence shows that indexed funds
typically do better than managed funds.
____ 77.
After the 1982 recession, the U.S. and world economies entered into a long period
a. of high unemployment rates.
b. high inflation rates.
c. that has become known as the “Great Moderation.”
d. that has become known as the “Great Recession.”
____ 78.
Writing in the Wall Street Journal in 2009, economist Jeremy Siegel argued that, in the years
leading up to the financial crisis of 2008–2009,
a. financial firms acted in too risky a fashion.
b. the Federal Reserves’s efforts to rein in the risky behavior of certain financial firms were
inadequate.
c. falling house prices “crashed the banks and the economy.”
d. All of the above are correct.
____ 79.
No particular stock is a better buy than any other stock if
a. stock prices are driven by investors’ “animal spirits.”
b. the random-walk theory of stock prices is incorrect.
c. the efficient markets hypothesis is correct.
d. actively managed mutual funds always outperform index funds.