Risk Aversion and Question

Question 3 (5 points) Suppose your dear old Grandfather approaches you for investment advice. He knows of your great training in finance and statistics and gives the following instructions: “Obviously, I want to maximize my returns, but since my life is now quite boring, I also enjoy a good thrill. My first priority is to pick the security with the highest return. After that, pick me the most volatile investment so I can enjoy the thrills of holding risk. Suppose there are three securities (X, Y, and Z) to choose from next year, the economy will be in an expansion, normal, or recession state with probabilities 0. 0, 0. 20, and 0. 40 respectively. The returns (%) on the securities in these states are as follows: Security X {expansion = +13, normal = +9, recession = +7}; Security Y,{+1 5,+1 5,+2}; Security Z {+17,+10,+2. 5}. Which investment best fits your grandfather’s needs? Your Answer Correct. Once you see the calculations, his preferences determine the obvious choice. Security X. An exposure to how your choices depend on your risk preferences.

Question 4 (10 points) The more idiosyncratic risk in the return of a security, the larger the risk premium investors will demand.

Your Answer True False. 10. 00 Correct. You understand risk-aversion and the implied diversification by investors. 10. 00 / 10. 00 Fundamentals of risk and diversification. Question 5 (10 points) We often want to find investments that perform well when other parts of our portfolio are struggling. When considering stocks to add to the portfolio, those with a correlation closer to zero with our existing portfolio will most effectively help us diversify. Your Answer Correct. You understand relationships and their critical role in diversification. True.

Again, understanding relationships and diversification.

Question 6 (10 points) As a CEO you wish to maximize the productivity of your workers. You are thinking about providing your employees with smartness so they can be readily available to clients and increase sales. However, you are also concerned that your employees are Just as likely to download APS that will distract them from their work, leading them to play games and update their social networking sites rather than focus on the Job of pleasing clients. To test this you randomly select 6 employees for an experiment.

You provide 3 with the new smart phone and the other 3 use their existing technology. The following chart shows their changes in sales. Based on this small sample, what is the correlation between smartened and increase in sales? [Hint: It may help to use the spreadsheet function COERCE to calculate the correlation] (Enter the answer with no more nor less than two decimal places, and leave off the % sign. For example, if your answer is 13. 97% you should enter it as 13. 97 NOT 0. 14 nor 14) {Anthony, Smartened: Yes; change in sales 120; Kirk,

Smartened No; Change in Sales 60; Michael, Smartened No; Change in Sales 150; Scarlet. , Smartened Yes; Change in Sales 130; Pete, Smartened Yes; Change in Sales 40; Angela, Smartened No; Change in Sales 60. }

Answer for Question 6 You entered: Your Answer 8. 03 Correct. You know how to calculate/measure relationships. Calculation of correlation; important to finance and Just about anything else.

Question 7 (10 points) Investors generally do not like to bear risk. Because of this, the price of an otherwise identical government bond relative to a corporate bond will be Your The same. Lower. Higher. Correct.

You will be willing to pay less for something that you dislike relative to the alternative. Total Simple pricing of risk-aversion.

Question 8 (1 5 points) Suppose your client is risk-averse but can invest in only one of the three securities, X, Y, or Z, in an uncertain world characterized as follows. Next year the economy will be in an expansion, normal, or recession state with probabilities 0. 40, 0. 40, and 0. 20, respectively. The returns (%) on the three securities in these states are as follows: Security X {expansion = +14, normal = +10, recession = +7}; Security Y {+1 1, 9, +8}; Security Z {+13, +8, +7. }. Which security can you rule out, that is, you will not advise your client to invest in it? Your Answer Inherent 0. 00 Calculate the basic statistics for all three securities and evaluate them based on risk- return trade-offs. Security Z. None of the securities. 0. 00/ 15. 00 This is a real life situation that requires you to think through a bit.

Question 9 (15 points) You have Just taken over as a fund manager at a brokerage firm. Your assistant, Thomas, is briefing you on the current portfolio and states “We have too such of our portfolio in Alpha.

We should probably move some of those funds into Gamma so we can achieve better diversification. ” Is he right? [Hint: Feel free to use spreadsheet statistical functions. ] Here is the data on all three stocks. Assume, for convenience, that all three securities do not pay dividends. Alpha, Current Price 40; Current Weight 80%; Next Year’s Price: Expansion 48, Normal 44, Recession 36; Beta, Current Price 27. 50; Current Weight 20%; Next Year’s Price: Expansion 27. 50, Normal 26, Recession 25; Gamma, Current Price 15; Current Weight 0%; Next Year’s Price: Expansion 16. 0, Normal 19. 50, Recession 12. Your Answer It depends. Yes. 15. 00 Correct. You know how to calculate relationships and to make informed portfolio management decisions. No. 15. 00/ 15. 00 A good question for figuring out portfolio composition given that we are into diversification.

Question 10 (1 5 points) Suppose there are two mortgage bankers. Banker 1 has two $1,000,000 mortgages to sell. The borrowers live on opposite sides of the country and face an independent probability of default of 5%, with the banker able to salvage 40% of the Ortega value in case of default.

Banker 2 also has two $1,000,000 mortgages to sell, but Banker g’s borrowers live on the same street, have the same Job security and income. Put differently, the fates and thus solvency of Banker g’s borrowers move in lock step. They have a probability of defaulting of 5%, with the banker able to salvage 40% of the mortgage value in case of default. Both Bankers plan to sell their respective mortgages as a bundle in a mortgage-backed security (MBPS) (I. E. , as a portfolio). Which of the following is correct? Your Answer Banker 1 ‘s MBPS has a higher expected return and more risk.

Banker g’s MBPS has a higher expected return and more risk. Banker 1 ‘s MBPS has more risk, but the expected returns on both MBPS are the same. Banker Xi’s MBPS has a higher expected return and less risk. Banker g’s MBPS has more risk, but the expected returns on both MBPS are the same. Correct. You can calculate, and base decisions on, risk-return trade-offs. Banker g’s MBPS has a higher expected return and less risk. A topical issue given the current crisis; requires you to both calculate and make decisions based on risk-return trade-offs.