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Question 1

(5 points) Shareholders of Excon Oil Company face a variety of risks in holding its shares. If the economy falters, people tend to travel less and so there is less demand from the airlines industry for Exxon’s fuels. This type of risk that Exxon’s shareholders bear is

Your Answer Score Explanation
Systematic/Market Risk 5.00 Correct. You have a good intuition for different types of risks.
Total 5.00/5.00
Question Explanation
Fundamental question of different types of risks.

Question 2

(5 points) Suppose there are three securities (A, B and C) to choose from, and next year the economy will be in an expansion, normal, or recession state with probabilities 0.30, 0.35, and 0.35, respectively. The returns (%) on the securities in these states are as follows: Security A {expansion=+10, normal=+8, recession=+6}; Security B {+25, +10,-10} Security C {+7.5, +7.5, +7.5}. If the investor is risk neutral (means that she does not care/worry about risk), which of these three securities would she buy?

Your Answer Score Explanation
Security A. 5.00 Correct. You know that she will choose the security with the highest expected return.
Total 5.00/5.00
Question Explanation
This is a question that makes you calculate expected returns and, given the investor`s attitude toward risk, also asks you to make a choice on her behalf.

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 0.40, 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, {+15, +15, +2}; Security Z {+17, +10, +2.5}. Which investment best fits your grandfather’s needs?

Your Answer Score Explanation
Security Z 5.00 Correct. Once you see the calculations, his preferences determine the obvious choice.
Total 5.00/5.00
Question Explanation
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 Score Explanation
False 10.00 Correct. You understand risk-aversion and the implied diversification by investors.
Total 10.00/10.00
Question Explanation
Fundamentals of risk and diversification.

Question 5

(10 points) While computing covariances among the returns of several stocks can be complicated, the covariance of a stock`s return with itself is always one.

Your Answer Score Explanation
False 10.00 Correct. You appear to understand the measurement of relationships.
Total 10.00/10.00
Question Explanation
Measurement of relationships; key to 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 smartphones 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 apps 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 smartphone and increase in sales? [Hint: It may help to use the spreadsheet function CORREL to calculate the correlation. Also, enter the correlation is percentage terms with no more than two decimals, but do not enter the % sign.). ] {Anthony, Smartphone: Yes; change in sales 120; Kira, Smartphone No; Change in Sales 60; Michael, Smartphone No; Change in Sales 150; Scarlett., Smartphone Yes; Change in Sales 130; Pete, Smartphone Yes; Change in Sales 40; Angela, Smartphone No; Change in Sales 60.}

Your Answer Score Explanation
8.03 10.00 Correct. You know how to calculate/measure relationships.
Total 10.00/10.00
Question Explanation
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 Answer Score Explanation
Higher 10.00 Correct. You will be willing to pay less for something that you dislike relative to the alternative.
Total 10.00/10.00
Question Explanation
Simple pricing of risk-aversion.

Question 8

(15 points) Suppose your client is risk-averse but can invest in only one of the three securities, A, B, or C, 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 A {expansion = +12, normal = +10, recession = +7}; Security B {+11, +9, +8}; Security C {+12, +8, +7.5}. Which security can you rule out, that is, you will not advise your client to invest in it?

Your Answer Score Explanation
Security C. 15.00 Correct. You understand when an investment is dominated by others on the risk-return spectrum.
Total 15.00/15.00
Question Explanation
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 much 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 18, Normal 16.50, Recession 13.50.

Your Answer Score Explanation
No. 15.00 Correct. You Know how to calculate relationships and to make informed portfolio management decisions.
Total 15.00/15.00
Question Explanation
A good question for figuring out portfolio composition given that we are into diversification.

Question 10

(15 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 mortgage value in case of default. Banker 2 also has two $1,000,000 mortgages to sell, but Banker 2′s borrowers live on the same street, have the same job security and income. Put differently, the fates and thus solvency of Banker 2′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 (MBS) (i.e., as a portfolio). Which of the following is correct?

Your Answer Score Explanation
Banker 2′s MBS has more risk, but the expected returns on both MBS are the same. 15.00 Correct. You can calculate, and base decisions on, risk-return trade-offs.
Total 15.00/15.00
Question Explanation
A topical issue given the current crisis; requires you to both calculate and make decisions based on risk-return trade-offs.
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