Understanding Risk Test Bank Answers Ch5

Student name:__________

1) Apply the definition of risk provided in the textbook to an individual's decision to purchase a car insurance policy. Suppose that the individual has two possibilities: no accident ($0 gain/loss) and accident (-$30,000 loss). If the probability of an accident is lower than the probability of an accident occurring (say the probability of an accident is 10%), then why do people buy car insurance? How is this related to the concept of value at risk and the time horizon of investment decisions?

2) What is the difference between standard deviation and value at risk? Consider the difference between purchasing a one-year bank CD compared with purchasing a homeowner's insurance policy. Which scenario do you believe is more likely to consider value at risk over standard deviation? Explain.

3) Explain why insurance companies may find themselves at times having to refuse business.

4) Suppose a saver is looking for the opportunity to make a very large return in a very short period of time. Would you recommend diversification for this individual?

5) Which one of the following wouldnot be included in a definition of risk?

A) Risk is a measure of uncertainty.
B) Risk can always be avoided at no cost.
C) Risk has a time horizon.
D) Risk usually involves some future payoff.

6) Why is measuring and assessing risk important in the study of financial markets?

A) Risk must be avoided at all costs.
B) Positive payoffs always outweigh losses.
C) Measuring risk is necessary in calculating a fair price for transferring risk.
D) It led to the discovery that changes in risk do not affect demand for financial instruments.

7) All other factors held constant, an investment with

A) more risk should offer a lower return and sell for a higher price.
B) less risk should sell for a lower price and offer a higher expected return.
C) more risk should sell for a lower price and offer a higher expected return.
D) less risk should sell for a lower price and offer a lower return.

8) Uncertainties that are not quantifiable

A) are what we define as risk.
B) are factored into the price of an asset.
C) cannot be priced.
D) are benchmarks against which quantifiable risks can be assessed.

9) When measuring the risk of an asset

A) one must measure the uncertainty about the size of future payoffs.
B) it is necessary to incorporate uncertainties that are not quantifiable.
C) one must remember that the concept of risk applies only to financial markets, not to financial intermediaries.
D) one cannot use other investments to evaluate the asset's risk.

10) Risk

A) cannot be quantified.
B) is best measured relative to a benchmark.
C) doesn’t exist if there is a single random event.
D) can be measured without knowing all of the possible outcomes.

11) Which one of the following is true?

A) Investments with higher risk generally have a higher expected return than risk-free investments.
B) Investments that pay a return over a longer time horizon generally have less risk.
C) Investments with a greater variance in the size of the future payoff generally pay a lower expected return.
D) Risk-free investments are the best benchmark for measuring the risk of all investment strategies.

12) How can investors make decisions about financial instruments that involvefuture payoffs?

A) There is no uncertainty in market economies.
B) This can be done only when the future payoffs are certain.
C) Prices are determined by supply and demand which is always certain.
D) Investors can use probabilities and risk measurement procedures to account for all possibilities.

13) Carolina is considering a $500 investment which will pay off $750 with a 30% probability, $600 with a 20% probability, and $350 with a 50% probability. Which of the following tables correctly summarizes her probabilities and payoffs?

A)

B)

C)

D)

14) Inflation presents risk because

A) inflation is always present.
B) inflation cannot be measured
C) there are different ways to measure it.
D) there is no certainty regarding what inflation will be in the future.

15) If the probability of an outcome equals one, the outcome

A) is more likely to occur than the others listed.
B) is certain to occur.
C) is certain not to occur.
D) has unquantifiable risk.

16) If a fair coin is tossed, what is the probability of coming up with either a head or a tail?

A) ½ or 50 percent
B) zero
C) 1 or 100 percent
D) This is unquantifiable.

17) If the probability of an outcome is zero, you know the outcome is

A) more likely to occur.
B) certain to occur.
C) less likely to occur.
D) certain not to occur.

18) The expected value of an investment

A) is what the owner will receive when the investment is sold.
B) is the sum of the payoffs.
C) is the probability-weighted sum of the possible outcomes.
D) cannot be determined in advance.

19) If an investment will return $1,500 half of the time and $700 half of the time, the expected value of the investment is

A) $1,250.
B) $1,050.
C) $1,100.
D) $2,200.

20) Another name for the expected value of an investment would be the

A) mean value.
B) upper-end value.
C) certain value.
D) risk-free value.

21) If an investment has a 20% (0.20) probability of returning $1,000, a 30% (0.30) probability of returning $1,500, and a 50% (0.50) probability of returning $1,800, the expected value of the investment is

A) $1,433.33.
B) $1,550.00.
C) $2,800.00.
D) $1,600.00.

22) Suppose that Fly-By-Night Airlines, Inc. has a return of 5% twenty percent of the time and 0% the rest of the time. The expected return from Fly-By-Night is

A) 10%.
B) 0.1%.
C) 0.2%.
D) 1.0%.

23) An investor puts $1,000 into an investment that will return $1,250 one-half of the time and $900 the remainder of the time. The expected return for this investor is

A) $1,075.
B) 5.0%.
C) 7.5%.
D) 15.0%.

24) An investor puts $2,000 into an investment that will pay $2,500 one-fourth of the time; $2,000 one-half of the time, and $1,750 the rest of the time. What is the investor's expected return?

A) 12.5%
B) $250.00
C) 6.25%
D) 3.125%

25) Risk-free investments have rates of return

A) equal to zero.
B) with a standard deviation equal to zero.
C) that are uncertain, but have a certain time horizon.
D) that exhibit a large spread of potential payoffs.

26) An investment with a large spread between possible payoffs will generally have

A) a low expected return.
B) a high standard deviation.
C) a low value at risk.
D) both a low expected return and a low value at risk.

27) An investment pays $1,500 half of the time and $500 half of the time. Its expected value and variance respectively are

A) $1,000; 500,000 dollars
B) $2,000; (250,000 dollars)²
C) $1,000; 250,000 dollars
D) $1,000; 250,000 dollars²

28) An investment pays $1,200 a quarter of the time; $1,000 half of the time; and $800 a quarter of the time. Its expected value and variance respectively are

A) $1,000; 20,000 dollars²
B) $1,050; 20,000 dollars²
C) $1,000; 40,000 dollars²
D) $1,000; 80,000 dollars²

29) An investment pays $1,000 three quarters of the time, and $0 the remaining time. Its expected value and variance respectively are

A) $1,000: 62,500 dollars²
B) $750; 46,875 dollars
C) $750; 62,500 dollars
D) $750; 187,500 dollars²

30) The standard deviation is generally more useful than the variance because

A) it is easier to calculate.
B) variance is a measure of risk, and standard deviation is a measure of return.
C) standard deviation is calculated in the same units as payoffs and variance isn't.
D) it can measure unquantifiable risk.

31) Given a choice between two investments with the same expected payoff most people will

A) choose the one with the lower standard deviation.
B) opt for the one with the higher standard deviation.
C) be indifferent since the expected payoffs are the same.
D) calculate the variance to assess the relative risks of the two choices.

32) An investment will pay $2,000 half of the time and $1,400 half of the time. The standard deviation for this investment is

A) $90,000.
B) $300.
C) $1,700.
D) $30.

33) An investment will pay $2,000 a quarter of the time; $1,600 half of the time and $1,400 a quarter of the time. The standard deviation of this asset is

A) $600.
B) $1,650.
C) $47,500.
D) $217.94.

34) Investment A pays $1,200 half of the time and $800 half of the time. Investment B pays $1,400 half of the time and $600 half of the time. Which one of the following statements is correct?

A) Investment A and B have the same expected value, but A has greater risk.
B) Investment B has a higher expected value than A, but also greater risk.
C) Investment A and B have the same expected value, but A has lower risk than B.
D) Investment A has a greater expected value than B, but B has less risk.

35) Investment A pays $1,200 half of the time and $800 half of the time. Investment B pays $1,400 half of the time and $600 half of the time. Which one of the following statements is correct?

A) Investment A and B have the same expected value, but A has greater risk.
B) Investment B has a higher expected value than A, but also greater risk.
C) Investment A has a greater expected value than B, but B has less risk.
D) Investment A and B have the same expected value, but B has greater risk.

36) Luis is a risk-averse investor who is considering Proposal A and Proposal B. Each proposal requires the same amount of investment and has equivalent expected values. However, the distribution of possible payoffs for Proposal A is more spread out than the distribution of possible payoffs for Proposal B. Based on this information, Luis should choose

A) Proposal A.
B) Proposal B.
C) either since they are equivalent.
D) neither there is too much risk involved.

37) The following figure illustrates two different options for investing $1,000 where the expected value is equal for both. Which one is riskier?

A) Case 1
B) Case 2
C) The risk is equal between the two cases.
D) More information is needed to compare the risk.

38) The greater the standard deviation of an investment, the

A) lower the return.
B) greater the risk.
C) lower the risk.
D) lower the risk and return.

39) The difference between standard deviation and value at risk is

A) nothing, they are two names for the same thing.
B) value at risk is a more common measure in financial circles than is standard deviation.
C) standard deviation reflects the spread of possible outcomes, whereas value at risk focuses on the value of the worst outcome.
D) value at risk is expected value times the standard deviation.

40) A $600 investment has the following payoff frequency: a quarter of the time it will be $0; three quarters of the time it will pay off $1,000. Its standard deviation and value at risk, respectively, are

A) $750; $600.
B) $433; $600.
C) $0; $1,000.
D) $433; $1,000.

41) A $500 investment has the following payoff frequency: half of the time it will pay $350 and the other half of the time it will pay $900. Its standard deviation and value at risk, respectively, are

A) $275; $150.
B) $625; $275.
C) $275; $350.
D) $125; $500.

42) The measure of risk that focuses on the worst possible outcome is called

A) expected rate of return.
B) risk-free rate of return.
C) standard deviation of return.
D) value at risk.

43) Leverage

A) reduces risk.
B) is synonymous with risk-free investment.
C) increases expected rate of return.
D) leads to smaller changes in the investment's price.

44) Which one of the following is least likely to use value at risk as an important factor in their investment decision?

A) an individual considering a mortgage to buy his first home
B) a family considering purchasing health insurance
C) a policy maker considering regulation of depository institutions
D) a mutual fund manager choosing the allocation of investments in the fund's portfolio

45) Comparing a lottery where a $1 ticket purchases a chance to win $1 million with another lottery in which a $5,000 ticket purchases a chance to win $5 billion, we notice many people would participate in the first but not the second, even though the odds of winning both lotteries are the same. We can perhaps best explain this outcome by the

A) higher expected value for the lottery paying $1 million.
B) higher expected value for the lottery paying $5 billion.
C) lower value at risk for the lottery paying $1 million.
D) higher value at risk for the lottery paying $1 million.

46) Leverage

A) increases expected return while lowering risk.
B) increases risk.
C) lowers the expected return and lowers risk.
D) lowers the expected return and increases risk.

47) Leverage

A) increases expected return and increases risk.
B) increases expected return and reduces risk.
C) decreases expected return but has no effect on risk.
D) decreases expected return and increases risk.

48) Which one of the following investment strategies involves generating a higher expected rate of return through increasing risk?

A) diversifying
B) hedging risk
C) leverage
D) value at risk

49) A risk-averse investor, compared toa risk-neutral investor,

A) will never take a risk, while the risk-neutral investor will.
B) needs greater compensation for the same risk versus the risk-neutral investor.
C) will take the same risks as the risk-neutral investor if the expected returns are equal.
D) needs less compensation for the same risk versus the risk-neutral investor.

50) A risk-averse investor will

A) always accept a greater risk with a greater expected return.
B) only invest in assets providing certain returns.
C) never accept lower risk if it means accepting a lower expected return.
D) sometimes accept a lower expected return if it means less risk.

51) A risk-averse investor will

A) never prefer an investment with a lower expected return.
B) always prefer an investment with a certain return to one with the same expected return but that has any amount of uncertainty.
C) always require a certain return.
D) always focus exclusively on the expected return.

52) Consider a game where a fair coin is flipped, and, if you call the correct outcome, the payoff is $2,000. A risk-neutral gambler would pay up to what amount to enter this game?

A) more than $1000 but less than $2000
B) up to $2,000
C) up to $1,000
D) more than $1,500

53) Professional gamblers know that the odds are always in favor of the house (casinos). The fact that they gamble says they are

A) irrational.
B) risk-neutral.
C) risk-averse.
D) risk seekers.

54) The risk premium for an investment

A) is negative for U.S. treasury securities.
B) is a fixed amount added to the risk-free return, regardless of the level of risk.
C) increases with risk.
D) is zero (0) for risk-averse investors.

55) A risk-averse investor compared to a risk-neutral investor would

A) offer the same price for an investment as the risk-neutral investor.
B) require a higher risk premium for the same investment as a risk-neutral investor.
C) place more focus on expected return and less on return than the risk-neutral investor.
D) place less focus on expected return than the risk-neutral investor.

56) When considering different investments, a risk-averse investor is most likely to focus on purchasing

A) investments with the greatest spread in the expected rate of return.
B) investments that offer the lowest standard deviation in the investments' expected rates of return for any given expected rate of return.
C) only risk-free investments.
D) investments with the lowest risk premium, regardless of the expected rate of return.

57) How are expected returns generally related to risk premiums?

A) Higher expected returns are associated with higher risk premiums.
B) Lower risk premiums are associated with higherexpected returns.
C) Lower expected returns are associated with higher risk premiums.
D) Expected returns are not associated with risk premiums.

58) The fact that over the long run the return on common stocks has been higher than that on long-term U.S. Treasury bonds is partially explained by the fact that

A) a lot more money is invested in common stocks than U.S. Treasury bonds.
B) There are regulations on the interest rates U.S. Treasury bonds can offer.
C) The risk premium is higher on common stocks.
D) Risk-averse investors buy more common stock.

59) When the home construction industry does poorly due to a recession, this is an example of

A) systematic risk.
B) idiosyncratic risk.
C) risk premium.
D) unique risk.

60) Unique risk is another name for

A) market risk.
B) systematic risk.
C) the risk premium.
D) idiosyncratic risk.

61) High oil prices tend to harm the auto industry and benefit oil companies; therefore, high oil prices are an example of

A) systematic risk.
B) idiosyncratic risk.
C) neither systematic nor idiosyncratic risk.
D) both systematic and idiosyncratic risk.

62) Changes in general economic conditions usually produce

A) systematic risk.
B) idiosyncratic risk.
C) risk reduction.
D) lower risk premiums.

63) Unexpected inflation can benefit some people/firms and harm others. This is an example of

A) systematic risk.
B) unmeasured risk.
C) idiosyncratic risk.
D) zero risk since the effects balance.

64) Diversification is the principle of

A) eliminating risk.
B) reducing the risk we carry to just two.
C) holding more than one asset to reduce risk.
D) eliminating investments from our portfolio that have idiosyncratic risk.

65) Diversification can eliminate

A) all risk in a portfolio.
B) risk only if the investor is risk averse.
C) the systematic risk in a portfolio.
D) the idiosyncratic risk in a portfolio.

66) An investor practicing hedging would be most likely to

A) avoid the stock market and focus on bonds.
B) purchase shares in General Motors and buy U.S. Treasury bonds.
C) purchase shares in General Motors and Amoco oil.
D) put their invested funds in CDs.

67) Hedging is possible only when investments have

A) opposite payoff patterns.
B) the same payoff patterns.
C) payoffs that are independent of each other.
D) the same risk premiums.

68) An investor who diversifies by purchasing a 50–50 mix of two stocks that are not perfectly positively correlated will find that the standard deviation of the portfolio is

A) the sum of the standard deviations of the two individual stocks.
B) greater than the sum of the standard deviations of the individual stocks.
C) greater than the standard deviation from holding the same balance in only one of these stocks.
D) less than the standard deviation from holding the same balance in only one of these stocks.

69) Which one of the following statements isfalse?

A) Diversification can reduce risk.
B) Diversification can reduce risk but only by reducing the expected return.
C) Diversification reduces idiosyncratic risk.
D) Diversification allocates savings across more than one asset.

70) Systematic risk

A) is the risk eliminated through diversification.
B) represents the risk affecting a specific company.
C) cannot be eliminated through diversification.
D) is another name for risk unique to an individual asset.

71) The Russian wheat crop fails, driving up wheat prices in the United States. This is an example of

A) idiosyncratic risk.
B) diversification.
C) systematic risk.
D) quantifiable risk.

72) If the returns of two assets are perfectly positively correlated, an investor who puts half of their savings into each will

A) reduce risk.
B) have a higher expected return.
C) not gain from diversification.
D) reduce risk but lower the expected return.

73) In order to benefit from diversification, the returns on assets in a portfolio must

A) be perfectly positively correlated.
B) be perfectly negatively correlated.
C) be positively correlated but not perfectly.
D) have the same idiosyncratic risks.

74) The main reason for diversification for an investor is to

A) gain from higher returns that accompany a higher number of investments.
B) take advantage of the fact that returns on assets are not perfectly correlated.
C) lower transaction costs.
D) gain from the greater returns that come from greater risk.

75) If ABC Inc. and XYZ Inc. have returns that are perfectly positively correlated,

A) adding XYZ Inc. to a portfolio that consists of only ABC Inc. will reduce risk.
B) adding ABC Inc. to a portfolio that includes only XYZ Inc. will increase risk.
C) adding XYZ Inc. to a portfolio that consists of only ABC Inc. will neither increase nor decrease the risk of the portfolio.
D) adding XYZ Inc. to a portfolio that consists of only ABC Inc. will neither increase nor decrease idiosyncratic risk but will lower systematic risk.

76) If an investment offered an expected payoff of $100 with $0 variance, you would know that

A) half of the time the payoff is $100 and the other half it is $0.
B) the payoff is always $100.
C) half of the time the payoff is $200 and the other half it is $0.
D) half of the time the payoff is $200 and the other half it is $50.

77) The fact that not everyone places all of their savings in U.S. Treasury bonds indicates that

A) most investors are not risk averse.
B) many investors are actually risk seekers.
C) even risk-averse people will take risk if they are compensated for it.
D) most people are risk-neutral.

78) Hedging risk and spreading risk are two ways to

A) increase expected returns from a portfolio.
B) diversify a portfolio.
C) lower transaction costs.
D) match up perfectly positively correlated assets.

79) Sometimes spreading has an advantage over hedging to lower risk because

A) it can be difficult to find assets that move predictably in opposite directions.
B) it is cheaper to spread than hedge.
C) spreading increases expected returns, hedging does not.
D) spreading does not affect expected returns.

80) Spreading risk involves:

A) finding assets whose returns are perfectly negatively correlated
B) adding assets to a portfolio that move independently.
C) investing in bonds and avoiding stocks during bad times.
D) building a portfolio of assets whose returns move together.

81) Investing in a mutual fund made up of hundreds of stocks of different companies is an example of all of the followingexcept

A) spreading risk.
B) diversifying.
C) risk reduction.
D) increasing the variance of a portfolio.

82) An automobile insurance company that writes millions of policies is practicing a form of

A) mutual fund.
B) hedging risk.
C) spreading risk.
D) eliminating systematic risk.

83) An automobile insurance company, on average, charges a premium that

A) equals the expected loss from each driver.
B) is less than the expected loss from each driver.
C) is greater than the expected loss from each driver.
D) equals 1/(expected loss) of each driver.

84) The variance of a portfolio of assets

A) decreases as the number of independent assets increases.
B) increases as the number of independent assets increases.
C) approaches 0 as the number of independent assets decreases.
D) approaches 1 as the number of independent assets increases.

85) A worker who holds all of his wealth in his company’s stock is in danger of

A) not spreading risk.
B) hedging risk.
C) “blowing up.”
D) innovating.

86) During the Great Moderation, aggregate income was stable while the volatility of household income actually rose. What type of risk increased for households?

A) inflation risk
B) systematic risk
C) idiosyncratic risk
D) interest rate risk

87) In investment matters, generally young workers compared to older workers will

A) minimize expected return and focus more on variability.
B) be less risk-averse.
C) have equal concern for expected return and variability.
D) be more risk-averse.

88) One can spread risk in a portfolio by:

A) increasing the number of assets with independent returns
B) decreasing the the number of assets with independent returns
C) increasing the number of assets with correlated returns
D) owning all of one type of asset

89) The expected return from a portfolio made up equally of two assets that move perfectly opposite of each other would have a standard deviation equal to

A) 1.0.
B) −1.0.
C) 0.0.
D) 0.5.

90) An individual who is risk-averse

A) never takes risks.
B) accepts risk but only when the expected return is very small.
C) requires larger compensation when the risk increases.
D) will accept a lower return as risk rises.

91) A portfolio of assets has lower risk than holding one asset but the same expected return and higher transaction costs. The portfolio is

A) attractive to people who are risk-averse and risk-neutral, but not to risk seekers.
B) attractive to investors who are risk-neutral.
C) not attractive to investors who are risk-neutral.
D) attractive to investors who are risk seekers.

92) Carolina is considering a $500 investment that will pay $750 with a 30% probability, $600 with a 20% probability, and $350 with a 50% probability. Construct a table showing her probabilities and payoffs and solve for the expected value of her investment option.

93) An individual faces two alternatives for an investment. Asset A has the following probability return schedule:

Asset B has a certain return of 8.0%. If the individual selects asset A, does she violate the principle of risk aversion? Explain.

94) An individual faces two alternatives for an investment. Asset A has the following probability of return:

Asset B has a certain return of 10.25%. If this individual selects asset A, does it imply that she is risk-averse? Explain.

95) Explain why returns on assets compensate for systematic risk but not for idiosyncratic risk.

96) Consider the following two assets with probability of return = Pi and return = R_i.

a. Calculate the expected return for each and the standard deviation.

b.Which assetcarries the greatest risk? Why?

97) Consider the following two assets, each costing $500, with the probabilities of return and payoffs illustrated in the following table. Construct a chart for each asset illustrating the probabilities on the vertical axis. Which asset carries more risk? How can you tell?

98) Sufia is preparing a report for next week’s planning meeting and, based on the research, she assigns the following probabilities to next year's sales:

a. Find Sufia’s expected value for next year’s sales.
b. Find the variance and standard deviation.

99) Explain why a riskier asset offers a higher expected return.

100) What is the expected value of a $100 bet on a flip of a fair coin, where heads pays double and tails pays zero?

101) An individual owns a $100,000 home. She determines that her chances of suffering a fire in any given year to be 1/1000 (0.001). She correctly calculates her expected loss in any year to be $100. Explain why this really is nota good way to measure her potential for loss.

102) Identify at least three possible sources for a risk an individual may face in planning for retirement.

103) What is the probability of tossing a pair of dice once and getting a 1? How about a 7?

104) If there are 1,000 people, each of whom owns a $100,000 house, and they each stand a 1/1,000 chance each year of suffering a fire that will totally destroy their house, what is the minimum that they would have to pay annually for fire insurance?

105) Calculate the expected value, the expected return, the variance, and the standard deviation of an asset that requires a $1,000 investment but will return $850 half of the time and $1,250 the other half of the time.

106) Explain the following: Risk results from the fact that more outcomes could happen than will happen.

107) Calculate the expected value of an investment that has the following payoff frequency: a quarter of the time it will pay $2,000, half of the time it will pay $1,000, and the remaining time it will pay $0.

108) Consider the following two investments. One is a risk-free investment with a $100 return. The other investment pays $2,000 20% of the time and a $375 loss the rest of the time. Based on this information, answer the following: (i) Compute the expected returns and standard deviations of these two investments individually. (ii) Compute the value at risk for each investment. (iii) Which investment will risk-averse investors prefer, if either? Which investment will risk-neutral investors prefer, if either?

109) Compute the expected return, standard deviation, and value at risk for each of the following investments

Investment (A): Pays $800 three-fourths of the time and a $1,200 loss otherwise.
Investment (B): Pays $1,000 loss half of the time and a $1,600 gain otherwise.

State which investment will be preferred by each of the following investors, and explain why.

(i) a risk-neutral investor

(ii) an investor who seeks to avoid the worst-case scenario.

(iii) a risk-averse investor.

110) You do some research and find, for a driver of your age and gender, the probability of having an accident that results in damage to your automobile exceeding $100 is 1/10 per year. Your auto insurance company will reduce your annual premium by $40 if you will increase your collision deductible from $100 to $250. Should you? Explain.

111) What would be the standard deviation for a $1000 risk-free asset that returns $1,100?

112) You buy an asset for $2,500. The asset will return $3,300 half of the time and $2,700, the other half. The expected return is 20% (a gain of $500) and the standard deviation is 12% ($300). How would using $1,250 of borrowed funds change the expected return and standard deviation specifically?

113) What would be the impact of leverage on the expected return and standard deviation of purchasing an asset with 10% of the owner's funds and 90% borrowed funds?

114) Why isn't it correct to say that people who are risk-averse avoid risk?

115) Briefly explain the difference between idiosyncratic risk and systematic risk. Provide an example of each.

116) Explain why a company offering homeowners insurance policies would want to insure homes across a wide geographic area.

117) Use the concept of risk to explain why the popularity of mutual funds rapidly increased as consumers learned about this type of investment.

118) Considering leverage, can you explain why a mortgage lender would want borrowers to have larger down payments, and when the borrower doesn't have the larger down payment, then the mortgage lender may require mortgage insurance?

119) You study horse racing avidly and discover for this year's Kentucky Derby you think you have the field pretty well figured out. In fact, you calculate the expected return and it is the same as the expected return you are getting from the stock market. Is this investment in the race valuable to you?

120) Consider an individual who plans to buy a new home. He has two options: (i) pay for mortgage insurance (that insures the lender in case the borrower defaults), or (ii) pay the lender a higher interest rate for the mortgage. Describe how these two options are related to the concept of risk premium and the lender's aversion to risk. Why does the interest rate on the mortgage differ in these two options?

121) How are the decisions of government policy makers, such as the Federal Reserve, related to risk and an individual investor's portfolio?