# Answers: Risk Aversion and Security

Topics: Risk aversion, Bond, Security Pages: 5 (1285 words) Published: August 25, 2013
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Assignment 7
The due date for this quiz is Mon 26 Aug 2013 6:00 AM PDT (UTC -0700). -------------------------------------------------
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Please read all questions and instructions carefully. Note that you only need to enter answers in terms of numbers and without any symbols (including \$, %, commas, etc.). Enter all dollars without decimals and all interest rates in percentage with up to two decimals. Read the syllabus for examples.The points for each question are listed in parentheses at the start of the question, and the total points for the entire assignment adds up to 100. This assignment covers Statistics as related to finance. Refer to Note on Review of Statistics before you attempt this assignment. And feel free to use the statistical functions in Excel/Spreadsheets to calculate stuff. In accordance with the Coursera Honor Code, I (Aditya Vats) certify that the answers here are my own work. Question 1

(5 points) Shareholders of Sparky's Kerosene Company (SKC) face a variety of risks in holding SKC shares. If SKC purchases fire insurance for their factories, their shareholders will face lower Systematic/Market Risk.

Specific/Idiosyncratic Risk.

Question 2
(5 points) Suppose there are three securities (X, Y, and Z) 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 securitiies in these states are as follows: Security X {expansion = +10, normal = +8, recession = +6}; Security Y {+25,+10,-10}; Security Z {+7.5,+7.5,+7.5}. If the investor is risk neutral and must choose whether to invest in Security Y or Security Z, which would she buy? Indifferent between Y & Z.

Security Z.
Security Y.

Answer: Indifferent between Y and Z.
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 securitiies 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? Security X.

Security Z.
Security Y.

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

Question 5
(10) While computing covariances among the returns of several stocks can be complicated, the covariance of a stock's return with itself is always one. False.
True.
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...