Chapter 4 Finance

Chapter 4 Questions

Explain why you would be more or less willing to buy a share of Polaroid stock in the following situations:

Your wealth falls. Less willing because your wealth falls

You expect it to appreciate in value. More because its relative expected value increases

The bond market becomes more liquid. Less because it becomes less liquid relative to bonds

Prices in the bond market become more volatile. More because it becomes less risky relative to bonds.

Explain why you would be more or less willing to buy a house under the following circumstances:

You just inherited $100,000. More because your wealth has increased

Real estate commissions fall from 6% of the sales price to 4% of the sales price. More because it has become more liquid

You expect Polaroid stock to double in value next year. Less because its expected return relative to other investments has reduced

You expect housing prices to fall. Less because its expected return has fallen.

“The more risk-averse people are, the more likely they are to diversify.” Is this statement true, false or uncertain? Explain your answer. True, because the benefits to diversification are greater for a person who cares more about reducing risk.

I own a professional football team, and I plan to diversify in either a company that owns a professional basketball team or a pharmaceutical company. Which of these two investments is more likely to reduce the overall risk I face? Why? Purchasing shares in the pharmaceutical company is more likely to reduce my overall risk because the correlation of returns on my investment in a football team with the returns on the pharmaceutical company shares should be low. By contrast, the correlation of returns on an investment in a football team and an investment in a basketball team are probably pretty high, so in this case there would be little risk reduction if I invested in both.

“No one who is risk-averse will ever buy a security that has a lower expected return,...