Deck 30: Risk Management

Question 1

Use the information for the question(s) below.
Your firm faces an 8% chance of a potential loss of $50 million next year. If your firm implements new safety policies, it can reduce the chance of this loss to 3%, but the new safety policies have an upfront cost of $250,000. Suppose that the beta of the loss is 0 and the risk-free rate of interest is 5%.

-Farmville Industries is a major agricultural firm and is concerned about the possibility of drought impacting corn production.In the event of a drought,Farmville Industries anticipates a loss of $75 million.Suppose the likelihood of a drought is 10% per year,and the beta associated with such a loss is 0.4.If the risk-free interest rate is 5% and the expected return on the market is 10%,then what is the actuarially fair insurance premium?

Answer 1

The expected loss = $75 million × .10 = $7.5 million
Since the beta of the loss is not equal to zero we need to calculate the appropriate discount rate for the loss using the CAPM:
r = r_f + $\beta$ (r_M - r_f)
r = .05 + .4(.10 - .05)= .07
Insurance Premium = So the actuarially fair cost of full insurance = = $7.01 million

Question 2

In a perfect market without other frictions,insurance companies should compete until they are just earning a fair return and the NPV from selling insurance is ________.

A) uncertain
B) positive
C) negative
D) zero

Answer 2

zero

Question 3

In reality market imperfections exist that can raise the cost of insurance above the actuarially fair price and offset some of these benefits.These insurance market imperfections include all of the following EXCEPT:

A) Adverse selection
B) Agency costs
C) Administrative and overhead costs
D) Taxation of insurance payments

Answer 3

Taxation of insurance payments

Question 4

Which of the following statements is false?

A) Because insurance reduces the risk of financial distress, it can relax this tradeoff and allow the firm to increase its use of debt financing.
B) By lowering the volatility of the stock, insurance discourages concentrated ownership by an outside director or investor who will monitor the firm and its management.
C) When a firm is subject to graduated income tax rates, insurance can produce a tax savings if the firm is in a higher tax bracket when it pays the premium than the tax bracket it is in when it receives the insurance payment in the event of a loss.
D) In a perfect market without other frictions, insurance companies should compete until they are just earning a fair return and the NPV from selling insurance is zero. The NPV is zero if the price of insurance equals the present value of the expected payment; in that case, we say the price is actuarially fair.

Question 5

Insurance that compensates for the loss or unavoidable absence of crucial employees in the firm is called

A) key personnel insurance.
B) business liability insurance.
C) property insurance.
D) business interruption insurance.

Question 6

Use the information for the question(s) below.
Your firm faces an 8% chance of a potential loss of $50 million next year. If your firm implements new safety policies, it can reduce the chance of this loss to 3%, but the new safety policies have an upfront cost of $250,000. Suppose that the beta of the loss is 0 and the risk-free rate of interest is 5%.
Assuming that your firm will purchase insurance,what is the minimum-size deductible that would leave your firm with an incentive to implement the new safety policies?

Question 7

Which of the following statements is false?

A) Not all insurable risks have a beta of zero. Some risks, such as hurricanes and earthquakes, create losses of tens of billions of dollars and may be difficult to diversify completely.
B) When a firm buys insurance, it transfers the risk of the loss to an insurance company. The insurance company charges an upfront premium to take on that risk.
C) By its very nature, insurance for non-diversifiable hazards is generally a positive beta asset; the insurance payment to the firm tends to be larger when total losses are low and the market portfolio is high.
D) Because insurance provides cash to the firm to offset losses, it can reduce the firm's need for external capital and thus reduce issuance costs.

Question 8

The most common strategies are ________.

A) horizontal integration and storage
B) vertical integration and storage
C) vertical integration and diversification
D) horizontal integration and diversification

Question 9

To insure their assets against hazards such as fire,storm damage,vandalism,earthquakes,and other natural and environmental risks firms commonly purchase

A) key personnel insurance.
B) business liability insurance.
C) business interruption insurance.
D) property insurance.

Question 10

Use the information for the question(s) below.
Your firm faces an 8% chance of a potential loss of $50 million next year. If your firm implements new safety policies, it can reduce the chance of this loss to 3%, but the new safety policies have an upfront cost of $250,000. Suppose that the beta of the loss is 0 and the risk-free rate of interest is 5%.
If your firm is fully insured,the NPV of implementing the new safety policies is closest to:

A) $2.15 million
B) $2.5 million
C) $2.25 million
D) -$.25 million

Question 11

The futures prices are determined in the market based on ________ for each delivery date.They depend on expectations of future oil prices,adjusted by an appropriate ________.

A) price and cost; risk premium
B) price and cost; inflation premium
C) supply and demand; risk premium
D) supply and demand; inflation premium

Question 12

Use the information for the question(s) below.
Your firm faces an 8% chance of a potential loss of $50 million next year. If your firm implements new safety policies, it can reduce the chance of this loss to 3%, but the new safety policies have an upfront cost of $250,000. Suppose that the beta of the loss is 0 and the risk-free rate of interest is 5%.
What is the actuarially fair cost of full insurance?

Question 13

Insurance allows the firm to exchange a(n)________ future loss for a certain ________ expense.

A) uncertain; upfront
B) certain; upfront
C) uncertain; afterward
D) certain; afterward

Question 14

Use the information for the question(s) below.
Your firm faces an 8% chance of a potential loss of $50 million next year. If your firm implements new safety policies, it can reduce the chance of this loss to 3%, but the new safety policies have an upfront cost of $250,000. Suppose that the beta of the loss is 0 and the risk-free rate of interest is 5%.
If your firm is uninsured,the NPV of implementing the new safety policies is closest to:

A) $2.25 million
B) -$.25 million
C) $2.5 million
D) $2.15 million

Question 15

The insurance payment to the firm tends to be ________ when total losses are ________ and the market portfolio is ________.

A) smaller; high; low
B) larger; high; low
C) larger; low; high
D) smaller; low; high

Question 16

The risk that arises because the value of the futures contract will not be perfectly correlated with the firm's exposure is called

A) commodity price risk.
B) basis risk.
C) liquidity risk.
D) speculation risk.

Question 17

To protect the firm against the loss of earnings if the business operations are disrupted due to fire,accident,or some other insured peril a firm would purchase

A) property insurance.
B) key personnel insurance.
C) business liability insurance.
D) business interruption insurance.

Question 18

To cover the costs that result if some aspect of the business causes harm to a third party or someone else's property a firm would purchase

A) business interruption insurance.
B) property insurance.
C) business liability insurance.
D) key personnel insurance.

Question 19

Hedging involves contracts or transactions that provide the firm with ________ that offset its losses from price changes.

A) profits
B) incomes
C) cash flows
D) net earnings

Question 20

The risk that the firm will not have,or be able to raise,the cash required to meet the margin calls on its hedges is called

A) liquidity risk.
B) basis risk.
C) commodity price risk.
D) speculation risk.

Question 21

Which of the following statements is false?

A) The most common method firms use to reduce the risk that results from changes in exchange rates is to hedge the transaction using currency forward contracts.
B) Fluctuating exchange rates cause a problem known as the importer-exporter dilemma for firms doing business in international markets.
C) Exchange rate risk naturally arises whenever transacting parties use different currencies: both of the parties will be at risk if exchange rates fluctuate.
D) Because the supply and demand for currencies varies with global economic conditions, exchange rates are volatile.

Question 22

Your oil refinery will need to buy 250,000 barrels of crude oil in one week and it is worried about crude oil prices.Suppose you go long 250 crude oil futures contracts,each for 1000 barrels of crude oil,at the current futures price of $68 per barrel.Suppose futures prices change each day over the next week as follows: What is the daily and cumulative mark to market profit or loss (in dollars)that you will have on each of the next five days?

Question 23

A currency forward contract specifies all of the following EXCEPT:

A) The amount of currency to exchange
B) The spot exchange rate
C) The delivery date on which the exchange will take place
D) The currencies to be exchanged

Question 24

Which of the following statements regarding long-term supply contracts is false?

A) The market value of the contract at any point in time may not be easy to determine, making it difficult to track gains and losses.
B) Long-term supply contracts are designed to eliminate credit risk.
C) Long-term supply contracts insulate the firms from commodity price risk.
D) Long-term supply contracts are bilateral contracts negotiated by a buyer and a seller.

Question 25

Which of the following statements is false?

A) Currency options allow firms to lock in a future exchange rate; currency forward contracts allow firms to insure themselves against the exchange rate moving beyond a certain level.
B) Generally speaking, cash-and-carry strategies are used primarily by large banks, which can borrow easily and face low transaction costs.
C) Currency options, like the stock options, give the holder the right-but not the obligation-to exchange currency at a given exchange rate.
D) Many managers want the firm to benefit if the exchange rate moves in their favour, rather than being stuck paying an above-market rate.

Question 26

Which of the following statements is false?

A) The covered interest parity equation states that the difference between the forward and spot exchange rates is related to the interest rate differential between the currencies.
B) By entering into a currency forward contract, a firm can lock in an exchange rate in advance and reduce or eliminate its exposure to fluctuations in a currency's value.
C) When the interest rate differs across countries, investors have an incentive to borrow in the low-interest rate currency and invest in the high interest rate currency
D) A currency forward is usually written between two firms, and it fixes a currency exchange rate for a transaction that will occur at a future date.

Question 27

The cash-and-carry strategy consists of all of the following simultaneous trades EXCEPT:

A) Borrow euros today using a one-year loan with the interest rate r_€
B) Exchange the euros for dollars today at the spot exchange rate S $/€
C) Purchase a forward contract to convert $ to €
D) Invest the dollars today for one year at the interest rate r_$

Question 28

In December 2005,the spot exchange rate for the British Pound was CND$1.7188/£ and the one-year forward rate was CND$1.8675/£.Suppose that at the same time Luther Industries entered into a contract to purchase goods with a price of £375,000 to be delivered in one year.Simultaneously Luther entered into a one-year forward contract to purchase £375,000.What is the amount of the payment in Canadian dollars that Luther Industries will have to make in one year to pay for their goods?

Question 29

Which of the following statements regarding futures contracts is false?

A) Both the buyer and the seller can get out of the contract at any time by selling it to a third party at the current market price.
B) Futures prices are not prices that are paid today. Rather, they are prices agreed to today, to be paid in the future.
C) Futures contracts are traded anonymously on an exchange at a publicly observed market price and are generally very illiquid.
D) Traders are required to post collateral, called margin, when buying or selling commodities using futures contracts.

Question 30

Like most foreign exchange rates,the dollar/euro rate is a floating rate,which means it changes constantly depending on the quantity supplied and demanded for each currency in the market.The supply and demand for each currency is driven directly by all of the following factors EXCEPT:

A) Relative inflation
B) Firms trading goods
C) Investors trading securities
D) The actions of central banks in each country

Question 31

The exchange rate between Canadian dollar and the U.S.dollar is a(n)________.

A) fixed rate
B) floating rate
C) flexible rate
D) eclectic rate

Question 32

What are some of the disadvantages of long-term supply contracts?

Question 33

Which of the following statements is false?

A) Firms generally do not possess better information than outside investors regarding the risk of future commodity price changes, nor can they influence that risk through their actions.
B) Cash flows are exchanged on a monthly basis, rather than waiting until the end of the contract, through a procedure called marking to market.
C) The firm may speculate by entering into contracts that do not offset its actual risks.
D) When a firm authorizes managers to trade contracts to hedge, it opens the door to the possibility of speculation.

Question 34

Exchange rate risk naturally arises whenever transacting parties use ________.

A) a fixed exchange rate
B) the same currency
C) different currencies
D) a floating exchange rate

Question 35

Which of the following statements regarding currency options is false?

A) Firms often prefer forward contracts to currency options if the transaction they are hedging might not take place.
B) Currency options are another method that firms commonly use to manage exchange rate risk. Currency options, like the stock options, give the holder the right-but not the obligation-to exchange currency at a given exchange rate.
C) Currency forward contracts allow firms to lock in a future exchange rate; currency options allow firms to insure themselves against the exchange rate moving beyond a certain level.
D) Many managers want the firm to benefit if the exchange rate moves in their favour, rather than being stuck paying an above-market rate.

Question 36

A decrease in interest rates raises ________ of short-term and long-term liabilities and can ________ the value of the firm.

A) the present value; lower
B) the present value; increase
C) the future value; lower
D) the future value; increase

Question 37

In December 2005,the spot exchange rate for the British Pound was CND$1.7188/£.Suppose that at the same time the one-year interest rate in Canada was 4.85% and the one-year interest rate in Great Britain was 3.15%.Based on these rates,what forward exchange rate is consistent with no arbitrage?

Question 38

Which of the following statements is false?

A) Long-term supply contracts cannot be entered into anonymously; the buyer and seller know each other's identity. This lack of anonymity may have strategic disadvantages.
B) A futures contract is an agreement to trade an asset on some future date, at a price that is locked in today.
C) An alternative to vertical integration or storage is a long-term supply contract.
D) Long-term supply contracts are unilateral contracts negotiated by a seller.

Question 39

When a firm authorizes managers to trade contracts to hedge,it opens the door to the possibility of ________.

A) expectation profit
B) risk premium
C) free cash flows
D) speculation

Question 40

Which of the following statements is false?

A) Horizontal integration entails the merger of a firm and its supplier or a firm and its customer.
B) Like insurance, hedging involves contracts or transactions that provide the firm with cash flows that offset its losses from price changes.
C) For many firms, changes in the market prices of the raw materials they use and the goods they produce may be the most important source of risk to their profitability.
D) Because an increase in the price of the commodity raises the firm's costs and the supplier's revenues, these firms can offset their risks by merging.

Question 41

The duration of a five-year bond with 8% annual coupons trading at par is closest to:

A) 2.5 Years
B) 4.3 Years
C) 5.0 Years
D) 6.2 Years

Question 42

What is the duration of a five-year zero-coupon bond?

A) 2.5 years
B) 1 year
C) 5 years
D) 0 years

Question 43

Which of the following statements is false?

A) Corporations use interest rate swaps routinely to alter their exposure to interest rate fluctuations. Firms can use interest rate swaps with duration-hedging strategies.
B) The value of a swap, while initially zero, will fluctuate over time as interest rates change.
C) An interest rate that adjusts to current market conditions is called a floating rate.
D) When interest rates rise, the swap's value will rise for the party receiving the fixed rate; conversely, it will fall for the party paying the fixed rate.

Question 44

Luther Industries needs to borrow $50 million in cash.Currently long-term AAA rates are 9%.Luther can borrow at 9.75% given its current credit rating.Luther is expecting interest rates to fall over the next few years,so it would prefer to borrow at the short-term rates and refinance after rates have dropped.Luther's management is afraid,however,that its credit rating may fall which could greatly increase the spread the firm must pay on new borrowings.How can Luther benefit from the expected decline in future interest rates without exposure to the risk that the potential future changes to its credit ratings brings?

Question 45

Which of the following statements is false?

A) As interest rates change, the market values of the securities and cash flows in the portfolio change as well, which in turn alters the weights used when computing the duration as the value-weighted average maturity.
B) The duration of a portfolio of investments is the simple average of the durations of each investment in the portfolio.
C) Adjusting a portfolio to make its duration neutral is sometimes referred to as immunizing the portfolio, a term that indicates it is being protected against interest rate changes.
D) When the durations of a firm's assets and liabilities are significantly different, the firm has a duration mismatch.

Question 46

The interest rate sensitivity of a single cash flow ________ with its maturity; the interest rate sensitivity of a stream of cash flows ________ with its duration.

A) decreases; increases
B) increases; decreases
C) decreases; decreases
D) increases; increases

Question 47

The Century 22 Fund has invested in a portfolio of mortgaged back securities that has a current market value of $245 million.The duration of this portfolio of mortgaged back securities is 14.7 years.The fund has borrowed to purchase these securities,and the current value of its liabilities (i.e.,the current value of the bonds Century 22 has issued)is $160 million.The duration of these liabilities is 5.4 years.What is the initial duration of the equity for the Century 22 fund?

Question 48

Which of the following statements is false?

A) Interest rate swaps are an alternative means of modifying the firm's interest rate risk exposure without buying or selling assets.
B) A portfolio with a negative duration is called a duration-neutral portfolio or an immunized portfolio, which means that for small interest rate fluctuations, the value of equity should remain unchanged.
C) Maintaining a duration-neutral portfolio will require constant adjustment as interest rates change.
D) A duration-neutral portfolio is only protected against interest rate changes that affect all yields identically.

Question 49

Which of the following statements is false?

A) The swap contract-like forward and futures contracts-is typically structured as a "zero-cost" security.
B) An interest rate swap is a contract entered into with a bank, much like a forward contract, in which the firm and the bank agree to exchange the coupons from two different types of loans.
C) In a standard interest rate swap, one party agrees to pay coupons based on a fixed interest rate in exchange for receiving coupons based on the prevailing market interest rate during each coupon period.
D) If short-term interest rates were to fall while long-term rates remained stable, then short-term securities would fall in value relative to long-term securities, despite their shorter duration.

Question 50

Which of the following statements is false?

A) We can measure a firm's sensitivity to interest rates by computing the duration of its balance sheet.
B) A firm's market capitalization is determined by the difference in the market value of its assets and its liabilities.
C) By restructuring the balance sheet to increase its duration, we can hedge the firm's interest rate risk.
D) A firm's market capitalization is determined by the difference in the market value of its assets and its liabilities