Deck 5: Risk-Handling Techniques: Diversification and Hedging

Question 1

Which of the following statements about bearing risk collectively is correct?

A) Bearing risk collectively means that the risk is spread over a larger group.
B) Bearing risk collectively results in a more cost-efficient outcome.
C) Bearing risk collectively is an application of risk diversification.
D) All of the above are correct.

Answer 1

D

Question 2

Which of the following statements about diversification is incorrect?

A) Risk-bearing financial institutions employ diversification.
B) Diversification reduces risk.
C) Mutual funds typically have a diversified portfolio.
D) Diversification requires that all investments have the same risk/return characteristics.

Answer 2

D

Question 3

Calculate the Standard Deviation of the following investment: State of the Economy Probability Outcome

The expected return for this investment is 5%

A) 0.66%
B) 5.77%
C) 8.12%
D) 10.41%

Answer 3

C

Question 4

Which of the following statements about the correlation coefficient is correct?

A) The correlation coefficient measures risk.
B) The correlation coefficient is a number between -1 and +1.
C) The correlation coefficient measures how two variables move relative to each other.
D) All of the above are correct.

Question 5

What is the correlation coefficient between the following two investments? Year Return A Return B

A) Positive
B) Negative
C) Zero
D) Unable to determine without knowing the covariance

Question 6

What is the correlation coefficient between the following two investments? Year Return A Return B

A) Positive
B) Negative
C) Zero
D) Unable to determine without knowing the covariance

Question 7

Calculate the Standard Deviation of the following investment: State of the Economy Probability Outcome

The expected return for this investment is 4.5%

A) 5.85%
B) 0.34%
C) 8.19%
D) 14.43%

Question 8

Output price risk is:

A) when a change in the commodity market unfavorably affects the price at which a firm can buy their raw materials
B) when a change in the commodity market unfavorably affects the price at which a firm can sell their products
C) taking two positions whose gains and losses will offset each other
D) when a company sells its products abroad and there is an unfavorable exchange rate movement

Question 9

Bearing risk collectively is:

A) not very cost-efficient
B) more effective for larger groups
C) not reducing risk
D) only effective when all group members experience the same negative consequences simultaneously

Question 10

Which of the following is not an example of a financial institution that applies collective risk bearing?

A) Swiss banks
B) Mutual funds
C) Pension plans
D) Insurance companies

Question 11

Which of the following statements about the covariance is correct?

A) The covariance measures risk.
B) The covariance is a number between -1 and +1.
C) The covariance measures how two variables move relative to each other.
D) All of the above are correct.

Question 12

Which of the following statements about bearing risk collectively is correct?

A) Bearing risk collectively is not very cost-efficient.
B) Bearing risk collectively only works for small groups.
C) Bearing risk collectively is bearing risk as part of a large group.
D) All of the above are correct.

Question 13

To lessen the impact of catastrophic losses, many insurers use all the following except:

A) contingent surplus notes
B) catastrophe bonds
C) forward purchase options
D) exchange traded options

Question 14

Hedging is:

A) selling two investments that are both expected to lose
B) buying two investments that are both expected to make a profit
C) taking two positions whose gains and losses will offset each other
D) buying insurance against a fortuitous loss

Question 15

Calculate the Standard Deviation of the following investment: State of the Economy Probability Outcome

A) 31.75%
B) 5.51%
C) 3.02%
D) 0.09%

Question 16

Which of the following statements about risk-bearing financial institutions is incorrect?

A) An example of a risk-bearing financial institution is a mutual fund.
B) Risk-bearing financial institutions concentrate their investments in a limited number of assets.
C) Risk-bearing financial institutions assume the risks of their customers.
D) All of the above are incorrect.

Question 17

Calculate the Standard Deviation of the following investment: State of the Economy Probability Outcome

A) 0.17%
B) 4.12%
C) 6.51%
D) 23.09%

Question 18

Which of the following statements about Enterprise Risk Management is incorrect?

A) It deals with a limited number of techniques.
B) It has expanded the responsibilities of the corporate risk manager.
C) It deals with pure risks.
D) It deals with speculative risks.

Question 19

Interest rate risk arises from changes in:

A) currency discount rates
B) the value of fixed income securities because of changes in interest rates
C) interest rates caused solely by inflation
D) the value of currency relative to another currency

Question 20

A financial instrument whose value is based on an underlying security or commodity is called a/an:

A) insurance contract
B) employment contract
C) enterprise contract
D) derivative security

Question 21

A futures contract is:

A) selling two investments that are both expected to lose in the future
B) buying two investments that are both expected to make a profit in the future
C) taking two positions whose gains and losses will offset each other
D) an agreement to buy or sell a commodity or financial asset at a specified price on a later date

Question 22

Which of the following statements about option contracts is correct?

A) Option contracts can create a legal right to buy a commodity.
B) Option contracts can create a legal right to sell a financial asset.
C) The option holder has the right to exercise the option.
D) All of the above are correct.

Question 23

Which of the following is not an advantage of risk-bearing financial institutions?

A) They provide diversification benefits.
B) The can save on investments in financial infrastructure.
C) They provide administrative services.
D) They provide professional management.

Question 24

What is the correlation coefficient between the following two investments? Year Return A Return B

A) Positive
B) Negative
C) Zero
D) Unable to determine without knowing the covariance

Question 25

Which of the following is not an example of a derivative security?

A) Futures contract
B) Forward contract
C) Hedge
D) Option

Question 26

Can risk be completely eliminated?

A) No, never
B) Yes, as long as the exposure units are positively correlated
C) Yes, as long as the exposure units are not correlated and enough are in the pool
D) Yes, as long as the correlation coefficient is 0.1

Question 27

What is the essential difference between a call option and a put option?

A) A call option transaction occurs now, while a put option transaction takes place in the future.
B) An call option transaction is the right to purchase the underlying asset, while a put option is the right to sell the underlying asset.
C) An call option transaction is not standardized, while put option transaction is standardized.
D) An call option transaction deals with financial assets, while a put option transaction deals with commodities.

Question 28

Which of the following is not a risk that can be hedged?

A) Flood
B) Commodity prices
C) Interest rate movements
D) Exchange rate movements

Question 29

Is there a reason why pure risk events, like a hurricane or earthquake, could be bundled into a more general risk portfolio?

A) No, pure risks have too devastating an effect.
B) Yes, since they are negatively correlated with other risk events.
C) No, they are too highly correlated with other risk events.
D) Yes, because an insurer can ask a very high premium for including it in the general risk portfolio.

Question 30

If the covariance between two stocks is 235 and the standard deviation of both stocks are 45 and 22 respectively, what is the Correlation Coefficient between the two stocks?

A) 0.24
B) 0.33
C) 0.76
D) There is not enough information to calculate the Correlation Coefficient.

Question 31

Which of the following statements about option contracts is not correct?

A) The option writer has the right to exercise the option.
B) Option contracts can create a legal right to buy or sell a financial asset.
C) The option holder has the right to exercise the option.
D) All of the above are correct.

Question 32

Which of the following statements about put options is correct?

A) If the option writer exercises the put option, the option holder has to sell the underlying asset to him or her.
B) If the option writer exercises the put option, the option holder has to buy the underlying asset from him or her.
C) If the option holder exercises the put option, the option writer has to buy the underlying asset from him or her.
D) If the option holder exercises the put option, the option writer has to sell the underlying asset to him or her.

Question 33

If two random variables are uncorrelated:

A) their correlation coefficient cannot be calculated
B) their correlation coefficient is zero
C) their correlation coefficient depends on the covariance
D) All of the above are incorrect.

Question 34

Which of the following statements about correlation is incorrect?

A) If two variables are statistically independent of each other, their correlation coefficient is zero.
B) Negatively correlated investments offer the best opportunities for diversification.
C) If two investments are perfectly correlated, their correlation coefficient is +1.
D) The risk of fire is positively correlated with the risk of traffic accidents.

Question 35

If the covariance between two stocks is 115 and the standard deviation of both stocks are 17 and -8 respectively, what is the Correlation Coefficient between the two stocks?

A) 0.18
B) 0.85
C) -0.85
D) There is not enough information to calculate the Correlation Coefficient.

Question 36

Why are derivatives effective instruments for hedging?

A) They are negatively correlated with the firm's underlying risk.
B) There are so many of them.
C) They enhance the risk pool.
D) All of the above are correct.

Question 37

What is the essential difference between an option and a futures contract?

A) An option transaction occurs now, while a futures contract takes place in the future.
B) An option transaction is a right to transact for the option holder, while a futures contract is an obligation to transact in the future.
C) An option transaction is not standardized, while a futures contract is standardized.
D) An option transaction deals with financial assets, while a futures contract deals with commodities.

Question 38

Which of the following statements about the counterparty to a risk management derivatives contract is correct?

A) The counterparty has the same expectations about future price movements as the risk manager.
B) The counterparty charges a fixed fee of $5 per contract.
C) The counterparty is in all likelihood a speculator.
D) All of the above are correct.

Question 39

From an insurance viewpoint, is a legal ruling that applies to many business owners a beneficial one?

A) No, because it creates a higher correlation coefficient among those business owners
B) No, because it creates uncertainty for those business owners
C) Yes, as long as the ruling applies to all business owners
D) Yes, as long as the ruling applies to enough business owners

Question 40

Which of the following statements about the bundling risks into portfolios is not correct?

A) Due to the randomness of business activity bundling risks into portfolios will be reducing risk.
B) Natural diversification occurs across uncorrelated risks that are bundled into a portfolio.
C) Bundling risk into a portfolio only reduces risk if uncorrelated and/or negatively correlated exposures are included.
D) The best reduction in risk is accomplished by including negatively correlated exposures into a portfolio.

Question 41

What are the generic tools used to deal with the exposures in the area of financial risk management?

Question 42

As long as their correlation coefficient is less than 1, risk is being reduced by adding investments to the pool.

Question 43

Explain the importance of the correlation coefficient for diversification.

Question 44

The correlation coefficient is calculated by taking the square root of the variance.

Question 45

The covariance shows the risk of a single variable.

Question 46

A traded option contract creates a legal right to buy or sell assets at a set price before a certain date.

Question 47

Exchange rate losses arise when the value of the domestic currency falls relative to foreign currencies.

Question 48

When the option holder decides to exercise the option, the option writer has the option to not fulfill the request.

Question 49

Input price risk and output price risk are both a form of commodity price risk.

Question 50

One of the benefits of bearing risk collectively is that the group can better afford to obtain better data compared to one company alone.

Question 51

When two investments have a negative correlation coefficient it means that they are bad investments.

Question 52

The core concept underlying the risk reducing effects of diversification and hedging is the correlation coefficient.

Question 53

Explain who the counterparty is to a risk management derivatives contract that an insurance company would engage in and what his or her motives are to engage in the derivatives contract.

Question 54

Which of the following is not correct about hedging speculators?

A) They charge a fee for their services.
B) They are the counterparty to a risk management derivatives contract.
C) They take risks which they mitigate by having superior knowledge of the market they trade in.
D) They provide professional management.

Question 55

Explain when and why a call option has value.

Question 56

Currency risk is risk associated with the fluctuation of currency values relative to another currency.