Deck 21: Risk Management

Question 1

In a perfect capital market,a company will not purchase insurance unless the NPV is positive.

Answer 1

False

Question 2

A firm estimates that the loss from a weather-related closing is $10 million and the probability of occurrence is 0.1% over the next year.If claims are paid at the end of the year,the annual risk-free rate is 5%,the market risk premium is 6%,and the beta of these losses is 0.5,compute the insurance premium.

A) $8198
B) $8918
C) $9259
D) $9598
E) $8574

Answer 2

$9259

Question 3

A firm wishes to buy fire insurance at its plant.The loss in case of fire is estimated to be $50 million and the probability of occurrence is 0.5% over the next year.If claims are paid at the end of the year and the annual risk-free rate is 10%,compute the insurance premium.

A) $250,303
B) $236,109
C) $245,368
D) $227,273
E) $260,154

Answer 3

$227,273

Question 4

The ________ is the annual fee a firm pays the insurance company in exchange for compensation in the event of a random future loss.

A) expected loss
B) market rate
C) market risk premium
D) insurance premium
E) mark up

Question 5

An operator of an oil well has a 0.5% chance of experiencing a catastrophic failure.This failure will cost the operator $500 million.If the risk-free rate is 2%,the expected return on the market is 8%,and the beta of the risk is -1.2,what is the actuarially fair insurance premium?

A) $2,500,000
B) $2,637,131
C) $2,550,000
D) $2,753,304
E) $2,145,000

Question 6

________ is one of the most common methods to reduce the risks related to business liability,business interruption,or loss of key personnel.

A) Management
B) Hedging
C) Insurance
D) Diversification
E) Working capital management

Question 7

A firm wishes to buy fire insurance at its plant.The loss in case of fire is estimated to be $30 million and the probability of occurrence is 0.5% over the next year.If claims are paid at the end of the year and the annual risk-free rate is 10%,compute the insurance premium.

A) $150,000
B) $136,364
C) $145,368
D) $155,691
E) $141,672

Question 8

Insurance allows the firm to exchange a random future loss for a certain upfront expense.

Question 9

A restaurant decides to insure itself against the risk of fire.The insurance company estimates that the probability of a fire is 0.1% and the expected payment should a fire occur is $10 million.If the risk-free rate is 4%,the expected return on the market is 9%,and the beta of the risk is -3,what is the actuarially fair insurance premium?

A) $9,174
B) $9,524
C) $9,615
D) $9,009
E) $11,236

Question 10

Insurance for large risks that cannot be well diversified has a(n)________,which increases its cost.

A) positive beta
B) moral hazard clause
C) negative beta
D) actuarially-biased risk
E) zero beta

Question 11

Adverse selection is a market friction that raises the cost of insurance.

Question 12

If the price of insurance equals the net present value (NPV)of the expected payment,it is said to be

A) actuarially fair.
B) market-based.
C) balanced.
D) equalized.
E) at equilibrium.

Question 13

A firm wishes to buy fire insurance at its plant.The loss in case of fire is estimated to be $20 million and the probability of occurrence is 0.1% over the next year.If claims are paid at the end of the year and the annual risk-free rate is 10%,compute the insurance premium.

A) $15,304
B) $16,364
C) $18,182
D) $19,234
E) $17,175

Question 14

A firm estimates that the loss from a weather-related closing is $20 million and the probability of occurrence is 0.2% over the next year.If claims are paid at the end of the year,the annual risk-free rate is 5%,the market risk premium is 6%,and the beta of these losses is 0.7,compute the insurance premium.

A) $28,198
B) $36,630
C) $37,259
D) $39,491
E) $38,175

Question 15

Insurance companies diversify their risks by pooling together highly correlated policies.

Question 16

Because insurance pays off in bad times,it is generally a negative-beta asset.

Question 17

An operator of an oil well has a 0.5% chance of experiencing a catastrophic failure.This failure will cost the operator $500 million.If the risk-free rate is 2%,the expected return on the market is 8%,and the beta of the risk is 0,what is the actuarially fair insurance premium?

A) $2,450,980
B) $2,500,000
C) $2,550,000
D) $2,314,815
E) $2,715,225

Question 18

A restaurant decides to insure itself against the risk of fire.The insurance company estimates that the probability of a fire is 0.1% and the expected payment should a fire occur is $10 million.If the risk-free rate is 4%,the expected return on the market is 9%,and the beta of the risk is 0,what is the actuarially fair insurance premium?

A) $9,016
B) $9,174
C) $9,524
D) $9,615
E) $10,000

Question 19

The change in behaviour that results from the presence of insurance is referred to as moral hazard.

Question 20

The value of insurance comes from its ability to reduce the cost of ________ for the firm.

A) adverse selection
B) vertical integration
C) fraud
D) market imperfections
E) capital

Question 21

A firm with above-average risk is more likely to purchase insurance.This is an example of

A) adverse selection.
B) moral hazard.
C) the insurance dilemma.
D) actuarial fairness.
E) insurance risk.

Question 22

________ costs impose several direct and indirect costs,including agency costs,whose insurance could lead to an increase in firm value.

A) Bankruptcy and financial distress
B) Market
C) Input
D) Output
E) Startup

Question 23

After purchasing fire insurance,a firm decides to cut costs by reducing spending on fire prevention.This is an example of

A) adverse selection.
B) moral hazard.
C) the insurance dilemma.
D) actuarial fairness.
E) insurance risk.

Question 24

Which of the following best describes how adverse selection affects the price of insurance?

A) Since insurers can acquire complete information regarding the riskiness of borrowers, they can charge actuarially fair premiums.
B) Since firms may have private information about how risky they are, insurers must raise premiums to compensate for the existence of this uncertainty.
C) Since purchasing insurance reduces the firm's incentive to avoid risk, insurers must raise premiums to compensate for the increase in risk.
D) Since purchasing insurance reduces the firm's risk, insurers can lower premiums to compensate for the reduction in risk.
E) Since high premiums will drive away the low-risk firms, insurers must lower premiums in order to attract low-risk borrowers.

Question 25

The risk of fire at a car assembly plant is 0.3%.If the firm will receive a payment of $20 million in one year if there is a fire during the year,what is the net present value (NPV)of purchasing insurance if the firm will face financial distress costs of $6 million and issuance costs of $1 million in the event of a loss if the risk-free rate is 5%?

A) $19,429
B) $20,000
C) $22,176
D) $23,981
E) $24,514

Question 26

Because insurance provides cash to the firm to offset losses,it can reduce the firm's need for external capital and thus reduce ________ costs.

A) labour
B) external
C) input
D) issuance
E) startup

Question 27

Which of the following best describes how moral hazard affects the price of insurance?

A) Since insurers can acquire complete information regarding the riskiness of borrowers, they can charge actuarially fair premiums.
B) Since firms may have private information about how risky they are, insurers must raise premiums to compensate for the existence of this uncertainty.
C) Since purchasing insurance reduces the firm's incentive to avoid risk, insurers must raise premiums to compensate for the increase in risk.
D) Since purchasing insurance reduces the firm's risk, insurers can lower premiums to compensate for the reduction in risk.
E) Since high premiums will drive away the low-risk firms, insurers must lower premiums in order to attract low-risk borrowers.

Question 28

A company has a current tax rate of 35% and faces a 10% chance that the its output prices will drop and it will lose 200,000 over the next year.The firm would then be in a 15% tax bracket if it faces a loss.Compute the net present value (NPV)from purchasing insurance if the rate of interest is 5% and the beta of the output prices is 0.

A) $2932
B) $3178
C) $3312
D) $3810
E) $2761

Question 29

A company has a current tax rate of 30% and faces a 20% chance that the its output prices will drop and it will lose $100,000 over the next year.The firm would then be in a 15% tax bracket if it faces a loss.Compute the net present value (NPV)from purchasing insurance if the rate of interest is 5% and the beta of the output prices is 0.

A) $2,857
B) $2,189
C) $2,357
D) $2,591
E) $2,062

Question 30

A company has a current tax rate of 30% and faces a 15% chance that the its output prices will drop and it will lose $100,000 over the next year.The firm would then be in a 10% tax bracket if it faces a loss.Compute the net present value (NPV)from purchasing insurance if the rate of interest is 5% and the beta of the output prices is 0.

A) $1932
B) $2178
C) $2857
D) $2591
E) $3122

Question 31

A firm estimates that the loss from a weather-related closing is $40 million and the probability of occurrence is 0.1% over the next year.If claims are paid at the end of the year,the annual risk-free rate is 5%,the market risk premium is 6%,and the beta of these losses is 0.9,compute the insurance premium.

A) $28,276
B) $28,672
C) $36,232
D) $39,491
E) $32,448

Question 32

The risk of fire at a car assembly plant is 0.2%.If the firm will receive a payment of $30 million in one year if there is a fire during the year,what is the net present value (NPV)of purchasing insurance if the firm will face financial distress costs of $5 million and issuance costs of $1 million in the event of a loss if the risk-free rate is 5%?

A) $11,429
B) $12,367
C) $12,967
D) $13,673
E) $14,356

Question 33

A provision in an insurance policy that limits the amount of loss that the policy covers regardless of the extent of the damage is known as a

A) security deposit.
B) coverage ceiling.
C) policy limit.
D) deductible.
E) loss premium.

Question 34

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.
E) damage insurance.

Question 35

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.
E) damage insurance.

Question 36

A provision in an insurance policy in which an initial amount of loss is not covered by the policy and must be paid by the insured is known as a

A) security deposit.
B) market imperfection.
C) policy limit.
D) deductible.
E) loss premium.

Question 37

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 net present value (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
E) $2.75 million

Question 38

The risk of fire at a car assembly plant is 0.1%.If the firm will receive a payment of $40 million in one year if there is a fire during the year,what is the net present value (NPV)of purchasing insurance if the firm will face financial distress costs of $7 million and issuance costs of $1 million in the event of a loss if the risk-free rate is 5%?

A) $5,421
B) $6,415
C) $6,923
D) $7,619
E) $7,142

Question 39

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.
E) damage insurance.

Question 40

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.
E) damage insurance.

Question 41

What is adverse selection?

Question 42

What is business liability insurance?

Question 43

How does insurance allow firms to increase their use of debt financing?

Question 44

Which of the following is a customized agreement between two parties who are known to each other to trade an asset on some future date,at a price that is fixed today?

A) margin
B) futures contract
C) forward contract
D) interest rate swap
E) option hedging

Question 45

What is business interruption insurance?

Question 46

When there is a mismatch between a firm's risk exposure and the underlying futures contract used for hedging,it referred to as basis risk.

Question 47

Being long a futures contract is equivalent to purchasing a put option.

Question 48

What is key personnel insurance?

Question 49

What is an actuarially fair price?

Question 50

A steel maker needs 5,000,000 tons of coal next year.The current market price for coal is $70.00 per ton.At this price,the firm expects its EBIT to be $500 million.What will the firm's EBIT if the firm enters into a supply contract for coal for a fixed price of $72.00 per ton?

A) $500 million
B) $510 million
C) $490 million
D) $350 million
E) $410 million

Question 51

How does insurance allow firms to reduce issuance costs?

Question 52

A manufacturer of breakfast cereal is concerned about corn prices.The firm anticipates needing 1 million bushels of corn in one month.The current price of corn is $6.50 per bushel and the futures price for delivery in one month is $7.00 per bushel.The cost to store the corn for 1 month is $100,000.What should the firm do?

A) Hedge with futures for a total cost of $7,000,000.
B) Hedge with futures for a total cost of $6,900,000.
C) Buy the corn now and store for 1 month, for a total cost of $6,500,000.
D) Buy the corn now and store for 1 month, for a total cost of $6,600,000.
E) Wait one month and buy the corn at the market price in one month.

Question 53

Firms can hedge risk by making real investments in assets with offsetting risk.

Question 54

The ability of a firm to pass on cost increases to its customers or revenue decreases to its suppliers is known as

A) a natural hedge.
B) vertical integration.
C) adverse selection.
D) operating insurance.
E) supply management.

Question 55

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.
E) margin risk.

Question 56

The risk that the firm will not have,or will not 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.
E) margin risk.

Question 57

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 net present value (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
E) $2.75 million

Question 58

What is the purpose of a deductible?

Question 59

What is moral hazard?

Question 60

Two firms can use vertical integration to hedge risks,because an increase in price represents an increase in revenues for one firm,offsetting an increase in costs for the other firm.

Question 61

Suppose oil futures prices are as given in the above table (price per barrel).Suppose you buy 100 crude oil futures contracts,each for 1000 barrels of crude oil,at the current futures price of $108 per barrel on day 0.What is your cumulative profit/loss in your margin account by the end of day 5?

A) -$200,000
B) $200,000
C) $100,000
D) -$100,000
E) $0

Question 62

________ is method of hedging because a firm can lock in the cost of a commodity at today's prices plus any carrying costs.

A) Vertical integration
B) Storage
C) Merger
D) Rationalization
E) Internalization

Question 63

A ________ contract is often used for hedging and is an exchange-traded agreement to purchase an asset at some future date at a price that is locked in today.

A) call option
B) futures
C) put option
D) long term
E) storage

Question 64

Vertical integration can increase firm value only if a merger provides gains from ________ and cost savings.

A) synergies
B) debt repayments
C) equity swaps
D) shareholders
E) bondholders

Question 65

________ is a method of hedging wherein a firm and its supplier merge so that an increase in the price of a commodity raises the firm's costs and the supplier's revenues.

A) Storage
B) Horizontal merger
C) Business rationalization
D) Vertical integration
E) Internalization

Question 66

How do futures contracts eliminate credit risk?

Question 67

A gold mining firm sells futures contracts worth 1000 ounces at a price of $800 per ounce for maturity one year from today.If gold futures prices decrease to $798 per ounce,what is the cash flow to the producer?

A) -$2000
B) $2000
C) $0
D) $800,000
E) $798,000

Question 68

Heinz uses 2000 tons of corn syrup each year as an ingredient in its tomato ketchup products.Heinz is concerned about the increase in prices of corn-based products and purchases a fixed-price contract to buy corn syrup at $20,000 per ton.What is the impact on earnings before taxes as opposed to no hedging if the price of corn is $15,000 per ton over the next year?

A) +$5 million
B) -$10 million
C) $0
D) +$10 million
E) -$5 million

Question 69

When a firm can pass on its cost increases to its customers and revenue decreases to its suppliers,it has a ________ hedge.

A) natural
B) basis
C) vertical
D) horizontal
E) hidden

Question 70

A gold mining firm sells futures contracts worth 1000 ounces at a price of $700 per ounce for maturity one year from today.If gold futures prices increase to $752 per ounce,what is the cash flow to the producer?

A) -$2000
B) $2000
C) $0
D) -$52,000
E) $52,000

Question 71

Futures contracts minimize default risk by requiring traders to post collateral called ________ when buying or selling commodities using futures contracts.

A) down payment
B) marked to market
C) margin
D) commission
E) deposit

Question 72

Heinz uses 1000 tons of corn syrup each year as an ingredient in its tomato ketchup products.Heinz is concerned about the increase in prices of corn-based products and purchases a fixed-price contract to buy corn syrup at $20,000 per ton.What is the impact on earnings before taxes as opposed to no hedging if the price of corn is $25,000 per ton over the next year?

A) +$5 million
B) -$5 million
C) $0
D) +$5,000
E) -$5,000

Question 73

A gold mining firm sells futures contracts worth 1000 ounces at a price of $700 per ounce for maturity one year from today.If gold futures prices increase to $702 per ounce,what is the cash flow to the producer?

A) -$2000
B) $2000
C) $0
D) $700,000
E) $702,000

Question 74

One of the drawbacks of using futures contracts to hedge is that managers in a firm may use the futures contracts to ________ and consequently increase the firm's risk rather than reducing it.

A) hedge
B) produce
C) speculate
D) increase managerial compensation
E) expand

Question 75

Use the table for the question(s) below.

Suppose oil futures prices are as given in the above table (price per barrel).Suppose you sell 100 crude oil futures contracts,each for 1000 barrels of crude oil,at the current futures price of $108 per barrel on day 0.What is your cumulative profit/loss in your margin account by the end of day 5?

A) -$300,000
B) $300,000
C) $400,000
D) -$400,000
E) $0

Question 76

Use the table for the question(s) below.

Suppose oil futures prices are as given in the above table (price per barrel).Suppose you buy 100 crude oil futures contracts,each for 1000 barrels of crude oil,at the current futures price of $108 per barrel on day 0.What is your cumulative profit/loss in your margin account by the end of day 5?

A) -$300,000
B) $300,000
C) $400,000
D) -$400,000
E) $0

Question 77

Use the table for the question(s) below.

Suppose oil futures prices are as given in the above table (price per barrel).Suppose you sell 100 crude oil futures contracts,each for 1000 barrels of crude oil,at the current futures price of $108 per barrel on day 0.What is your profit/loss in your margin account from the end of day 4 to the end of day 5?

A) -$300,000
B) $300,000
C) $400,000
D) -$400,000
E) $0

Question 78

Use the table for the question(s) below.

Suppose oil futures prices are as given in the above table (price per barrel).Suppose you buy 100 crude oil futures contracts,each for 1000 barrels of crude oil,at the current futures price of $108 per barrel on day 0.What is your profit/loss in your margin account from the end of day 4 to the end of day 5?

A) -$300,000
B) $300,000
C) $400,000
D) -$400,000
E) $0

Question 79

Heinz uses 2000 tons of corn syrup each year as an ingredient in its tomato ketchup products.Heinz is concerned about the increase in prices of corn-based products and purchases a fixed-price contract to buy corn syrup at $10,000 per ton.What is the impact on earnings before taxes as opposed to no hedging if the price of corn is $10,000 per ton over the next year?

A) +$5 million
B) -$5 million
C) $0
D) -$10 million
E) +$10 million

Question 80

When firms use futures contracts for hedging,cash flows are received and paid daily rather than waiting until the end of the contract through a procedure called

A) cash flow hedging.
B) marking to market.
C) swaps.
D) put-call parity.
E) daily settlement.