Deck 20: Corporate Risk Management

Question 1

Well managed firms will always seek to transfer as much risk as possible.

Answer 1

False

Question 2

What are some of the means by which firms can transfer risk to other parties? Should firms always transfer risks when it is possible to do so?

Answer 2

Firms can purchase insurance policies which transfer certain risks to the insuring party. Companies can and often do purchase policies to cover lawsuits brought by employees or customers, worksite accidents, fire or storm damage, and the like. Businesses like ski resorts can even purchase weather insurance. Firms cans use derivatives markets (futures and options contracts) to protect themselves against sudden spikes or declines in commodity prices or financial assets, as well adverse moves in currency exchange rates. Transferring risk is costly, so it always reduces cash flows. The decision to keep or transfer risk must result from a cost/benefit analysis and an attempt to discern the preferences of their shareholders.

Question 3

The optimal corporate risk management strategy is to

A) avoid or transfer every possible risk.
B) do nothing to transfer risk.
C) transfer about half the risk.
D) there is no strategy that is optimal for all firms.

Answer 3

D

Question 4

What is the general rule that firms should follow when deciding how much risk to assume?

Question 5

Firms that wish to minimize risk will attempt to

A) minimize the standard deviation of expected cash flows.
B) maximize the standard deviation of expected cash flows.
C) maximize expected cash flows.
D) balance expected cash flows with the standard deviation of expected cash flows.

Question 6

An example of commodity risk would be

A) volatile exchange rates with countries from which commodities are imported.
B) the price of copper for electrical contractors.
C) volatile exchange rates with countries to which commodities are exported.
D) raw materials that do not meet quality specifications.

Question 7

A manufacturer of breakfast cereals should always be fully hedged against both rising and falling grain prices.

Question 8

Which of the following types of risk cannot typically be transferred to an insurance company?

A) Losses due to property damage from storms.
B) Losses due to on-the job injuries suffered by employees.
C) Losses due to rising raw materials costs that cannot be passed on to customers.
D) Losses due to the untimely death of an employee in a key position.

Question 9

Which of the following scenarios carries the least risk of NOT being able to meet required payments (capital expenditure, dividend, interest and principal requirements) totaling $96 million?

A) Expected cash flow, $116 million, standard deviation $5 million
B) Expected cash flow, $107 million, standard deviation $5.5 million
C) Expected cash flow, $112 million, standard deviation $8 million
D) Expected cash flow, $134 million, standard deviation $38 million

Question 10

Which of the following is NOT part of the five step corporate risk management process?

A) Identify and understand the firm's major risks
B) Accept projects only if the NPV of the worst case scenario is positive.
C) Monitor and manage the risks the firm assumes
D) Decide how much risk to assume.

Question 11

Corporations should spread responsibility for monitoring risk among as many different individuals as possible.

Question 12

A major factor impacting the demand for residential real estate is the availability of credit.

Question 13

In 2010, a deep water oil drilling rig owned by British Petroleum exploded in the Gulf of Mexico resulting in the deaths of several crew members, one of the worst ecological disasters in history, and major financial damage to the company. How could the five step corporate risk management process have avoided or mitigated this disaster.

Question 14

The major risks assumed by firms include

A) demand risk.
B) foreign-exchange risk.
C) operational risk.
D) all of the above.

Question 15

Aspects of demand risk controllable by the firm include

A) product quality.
B) interest rates.
C) entry of external competitors.
D) status of the regional and national economy.

Question 16

Which of the following scenarios carries the greatest risk of NOT being able to meet required payments (capital expenditure, dividend, interest and principal requirements) totaling $96 million?

A) Expected cash flow, $116 million, standard deviation $5 million
B) Expected cash flow, $107 million, standard deviation $5.5 million
C) Expected cash flow, $112 million, standard deviation $8 million
D) Expected cash flow, $134 million, standard deviation $38 million

Question 17

Eliminating all possible risk will ultimately

A) guarantee the highest possible cash flow over the long run.
B) cancel out all profits with cost of hedging.
C) result in lower expected cash flow but the highest cash flow for the worst case scenario.
D) guarantee that the firm will not experience losses.

Question 18

Assume that government and insurance providers pressure physicians to prescribe generic drugs whenever possible. For the producers of branded drugs, this change represents

A) insurable risk.
B) operational risk.
C) demand risk.
D) hedgeable risk.

Question 19

Foreign-exchange risk can be important even for firms that have only U.S. operations.

Question 20

Some risks cannot be transferred to other parties.

Question 21

A maker of breakfast cereals has contracted to buy 100,000 bushels of wheat for $4.50 a bushel at the end of October. On the delivery date, the spot price of wheat is $4.70 per bushel. Which of the following is true?

A) The seller of the contract has $20,000 profit.
B) The buyer of the contract has a $20,000 loss.
C) The buyer of the contract has a $20,000 profit
D) Both A and B are true

Question 22

Self-insurance would not provide adequate protection in which of the following circumstances?

A) Unemployment insurance for a firm that rarely lays off employees.
B) Damage to the company's own vehicles.
C) Major ecological disasters resulting from oil spills.
D) Revenue lost because of bad weather during the peak shopping season.

Question 23

The purpose of a hedging strategy is to

A) avoid speculation on future prices.
B) speculate that future prices will be lower than the spot price.
C) speculate that future prices will be higher than the spot price.
D) avoid exposure to commodity rate risk.

Question 24

Self-insurance is the practice of

A) holding reserves within the firm to cover potential losses.
B) CEO's holding large life insurance policies on themselves, payable to the company.
C) companies in unrelated businesses forming subsidiaries to cover their insurance needs.
D) purchasing insurance policies directly rather than through a broker.

Question 25

A large agribusiness firm has contracted to deliver 100,000 bushels of wheat for $4.50 a bushel at the end of October. On the delivery date, the spot price of wheat is $4.70 per bushel. Which of the following is true?

A) The seller of the contract has $20,000 loss.
B) The buyer of the contract has a $20,000 loss.
C) The buyer of the contract has a $20,000 profit
D) Both A and C are true

Question 26

The party that agrees to sell a commodity or currency in the forward market is said to have a

A) long position.
B) short position
C) protected position.
D) split position.

Question 27

Which of the following should determine whether or not the firm should purchase insurance from an outside party?

A) Only the frequency of incidents
B) The cost of the policy and the expected losses
C) Only the maximum size of incidents
D) Only the firms normal cash reserves

Question 28

Which of the following individual situations would best justify the cost of a life insurance policy?

A) Single income with young children.
B) Single income, no dependents.
C) Dual income, grown children.
D) Married couple, each had substantial income before retirement.

Question 29

The decision to purchase insurance is justified if the cost of the contract is less than the expected loss.

Question 30

Workers' compensation insurance provides coverage for on-the-job injuries suffered by employees.

Question 31

(Business of Life) What guidelines should determine whether or not an individual should buy life insurance?

Question 32

Which of the following is a consequence of transferring risk to an insurance company?

A) An increase in stock value because risk has been reduced.
B) A guaranteed small loss in exchange for protection against large losses.
C) Higher rates of return because the firm is now free to pursue high-risk projects.
D) Protection against losses at no significant cost to the firm.

Question 33

Swenson Oil & Gas allows its customers to prepurchase heating oil in June for the coming winter. Swenson's customers who take advantage of the offer

A) are speculating that fuel prices will be higher in the future.
B) have purchased a form of call option for heating fuel.
C) are entering into a futures contract to offset the risk of higher fuel prices during the winter.
D) are purchasing a form of insurance against fuel shortages.

Question 34

How should corporations decide when to self insure against certain risks and when to purchase insurance from outside parties?

Question 35

Purchasing insurance coverage is not justified in cases where potential losses are unlikely, but potentially catastrophic.

Question 36

Directors and officers insurance protects the company if key personnel die or leave the firm for other opportunities.

Question 37

Which of the following risks would be the best candidate for self insurance?

A) Potential malpractice suits for a 5 doctor surgery group.
B) Fire insurance for a business that operates 3 restaurants.
C) Life insurance on the partners of a 3 lawyer law firm. If one of the partners dies, the other two will need to buy her share of the business.
D) A large parcel delivery company sustains occasional damage to its vehicles.

Question 38

It is not legal for a corporation to hold life insurance policies on its employees.

Question 39

Which of the following types of insurance does NOT involve a contract with an external party?

A) Property insurance
B) Life insurance
C) Directors and officers insurance
D) Self insurance

Question 40

Workers' compensation insurance protects employees income in case they are laid off or fired.

Question 41

Swenson Oil & Gas allows its customers to prepurchase heating oil in June for the coming winter. Customers who took advantage of the offer prepurchased 400,000 gallons of oil at $3.50 per gallon. Swenson hedged its position by contracting to purchase 400,000 gallons of oil for November delivery at a price of $3.00 per gallon. If the November spot price is $3.25 per gallon, the payoff to Swenson is

A) $100,000.
B) ($100,000).
C) $200,000.
D) $0.00.

Question 42

How is an airline that sells tickets that will be used several months in the future exposed to the risk of rising jet fuel prices? How can it manage that risk?

Question 43

Swenson Oil & Gas allows its customers to prepurchase heating oil in June for the coming winter. Customers who took advantage of the offer prepurchased 400,000 gallons of oil at $3.50 per gallon. Swenson hedged its position by contracting to purchase 400,000 gallons of oil for November delivery at a price of $3.00 per gallon. If the November spot price is $2.75 per gallon, the payoff to Swenson is

A) $100,000.
B) ($100,000).
C) $200,000.
D) $0.00.

Question 44

A purchaser of commodities who is completely hedged with forward contracts has eliminated the risk that prices will rise before the purchase is concluded.

Question 45

A commodity such as diesel fuel for which there is no available futures contract might be satisfactorily hedged with

A) stock index futures.
B) interest rate futures.
C) heating oil futures.
D) electricity futures.

Question 46

You purchased one July futures contract of pork bellies at $.59 per lb. One contract represents 40,000 lbs. of pork bellies. Initial margin on the contract was 4% of the contract price with a maintenance margin of $500. By the end of the day, the price had fallen to $.57 per lb. How much will you be required to add to your margin account to replenish your maintenance margin?

A) None
B) $356
C) $144
D) $32

Question 47

Hudson Valley Distributors wants to be sure it has 10,000 cases of Beaujolais Nouveau to sell next November. In January, they enter into an agreement to buy the wine at a price of 34.62 euro to the case. Payment will be due at the end of November. They expect to sell the wine to restaurants and retailers for $63 per case. Hudson Valley has hedged its foreign exchange risk by entering into a forward contract to purchase euros in November at $1.30/euro. If the spot exchange rate at the end of November is $1.25/euro, the payoff to Hudson Valley for hedging is

A) $13,315.
B) $17,310.
C) ($17,310).
D) ($500).

Question 48

What motivates users of raw materials to hedge future prices by entering into futures contracts? What is the disadvantage of this practice?

Question 49

A seller of commodities who has entered into forward contracts with customers will profit if prices fall before the purchase is concluded.

Question 50

Swenson Oil & Gas allows its customers to prepurchase heating oil in June for the coming winter. Customers who took advantage of the offer prepurchased 400,000 gallons of oil at $3.50 per gallon. Swenson hedged its position by contracting to purchase 400,000 gallons of oil for November delivery at a price of $3.00 per gallon. If the November spot price is $3.85 per gallon, Swenson's gross profit on the heating oil sold in June will be

A) $100,000.
B) ($100,000).
C) $200,000.
D) $0.00.

Question 51

Hudson Valley Distributors wants to be sure it has 10,000 cases of Beaujolais Nouveau to sell next November. In January, they enters into an agreement to buy the wine at a price of 34.62 euro per case. Payment will be due at the end of November. They expect to sell the wine to restaurants and retailers for $63 per case. If Hudson Valley does not hedge its position and the exchange rate in November is $1.30 /euro, what is the gross profit on the wine? (Round to the nearest dollar.)

A) $179,940
B) ($179,940)
C) $363,692
D) $283,800

Question 52

Swenson Oil & Gas allows its customers to prepurchase heating oil in June for the coming winter. If Swenson does not hedge its positions in the futures market

A) it could make unexpected profits if fuel prices decline.
B) it could suffer large losses if the winter wholesale cost of fuel rises above the June retail price.
C) it will make normal profits if winter prices do not change very much from the June spot price.
D) all of the above.

Question 53

Uses of future contracts include

A) reducing uncertainty about the future cost of key inputs.
B) reducing uncertainty about the prices that will be received when a commodity is ready for market.
C) speculating on future price movements of commodities which the speculator neither uses nor produces.
D) all of the above.

Question 54

Hudson Valley Distributors wants to be sure it has 10,000 cases of Beaujolais Nouveau to sell next November. In January, they enters into an agreement to buy the wine at a price of 34.62 euros to the case. Payment will be due at the end of November. They expect to sell the wine to restaurants and retailers for $63 per case. Hudson Valley has hedged its foreign exchange risk by entering into a forward contract to purchase euros in November at $1.30/euro. If the spot exchange rate at the end of November is $1.35/euro, Hudson Valley's gross profit will be

A) $283,800.
B) $138,415.
C) $162,630.
D) $179,940.

Question 55

Banque de Lyon agrees to sell Golden Socks 1,000,000 euro at a price of $1.10 to the euro 6 months from today. If the spot price of the euro in six months is $1.20,

A) the payoff to Banque de Lyon is $100,000.
B) the payoff to Banque de Lyon is ($100,000).
C) the payoff to Banque de Lyon is ($135,000).
D) the payoff to Golden Socks is ($100,000).

Question 56

Bowman-Daniela-Mainland is a major producer and exporter of agricultural commodities. It has sold soy beans for future delivery to a Japanese firm and expects to receive payments of 400 million yen in 6 months and another 400 million yen in 1 year. To lock in the exchange rates on these two payments, BDM arranges forward contracts with an investment banker to sell 400 million yen at $0.0110 in 6 months and $0.0115 in 1 year. What will BDM's cash flow be in dollars from each of these transactions? How has it fixed its revenue in dollars from the soy bean sales?

Question 57

A purchaser of commodities who is completely hedged with forward contracts will profit if prices fall before the purchase is concluded.

Question 58

The objective of a prudent financial manager is to eliminate all foreign exchange risk.

Question 59

The long and short positions on forward contracts will always have equal and opposite payoffs.

Question 60

Which of the following is NOT an advantage of futures contracts?

A) They are inexpensive compared to customized forward contracts.
B) They trade on exchanges rather than over the counter.
C) Features such as contract size and expiration date are standardized.
D) The size and commodity can always be perfectly tailored to form a perfect hedge.

Question 61

Erin wrote a put option on Verizon stock with a striking price of $53 per share. At the expiration date, Verizon was selling for $50 per share. Which statement best describes the action that Erin should or must take?

A) Erin will do nothing because the market price is lower than the striking price.
B) Erin is obliged to buy the Verizon shares at $53, even though the market price $3.00 lower.
C) Erin must sell the Verizon stock for $53 per share.
D) Erin has the right to sell Verizon stock at $3.00 per share over the market price.

Question 62

The minimum value of a call option equals

A) exercise price - the stock price.
B) stock price - exercise price.
C) call premium - (stock price - exercise price).
D) put premium - (exercise price - stock price).

Question 63

Unlike the owner of a(n) ________ contract, the owner of a(n) ________ contract does not have to exercise it

A) put, call
B) option, futures
C) futures, option
D) long, short

Question 64

A(n) ________ gives the holder the right to buy a stated number of shares at a specified price for a limited time.

A) stock index futures contract
B) put option
C) call option
D) interest rate futures contract

Question 65

A(n) ________ gives the holder the right to sell a stated number of shares at a specified price for a limited time.

A) stock index futures contract
B) put option
C) call option
D) interest rate futures contract

Question 66

How can a currency futures contract be used as a hedge against a potentially dramatic appreciation of a foreign currency that a U.S. company is expecting to convert into U.S. dollars?

A) The U.S. company should sell the foreign currency using futures contracts.
B) The U.S. company should buy more foreign currency futures contracts than it should sell.
C) The U.S. company should buy the foreign currency using futures contracts.
D) This is a standard business situation that would be favorable if it were to happen, so no hedge is needed.

Question 67

Ahmad bought put options on Home Depot with a strike price of $130. The option premium was $2.83. Just before the contract expired, Home Depot stock was at $132.83 per share. Ahmad

A) made a profit of $2.83 per share.
B) lost $2.83 per share because the option would not be exercised.
C) lost $1.5.66 per share.
D) made a profit of $5.66 per share.

Question 68

A(n) ________ can be exercised only on the expiration date.

A) European option
B) at-the-money option
C) short option
D) American option

Question 69

Ahmad bought call options on Home Depot with a strike price of $130. The option premium was $6.68. Just before the contract expired, Home Depot stock was $135 per share. Ahmad

A) made a profit of $1.68 per share.
B) lost $6.68 per share because the option would not be exercised.
C) made a profit of $6.68 per share.
D) lost $1.68 per share.

Question 70

How can a gold futures contract be used as a hedge against a potentially dramatic decrease in the price of the gold needed as an input into the production of computer microprocessors?

A) The computer company should sell gold futures contracts.
B) The computer company should sell more gold futures contracts than it should buy.
C) This is a standard business situation, which would be favorable if it were to happen, so no hedge is needed.
D) The computer company should lower its finished product prices now in anticipation of the decrease in the price of gold inputs.

Question 71

Futures contracts differ from forward contracts in that

A) they can be used by financial managers to reduce risk.
B) they provide their holder with an opportunity to buy or sell an asset at some future time if the asset's value has changed in a manner favorable to the futures contract holder.
C) they sustain a small change in value when there is a small change in the price of the underlying commodity.
D) they are for standardized commodities in standardized quantities and have standardized expiration dates.

Question 72

The owner of a large, diversified stock portfolio could hedge against a steep decline in prices by

A) buying call options on a stock index.
B) buying put options on a stock index.
C) selling put options on a stock index.
D) buying both call and put options with the same expiration date.

Question 73

An investor would buy a ________ if he or she believes that the price of the underlying stock or asset will fall in the near future.

A) call option
B) convertible bond
C) put option
D) futures contract to take delivery of an asset at a future date

Question 74

Financial futures include

A) Treasury bond futures, which are the most popular of all futures contracts in terms of contracts issued.
B) interest rate futures, which have been around the longest.
C) stock index futures, which allow for either a cash settlement or a stock settlement.
D) all of the above.

Question 75

Barco Corp. common stock is currently selling for $36.50. A call option on Barco stock costs $.75 per share on a normal contract of 100 shares. This option has an exercise price of $39 and expires in one month. What is the minimum value of this option?

A) $2.50
B) $75
C) $0
D) $36.50

Question 76

The price at which the stock or asset may be purchased from (or sold to) the option writer is referred to as

A) intrinsic value of the option.
B) option premium.
C) open interest.
D) exercise or strike price.

Question 77

Mayspring Corporation common stock is currently selling for $72.00 per share. A call option on Mayspring Corporation that expires in two months has an exercise price of $72.50. This call option is said to be

A) out-of-the-money.
B) at-the-money.
C) in-the-money.
D) covered.

Question 78

A call option on a stock is a financial instrument defined by which of the following statements?

A) It obligates the investor holding it to sell the stock at the specified price at the stated date in the future.
B) It obligates the investor holding it to buy the stock at the specified price at the stated date in the future.
C) It gives the investor holding it the right, but not the obligation, to buy the stock at the specified price at the stated date in the future.
D) It gives the investor holding it the right, but not the obligation, to sell the stock at the specified price at the stated date in the future.

Question 79

You sold one July futures contract of pork bellies at $.59 per lb. One contract represents 40,000 lbs. of pork bellies. By the end of the day, the price had fallen to $.57 per lb. What was your profit or loss for the day?

A) $800 profit
B) $356 loss
C) $800 loss
D) There is no profit or loss until the contract expires.

Question 80

You purchased one July futures contract of pork bellies at $.59 per lb. One contract represents 40,000 lbs. of pork bellies. By the end of the day, the price had fallen to $.57 per lb. How much did the value of your contract change during the day?

A) It rose by $800.
B) It fell by $356.
C) It fell by $800.
D) There is no change in value until the contract expires.