Deck 21: Corporate Risk Management

Question 1

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

Answer 1

A

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

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

Answer 3

D

Question 4

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 5

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 6

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 7

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

Question 8

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

Question 9

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

Question 10

The major risks assumed by firms include

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

Question 11

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 12

Risk profile is the concept of a firm's 'appetite' for assuming risk.

Question 13

Firms that wish to minimise risk will attempt to

A)minimise the standard deviation of expected cash flows.
B)maximise the standard deviation of expected cash flows.
C)maximise expected cash flows.
D)balance expected cash flows with the standard deviation of expected cash flows.

Question 14

[blank] is a contract that involves compensation for specific potential future losses in exchange for periodic payments and that provides for the transfer of the risk of a loss, from one entity to another, in exchange for a premium.

A)Forward contract
B)Hedging
C)Insurance
D)Spot contract

Question 15

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 16

Some risks cannot be transferred to other parties.

Question 17

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.

Question 18

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

Question 19

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

Question 20

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 21

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

Question 22

Self-insurance is the practice of

A)holding reserves within the firm to cover potential losses.
B)CEOs 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 23

[blank] is a contract wherein a price is agreed upon today for an asset to be sold in the future.

A)Forward contract
B)Hedging
C)Insurance
D)Spot contract

Question 24

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 25

National Fuel allows its customers to prepurchase heating oil in May for the coming winter.National Fuel'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 26

The purchase of a forward contract involves the transfer of the risk of a loss from one entity to another.

Question 27

A maker of salsa has contracted to buy 100,000 bushels of tomatoes for $4.50 a bushel at the end of August.On the delivery date, the spot price of tomatoes 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 28

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 29

[blank] is a strategy designed to minimise exposure to unwanted risk by taking a position in one market that offsets exposure to price fluctuations in an opposite position in another market.

A)Forward contract
B)Hedging
C)Insurance
D)Spot contract

Question 30

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

Question 31

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

Question 32

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

Question 33

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 34

What guidelines should determine whether or not an individual should buy life insurance?

Question 35

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

Question 36

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

Question 37

A large agribusiness firm has contracted to deliver 100 000 bushels of tomatoes for $4.50 a bushel at the end of August.On the delivery date, the spot price of tomatoes 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 38

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 39

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 having substantial income before retirement.

Question 40

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

A)Potential malpractice suits for a five-doctor surgery group.
B)Fire insurance for a business that operates three restaurants.
C)Life insurance on the partners of a three-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 41

What are some limitations of forward contracts?

Question 42

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 ($200 000).
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 43

Queen City Enterprises wants to be sure it has 10,000 cases of Pinot Nior to sell next December.In February, they enter 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 December.They expect to sell the wine to restaurants and retailers for $63 per case.Queen City has hedged its foreign exchange risk by entering into a forward contract to purchase euros in December at $1.30/euro.If the spot exchange rate at the end of December is $1.35/euro, Queen City's gross profit will be

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

Question 44

National Fuel allows its customers to prepurchase heating oil in May 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 May will be

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

Question 45

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

Question 46

Queen City Enterprises wants to be sure it has 10,000 cases of Pinot Nior to sell next December.In February, they enter into an agreement to buy the wine at a price of 34.62 euro per case.Payment will be due at the end of December.They expect to sell the wine to restaurants and retailers for $63 per case.If Queen City does not hedge its position and the exchange rate in December 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 47

National Fuel allows its customers to prepurchase heating oil in May 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 May retail price.
C)it will make normal profits if winter prices do not change very much from the May spot price.
D)All of the above.

Question 48

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 49

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 six months and another 400 million yen in one 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 six months and $0.0115 in one 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 50

[blank] is an exchange in which the buyer agrees to purchase something and the seller agrees to sell it for a specific price.

A)Forward contract
B)Hedging
C)Insurance
D)Spot contract

Question 51

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 52

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)$35
D)$56

Question 53

Long position is a term used to refer to the fact that you have sold a security, contract or commodity.

Question 54

National Fuel allows its customers to prepurchase heating oil in May 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 55

National Fuel allows its customers to prepurchase heating oil in May 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 56

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 57

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 58

Queen City Enterprises wants to be sure it has 10,000 cases of Pinot Nior to sell next December.In February, 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 December.They expect to sell the wine to restaurants and retailers for $63 per case.Queen City has hedged its foreign exchange risk by entering into a forward contract to purchase euros in December at $1.30/euro.If the spot exchange rate at the end of December is $1.25/euro, the payoff to Queen City for hedging is

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

Question 59

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

Question 60

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 61

[blank] is a security whose value is derived from the value of another asset or security.

A)Derivative contract
B)Futures contract
C)Option contract
D)Option premium

Question 62

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 63

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)$3.65
B)$39
C)$0
D)$36.50

Question 64

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 favourable 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 65

[blank] is a contract to buy or sell a stated commodity or financial claim at a specified price at some future specified time.

A)Derivative contract
B)Futures contract
C)Option contract
D)Option premium

Question 66

A(n)[blank] can be exercised only on the expiration date.

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

Question 67

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 68

A(n)[blank] 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 69

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 favourable if it were to happen, so no hedge is needed.

Question 70

An investor would buy a [blank] 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 71

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

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

Question 72

[blank] is the price paid for an option.

A)Derivative contract
B)Futures contract
C)Option contract
D)Option premium

Question 73

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 [blank].

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

Question 74

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)It rose by $356.

Question 75

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)$356 profit

Question 76

[blank] is the right but not the obligation to buy or sell something at a specified price and within a specified period of time.

A)Derivative contract
B)Futures contract
C)Option contract
D)Option premium

Question 77

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 78

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 $1.66 per share.
D)made a profit of $1.66 per share.

Question 79

A(n)[blank] 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 80

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 favourable 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.