Deck 25: Insurance and 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%.
What is the actuarially fair cost of full insurance?

Answer 1

Insurance Premium = The actuarially fair cost of full insurance = = $3.81 million

Question 2

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.

Answer 2

property insurance.

Question 3

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?

Answer 3

If the firm is fully insured (no deductible), the insurance company will pay for the loss regardless if whether the safety program is in force or not. Therefore, the end of period cash flows will be identical with or without the program and the NPV is −$250,000 reflecting the cost of the safety program.
In order to give the firm the incentive to buy the insurance the NPV of the safety program must be positive.
Another way of looking at this is to find the point where the PV of the expected deductible equals the cost of the safety program. Mathematically we have:
(.08 - .03) = $250,000, solving for the Deductible = = $5,250,000
To show that this indeed is the correct answer:
(.08) = (.03) - $250,000

Question 4

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 5

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 discourage 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 6

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 nondiversifiable 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 7

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 8

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 9

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 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%.
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

Question 11

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 12

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 13

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

A)adverse selection
B)vertical integration
C)overhead
D)market imperfections

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%.
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?

Question 15

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 16

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 17

The risk that arises because the value of a 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 18

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%.
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

Question 19

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

Question 20

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%.
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

Question 21

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 marked to market profit or loss (in dollars)that you will have on each of the next five days?

Question 22

An S&L owns mortgages that have a current market value of $325 million. The duration of this portfolio of mortgages is 15.9 years. The S&L finances its mortgages by issuing CDs and the current value of these liabilities is $275 million. The duration of these liabilities is 4.6 years. What is the initial duration of the equity for the S&L?

A)103.25 years
B)78.05 years
C)25.30 years
D)53.00 years

Question 23

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 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 of the potential future changes to its credit ratings bring?

Question 24

The Century 22 fund has invested in a portfolio of mortgage-backed 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 25

Firms use all of the following for reducing their exposure to commodity price movements EXCEPT ________.

A)horizontal integration
B)vertical integration
C)long-term storage of inventory
D)futures contracts

Question 26

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

Question 27

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 28

Which of the following statements is FALSE?

A)We can access a firm's sensitivity to interest rates by examining its balance sheet.
B)Just as the interest rate sensitivity of a single cash flow increases with its maturity, the interest rate sensitivity of a stream of cash flows increases with its duration.
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.

Question 29

Which of the following is an agreement to trade an asset on some future date, at a price that is fixed today?

A)margin
B)futures contract
C)notional contract
D)interest rate swap

Question 30

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 31

Which of the following statements is FALSE?

A)Corporations use interest rate swaps routinely to alter their exposure to interest rate fluctuations.
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 32

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)Investors are required to post collateral, called margin, when buying or selling commodities using futures contracts.

Question 33

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 34

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.

Question 35

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

Question 36

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 37

An interest rate that adjusts to current market conditions is called a(n)________.

A)floating rate
B)fixed rate
C)notional rate
D)arbitrage rate

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.