Question 1

Which of the following is true of the financial distress of a company and hedging?

Accepted Answer

Firms that face high financial distress costs have greater incentives to hedge as they are more vulnerable to adverse events, such as sudden increases in interest rates or commodity prices, and may struggle to obtain financing in such situations. Hedging does not eliminate the possibility of financial distress but can mitigate its effects by reducing the volatility of the firm's cash flows. Additionally, hedging can increase the costs of financial distress for a levered firm if it hedges only a portion of its exposure and suffers losses on the unhedged portion.

Question 2

Assume that a UK enterprise has a German subsidiary.The UK enterprise is exposed to the risk of the euro weakening,and the value of the subsidiary's assets decreasing in pound sterling terms in consolidated financial statements.This risk is referred to as _____.

Accepted Answer

Translation risk arises from the translation of foreign-currency-denominated financial statements of a subsidiary to the functional currency of the parent company. In this case, the UK enterprise is exposed to the risk of the euro weakening, which could result in the value of the German subsidiary's assets decreasing in pound sterling terms in consolidated financial statements. This is a type of translation risk. Reinvestment risk is the risk that future investments may not generate the same returns as past investments. Transaction risk is the risk that arises from fluctuations in foreign-currency exchange rates when a company engages in transactions denominated in a currency other than its home currency. Economic risk is the risk that arises from macroeconomic factors such as inflation, interest rates, and political instability in a foreign country.

Question 3

Which of the following is a managerial incentive to speculate?

Accepted Answer

Executive equity options provide managers with the opportunity to benefit financially from an increase in the firm's stock price, which can create an incentive for speculation. This is because the potential gains from speculation can outweigh the risks involved, especially if managers believe they have the skills to successfully predict market movements. Options also provide managers with flexibility, which allows them to adjust their exposure to risk more easily than with stock ownership alone. Consequently, executive equity options can encourage managers to take on more risk than they otherwise would, with the hope of generating higher returns.

Question 4

Which of the following is true of factor risk?

Accepted Answer

Factor risk, also known as systematic risk, affects a large number of assets and can be hedged with financial derivatives. Unlike unsystematic risk, which is diversifiable and specific to a single company or industry, factor risk stems from broader economic, political, or social factors.

Question 5

Explain a firm's hedging exposure to credit rate changes.

Accepted Answer

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Question 6

Which of the following is a reason why most firms do not hedge economic risk?

Accepted Answer

Economic risk is a complex and unpredictable factor that depends on various global macroeconomic factors. As a result, it becomes difficult for firms to estimate both the current and long-term effects of exchange rate changes on their cash flows. It is one of the main reasons why most firms do not hedge the economic risk.

Question 7

Which of the following is an example in which a firm might be indifferent between liability and risk management choices?

Accepted Answer

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Question 8

A UK based firm that has business in the United States takes offsetting positions in certain securities to eliminate the dollar exposure of its sales in the USThis method of risk management is referred to as _____.

Accepted Answer

This is because hedging refers to the practice of taking offsetting positions in securities or other financial instruments to reduce or eliminate the risk of loss from adverse movements in market prices or exchange rates. In this case, the UK based firm is using hedging to eliminate its exposure to fluctuations in the dollar exchange rate and thereby manage its risk effectively. Arbitraging involves taking advantage of price differentials in different markets to earn a profit, speculating involves taking a position in a security with the expectation of profiting from its price movement, and scalping involves making multiple trades in a short period of time to profit from small price movements.

Question 9

Which of the following is an advantage of hedging?

Accepted Answer

Hedging can reduce the costs of financial distress by managing and mitigating risks, thus potentially lowering the likelihood of financial difficulties.

Question 10

Which of the following is true of the Modigliani-Miller theorem in the absence of taxes and transaction costs?

Accepted Answer

The Modigliani-Miller theorem states that in the absence of taxes and transaction costs, the value of a firm is not affected by its financing choices. Similarly, if hedging does not affect cash flows from real assets, it also does not affect the value of the firm. Therefore, choice C is true. Choices A, B, and D are incorrect because they do not accurately describe the Modigliani-Miller theorem.

Question 11

Which of the following is a determinant of the economic risk?

Accepted Answer

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Question 12

How does hedging improve executive compensation contracts and performance evaluation?

Accepted Answer

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Question 13

Explain the implications of the Modigliani-Miller theorem for hedging.

Accepted Answer

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Question 14

Most risk management programmes are implemented at the corporate rather than the divisional level.Why?

Accepted Answer

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Question 15

Which of the following is true of the hedging effects on stakeholders?

Accepted Answer

Bankers and bondholders would like the firm to hedge so that they can ensure timely payment of interest and principal on their loans. Hedging reduces the risk of bankruptcy and default, making the firm more creditworthy. Option A is incorrect because hedging can increase firm value by reducing financial distress costs and making the firm more creditworthy. Option C is incorrect because managers have a fiduciary duty to act in the best interests of their stakeholders, including employees, and hedging can reduce the risk of bankruptcy and job loss. Option D is incorrect because the interests of most employees are closer to those of debt holders, who require stable cash flows and lower risk, than of equity holders, who seek high returns and accept higher risk.

Question 16

Which of the following is a component of the liability stream of a firm?

Accepted Answer

Default-free interest rates are a component of the liability stream of a firm as they represent the cost of borrowing for the firm. Inflation rate, beta, and market risk premium are components of the asset stream of a firm.

Question 17

Assume that changes in interest rates reflect mainly changes in the rate of inflation.If a firm's unlevered cash flows:

Accepted Answer

If a firm's unlevered cash flows increase with the rate of inflation, then high inflation rates and high interest rates will benefit the firm as it can earn higher returns on its investments. Therefore, the firm would want its liabilities to be exposed to interest rate risk.

Question 18

Which of the following is true of the impact of hedging on executive compensation contracts?

Accepted Answer

Hedging can help a firm manage risk more effectively, which in turn allows for a more accurate assessment of executive performance by isolating it from market and other external risks. This makes it easier to evaluate executives based on their actual performance rather than on uncontrollable external factors.

Question 19

_____ is usually associated with transactions denominated in foreign currencies.

Accepted Answer

Transaction risk refers to the risk of loss that arises from changes in exchange rates between the time a transaction is initiated and settled. This risk is usually associated with transactions denominated in foreign currencies. Reinvestment risk refers to the risk that future cash flows will not be reinvested at the same rate as the initial investment. Translation risk refers to the risk of loss that arises from translating financial statements or other financial documents from one currency to another. Economic risk refers to the risk of loss that arises from changes in economic conditions, such as interest rates, inflation, and political instability.

Quiz 21: Risk Management and Corporate Strategy