Multiple Choice - Part 8: Corporate Risk Management, Insurance, Hedging

7.1 Which of the following statements is FALSE about insurance and beta?

A) Not all insurable risks have beta zero; large events like hurricanes may be hard to diversify completely

B) When a firm buys insurance it transfers risk to an insurer and pays an upfront premium

C) By its nature insurance for non diversifiable hazards is generally a positive beta asset paying more when total losses are low and the market is high

D) Because insurance pays cash to offset losses it can reduce the firm’s need for external capital and issuance costs

C) By its nature insurance for non diversifiable hazards is generally a positive beta asset paying more when total losses are low and the market is high

7.2 Which of the following statements is FALSE about why firms manage risk with insurance?

A) Because insurance reduces financial distress risk it can allow higher use of debt

B) Similar to equity issuance purchasing insurance may signal below average risk and insurers should be compensated with lower premiums

C) A proper risk management strategy ensures firms have cash when needed for investment but does not try to eliminate all risks

D) In perfect markets insurers compete until NPV from selling insurance is zero so the actuarially fair price equals the PV of expected payments

B) Similar to equity issuance purchasing insurance may signal below average risk and insurers should be compensated with lower premiums

7.3 A company faces earthquake damage of 100 million with probability 8 percent next year. Construction can reduce the probability of damage by 3 percentage points. The risk is idiosyncratic and the risk free rate is 10 percent. What is the maximum amount the firm should pay for the construction work?

A) 7.27 million

B) 5.00 million

C) 4.54 million

D) 3.00 million

E) 2.72 million

E) 2.72 million

7.4 In the previous earthquake setting suppose instead the firm can buy full insurance against the damage and the construction measures are unobservable. What is the actuarially fair premium for full insurance?

A) 7.27 million

B) 5.00 million

C) 4.54 million

D) 3.00 million

E) 2.72 million

A) 7.27 million

7.5 Which of the following statements is FALSE about insurance design and hedging?

A) Insurers may require the firm to retain some fraction of the insured risk to limit moral hazard

B) Insurers often offer a menu of contracts with different coverage and premiums to address adverse selection

C) Hedging only a single risk can increase cash flow volatility if that risk is positively correlated with another risk

D) Under perfect capital markets hedging financial risks is zero NPV and does not by itself increase firm value

C) Hedging only a single risk can increase cash flow volatility if that risk is positively correlated with another risk

7.6 A Portuguese family business sells mobile homes in dollars and faces euro dollar exchange risk. It forecasts dollar sales and euro receipts under three exchange rates: 0.7 gives 1.5 million euros 0.8 gives 1.3125 million euros 0.9 gives 1.1667 million euros. Which hedging strategy is most appropriate?

A) Hedge with short calls

B) Hedge with short puts

C) Hedge with long puts

D) Hedge with futures

E) Do not hedge

E) Do not hedge

In a perfect capital market with no frictions how should shareholders view firms’ hedging activities?

A) Hedging is always value increasing

B) Hedging is unnecessary because diversified shareholders can hedge on their own

C) Hedging is illegal for non financial firms

D) Hedging always reduces beta to zero

B) Hedging is unnecessary because diversified shareholders can hedge on their own

Which is a realistic reason why hedging may increase firm value in practice?

A) It increases expected cash flows by eliminating taxes

B) It allows managers to speculate on market views

C) It reduces the probability of costly distress and underinvestment when external finance is expensive

D) It guarantees positive NPV for all projects

C) It reduces the probability of costly distress and underinvestment when external finance is expensive

From a corporate perspective what is the difference between hedging and speculation?

A) Hedging always uses options while speculation uses forwards

B) Hedging reduces an existing risk exposure; speculation takes on a new risk position

C) Hedging is illegal but speculation is not

D) They are identical

B) Hedging reduces an existing risk exposure; speculation takes on a new risk position

Which type of risk is easiest to justify hedging at the firm level?

A) Fully diversifiable idiosyncratic risk with no distress impact

B) Non diversifiable risk that threatens the firm’s ability to fund core projects

C) CEO employment risk

D) Stock market index risk for shareholders

B) Non diversifiable risk that threatens the firm’s ability to fund core projects

A firm enters a pay fixed receive floating interest rate swap on its variable rate debt. What is it effectively doing?

A) Converting fixed rate debt into floating rate exposure

B) Converting floating rate debt into synthetic fixed rate debt

C) Issuing new equity

D) Eliminating all credit risk

B) Converting floating rate debt into synthetic fixed rate debt

What is basis risk in hedging?

A) Risk that the hedge position is mispriced on day one

B) Risk that the hedging instrument cannot be traded

C) Risk that the hedged item and the hedge instrument do not move perfectly together so the hedge is imperfect

D) Risk that taxes change during the hedge

C) Risk that the hedged item and the hedge instrument do not move perfectly together so the hedge is imperfect

A firm with a known future foreign currency payment wants to lock in the home currency cost today. Which simple instrument is most appropriate?

A) Long forward in the foreign currency

B) Short forward in the foreign currency

C) Buy a call option on the foreign currency

D) Sell a call option on the foreign currency

A) Long forward in the foreign currency

Which of the following is NOT a typical goal of a corporate risk management policy?

A) Ensure sufficient liquidity to fund positive NPV projects

B) Avoid large fluctuations that threaten covenant violations

C) Eliminate all volatility in reported earnings regardless of cost

D) Align hedging with the firm’s risk appetite and constraints

C) Eliminate all volatility in reported earnings regardless of cost