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CHAPTER 14: FINANCIAL RISK MANAGEMENT TECHNIQUES AND APPPLICATIONS
MULTIPLE CHOICE TEST QUESTIONS
1. Risk management encompasses all of the following except
a. determining a firm’s actual level of risk
b. determining a firm’s desired level of risk
c. setting policies and procedures
d. monitoring your position after-the-fact
e. none of the above
2. Market risk is which of the following
a. the risk associated with failing to properly record market transactions
b. the risk that a dealer will lose market share to a competing dealer
c. the risk associated with movements in such factors as interest rates and exchange rates
d. the risk of the government declaring a transaction illegal
e. none of the above
3. What is the reason for undertaking a gamma hedge?
a. government regulation
b. the possibility of counterparty default
c. changes in volatility
d. large movements in the underlying
e. none of the above
4. Which of the following is the interpretation of a VAR of $5 million for one year at 5 percent probability.
a. the probability is 5 percent that the firm will lose at least $5 million in one year
b. the probability is at least 5 percent that the firm will lose $5 million in one year
c. the probability is 5 percent that the firm will lose $5 million in one year
d. the probability is less than 5 percent that the firm will lose $5 million in one year
e. none of the above
5. Which of the following are not methods of determining the VAR?
a. simulation method
b. historical method
c. estimation method
d. analytical method
e. none of the above
6. Which of the following methods is not used to reduce credit risk?
a. delta-gamma-vega hedging
b. collateral
c. marking to market
d. limiting the amount of business you do with a party
e. none of the above
7. Which of the following are types of risks faced by a derivatives dealer?
a. tax risk
b. operational risk
c. accounting risk
d. legal risk
e. none of the above
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8. Netting permits a firm to?
a. subtract losses from price increases from losses from price decreases
b. net its transactions with a given counterparty against each other
c. net all of its gains against all of its losses
d. all of the above
e. none of the above
9. Systemic risk is
a. the risk of a failure of the entire financial system
b. the risk associated with broad market movements
c. the risk of a failure of a firm’s financial risk management system
d. the risk of large price movements throughout the financial system
e. none of the above
10. Which of the following is the primary impetus for the growth in the practice of risk management?
a. faster computers
b. better pricing models
c. improved knowledge of risk management
d. tighter government regulation
e. concern over volatility
11. Each of the following is a benefit of practicing risk management by companies except
a. companies can manage risk better than their shareholders
b. risk management can avoid bankruptcy costs
c. risk management can lower taxes
d. risk management can increase employment opportunities
e. risk management can help prevent companies from passing up valuable investment opportunities
12. Find the number of Eurodollar futures each having a delta of –$25 that would delta-hedge a portfolio of a long
position in swaps with a delta of $5,000 and a short position in a put option with a delta of –$2,300.
a. long 292 contracts
b. short 108 contracts
c. short 292 contracts
d. long 200 contracts
e. long 108 contracts
13. A total return swap is best described as
a. A swap in which the payments include only capital gains
b. a swap in which the total return on a stock index is swapped for the total return on a bond
c. a swap in which the return on one bond is swapped for some other payment
d. a swap designed to substitute for a basis swap
e. none of the above
14. Which of the following best describes a credit default swap?
a. it is protected against default
b. it has a higher rate to compensate for the possibility of one party defaulting
c. it carries a higher credit rating than most other swaps
d. it off if another party external to the swap defaults
e. none of the above
15. Which of the following statements is not true about a credit spread option?
a. it is an option on the spread of a bond over a reference bond
b. its value would change with changes in investors’ perceptions of a party’s credit quality
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c. it requires payment of a premium up front
d. it requires that the underlying bond be relatively liquid
e. none of the above
16. Which of the following forms of hedging requires the use of options?
a. delta hedging
b. vega hedging
c. gamma hedging
d. credit risk hedging
e. none of the above
17. If a firm engages in risk management to capture arbitrage profits, what is it easy to overlook?
a. the additional credit risk it assumes
b. the cost is greater than the benefit
c. the market risk is high
d. all of the above
e. none of the above
18. Which of the following best describes the delta normal method?
a. a method of managing a delta hedge to assure a low gamma
b. the historical method when the distribution is normal
c. the Monte Carlo method when price changes are normally distributed
d. the analytical method applied to options
e. a method of measuring changes in an option’s delta
19. The risk that errors can occur in inputs to a pricing model is called
a. input risk
b. model risk
c. pricing risk
d. valuation risk
e. none of the above
20. Which of the following techniques is a more appropriate risk management tool for a company in which asset
value is not easily measurable?
a. stress risk
b. credit value at risk
c. market risk
d. delta at risk
e. cash flow at risk
21. In option terms, the limited liability of corporate stockholders is
a. a forward contract
b. a call option
c. a put option
d. a protective put
e. a fiduciary call
22. The risk that a party will not pay while the counterparty is sending payment is called
a. wire transfer risk
b. payment risk
c. settlement risk
d. cross-border risk
e. none of the above
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23. A bond subject to default is equivalent to
a. a payer swaption
b. a call and a default-free bond
c. a put and a call
d. a default-free bond and a short put
e. none of the above
24. Which of the following instruments could be used to execute a delta, gamma and vega hedge?
a. a swap
b. an option
c. a futures
d. an FRA
e. none of the above
25. Which of the following is approximately the Value at Risk at 5 percent of a portfolio of $10 million of asset
A, whose expected return is 15 percent and volatility is 35 percent, and $15 million of asset B, whose
expected return is 21 percent and volatility is 30 percent, where the correlation between the two assets is 0.2.
a. $5.6 million
b. $10 million
c. $15 million
d. $1.25 million
e. none of the above
26. A delta-hedged position is one in which the
a. combined spot and derivatives positions have a delta of one.
b. spot position has a delta of zero.
c. derivatives position has a delta of zero.
d. combined spot and derivatives positions have a delta of zero.
e. combined spot and derivatives positions have a gamma of zero.
27. A delta and gamma hedge is
a. one in which the combined spot and derivatives positions have a delta of zero and a gamma of zero.
b. one that is not guaranteed to be free of all risks
c. effective only for small changes in the underlying instrument.
d. all of the above statements are true
e. none of the above statements are true
28. Which of the following positions has a negative vega?
a. Receive fixed and pay floating LIBOR-based interest rate swap contract
b. Short cattle futures contract
c. Receive floating, pay fixed LIBOR-based forward rate agreement
d. Long Apple, Inc. put option
e. Short S&P 500 index call option
29. Delta, gamma, and vega hedging is rather complex. Identify the false statement.
a. Requires the use of four hedging instruments
b. At least one of the instruments has to be an option
c. Involves designing a portfolio where delta, gamma, and vega are set equal to zero
d. Typically involves the solution to three simultaneous equations
e. All of the above statements are true
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30. Which of the following is not a method for computing Value at Risk?
a. Analytical method
b. Variance-covariance method
c. Comprehensive method
d. Historical method
e. Delta normal method
31. The present value of the payments made to convert a bond subject to default to a default-free bond is called
the
a. Insurance cost
b. Credit default swap premium
c. Annuity risk factor
d. Present value of the default volatility
e. None of the above
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CHAPTER 14: FINANCIAL RISK MANAGEMENT TECHNIQUES AND APPPLICATIONS
TRUE/FALSE TEST QUESTIONS
T F 1. Earnings at Risk is a better risk measure for a derivatives dealer than is Value at Risk.
T F 2. One good reason for practicing risk management is that arbitrage opportunities can be
earned.
T F 3. Conditional Value at Risk is the expected loss, given that a loss occurs.
T F 4. The equity of a company with leverage is a put option on the assets.
T F 5. If a firm holds a position in an option, it can delta and gamma hedge the position by adding
a position in another option.
T F 6. Current credit risk is encountered is by only one party at a time in a swap.
T F 7. Potential credit risk is encountered by only one party at a time in a swap.
T F 8. A dealer who engages in derivatives transactions with customers of low credit quality will
offer a less attractive rate.
T F 9. Netting allows a significant reduction in credit risk but increases market risk
T F 10. A credit default swap is an ordinary swap that is subject to default.
T F 11. The credit risk in an interest rate swap is smallest at the beginning and at the end of the life
of the swap.
T F 12. Eurodollar futures are widely used to hedge gamma and vega risk.
T F 13. Operational risk is more difficult to manage than market risk and credit risk.
T F 14. Vega hedging is required only in options portfolios.
T F 15. Value at Risk provides an estimate of the worst possible loss a firm can incur with a given
probability.
T F 16. Value at Risk estimates for portfolios must take into account the correlations among the
various assets and liabilities in a portfolio.
T F 17. Stress testing allows a firm to see how its portfolio will behave under extremely rare but
favorable conditions.
T F. 18. Credit derivatives are derivatives that are insured against credit losses.
T F 19. Model risk can occur when the wrong pricing models are used.
T F 20. Companies can benefit from risk management if their incomes fluctuate across different tax
brackets.
T F 21. The analytical (variance-covariance) method of estimating Value at Risk requires the
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assumption of a normal distribution.
T F 22. The historical method of estimating Value at Risk uses the performance of the portfolio
over the last ten years.
T F 23. The Monte Carlo simulation method of estimating Value at Risk is one of the most flexible
methods because it permits the user to assume any probability distribution.
T F 24. A total return swap allows substitution of the total return on a bond for the total return on a
loan of comparable maturity.
T F 25. Legal risk is the risk that the government will declare derivatives illegal.
T F 26. One reason firms manage risk with derivatives is to lower bankruptcy costs.
T F 27. Credit risk is the uncertainty of a firm’s value or cash flow that is associated with
movements in an underlying source of risk.
T F 28. A delta and gamma hedge is one in which the combined spot and derivatives positions have
a delta of zero and a gamma of zero.
T F 29. The historical method for computing Value at Risk estimates the distribution of the
portfolio’s performance by collecting data on the past performance of the portfolio and
using it to estimate the future probability distribution.
T F 30. Stress testing is one method of estimating Value at Risk.
T F 31. A CDS premium is paid by the CDS seller to the CDS buyer to transfer the credit risk.
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CHAPTER 14