Exam
Name___________________________________
MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question.
1)
To insure their assets against hazards such as fire, storm damage, vandalism, earthquakes, and
other natural and environmental risks firms commonly purchase
1)
A)
business liability insurance.
B)
business interruption insurance.
C)
property insurance.
D)
key personnel insurance.
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%.
2)
If your firm is fully insured, the NPV of implementing the new safety policies is closest to:
2)
A)
$2.25 million
B)
$2..15 million
C)
$2.5 million
D)
–$.25 million
D
3)
Which of the following statements is false?
3)
A)
A futures contract is an agreement to trade an asset on some future date, at a price that is
locked in today.
B)
Long–term supply contracts are unilateral contracts negotiated by a seller.
C)
Long–term supply contracts such contracts cannot be entered into anonymously; the buyer
and seller know each other’s identity. This lack of anonymity may have strategic
disadvantages.
D)
An alternative to vertical integration or storage is a long–term supply contract.
B
C
4)
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
4)
A)
key personnel insurance.
B)
business liability insurance.
C)
property insurance.
D)
business interruption insurance.
5)
Which of the following statements is false?
5)
A)
The firm may speculate by entering into contracts that do not offset its actual risks.
B)
When a firm authorizes managers to trade contracts to hedge, it opens the door to the
possibility of speculation.
C)
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.
D)
Cash flows are exchanged on a monthly basis, rather than waiting until the end of the
contract, through a procedure called marking to market.
D
6)
Which of the following statements is false?
6)
A)
The duration of a portfolio of investments is the simple average of the durations of each
investment in the portfolio.
B)
Adjusting a portfolio to make its duration neutral is sometimes referred to as immunizing the
portfolio, a term that indicates it is being protected against interest rate changes.
C)
When the durations of a firm’s assets and liabilities are significantly different, the firm has a
duration mismatch.
D)
As interest rates change, the market values of the securities and cash flows in the portfolio
change as well, which in turn alters the weights used when computing the duration as the
value–weighted average maturity.
A
B
7)
Which of the following statements is false?
7)
A)
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.
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)
Because insurance reduces the risk of financial distress, it can relax this tradeoff and allow the
firm to increase its use of debt financing.
8)
What is the duration of a five–year zero–coupon bond?
8)
A)
5 Years
B)
1 Year
C)
0 Years
D)
2.5 Years
9)
The duration of a five–year bond with 8% annual coupons trading at par is closest to:
9)
A)
4.3 Years
B)
5.0 Years
C)
6.2 Years
D)
2.5 Years
10)
Which of the following statements regarding futures contracts is false?
10)
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)
Traders are required to post collateral, called margin, when buying or selling commodities
using futures contracts.
D)
Futures contracts are traded anonymously on an exchange at a publicly observed market
price and are generally very illiquid.
11)
Like most foreign exchange rates, the dollar/euro rate is a floating rate, which means it changes
constantly depending on the quantity supplied and demanded for each currency in the market. The
supply and demand for each currency is driven directly by all of the following factors except:
11)
A)
Relative inflation
B)
Investors trading securities
C)
Firms trading goods
D)
The actions of central banks in each country
12)
Which of the following statements is false?
12)
A)
Exchange rate risk naturally arises whenever transacting parties use different currencies: Both
of the parties will be at risk if exchange rates fluctuate.
B)
Fluctuating exchanges rates cause a problem known as the importer—exporter dilemma for
firms doing business in international markets.
C)
The most common method firms use to reduce the risk that results from changes in exchange
rates is to hedge the transaction using currency forward contracts.
D)
Because the supply and demand for currencies varies with global economic conditions,
exchange rates are volatile.
13)
Which of the following statements is false?
13)
A)
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.
B)
Horizontal integration entails the merger of a firm and its supplier or a firm and its customer.
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)
Like insurance, hedging involves contracts or transactions that provide the firm with cash
flows that offset its losses from price changes.
14)
Which of the following statements is false?
14)
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)
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.
D)
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.
If short–term interest rates were to rise while long–term rates remained stable, then
short–term securities would fall in value relative to long–term securities, despite
15)
Which of the following statements is false?
15)
A)
A currency forward is usually written between two firms, and it fixes a currency exchange
rate for a transaction that will occur at a future date.
B)
When the interest rate differs across countries, investors have an incentive to borrow in the
low–interest rate currency and invest in the high interest rate currency
C)
By entering into a currency forward contract, a firm can lock in an exchange rate in advance
and reduce or eliminate its exposure to fluctuations in a currency’s value.
D)
The covered interest parity equation states that the difference between the forward and spot
exchange rates is related to the interest rate differential between the currencies.
16)
Which of the following statements is false?
16)
A)
An interest rate that adjusts to current market conditions is called a floating rate.
B)
Corporations use interest rate swaps routinely to alter their exposure to interest rate
fluctuations.
Firms can use interest rate swaps with duration–hedging strategies.
C)
The value of a swap, while initially zero, will fluctuate over time as interest rates change.
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.
17)
The cash–and–carry strategy consists of all of the following simultaneous trades except:
17)
A)
Borrow euros today using a one–year loan with the interest rate r€
B)
Exchange the euros for dollars today at the spot exchange rate S $/€
C)
Invest the dollars today for one year at the interest rate r$
D)
Purchase a forward contract to convert $ to €
18)
Which of the following statements regarding currency options is false?
18)
A)
Currency forward contracts allow firms to lock in a future exchange rate; currency options
allow firms to insure themselves against the exchange rate moving beyond a certain level.
B)
Firms often prefer forward contracts to currency options if the transaction they are hedging
might not take place.
C)
Currency options are another method that firms commonly use to manage exchange rate risk.
Currency options, like the stock options, give the holder the right–but not the obligation–to
exchange currency at a given exchange rate.
D)
Many managers want the firm to benefit if the exchange rate moves in their favor, rather than
being stuck paying an above–market rate.
might not take place.
19)
Which of the following statements regarding long–term supply contracts is false?
19)
A)
Long–term supply contracts insulate the firms from commodity price risk.
B)
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.
C)
Long–term supply contracts are designed to eliminate credit risk.
D)
Long–term supply contracts are bilateral contracts negotiated by a buyer and a seller.
20)
A currency forward contract specifies all of the following except:
20)
A)
The amount of currency to exchange
B)
The currencies to be exchanged
C)
The delivery date on which the exchange will take place
D)
The spot exchange rate
D
21)
Insurance that compensates for the loss or unavoidable absence of crucial employees in the firm is
called
21)
A)
business liability insurance.
B)
key personnel insurance.
C)
business interruption insurance.
D)
property insurance.
B
22)
Which of the following statements is false?
22)
A)
Currency options allow firms to lock in a future exchange rate; currency forward contracts
allow firms to insure themselves against the exchange rate moving beyond a certain level.
B)
Currency options, like the stock options, give the holder the right–but not the obligation–to
exchange currency at a given exchange rate.
C)
Generally speaking, cash–and–carry strategies are used primarily by large banks, which can
borrow easily and face low transaction costs.
D)
Many managers want the firm to benefit if the exchange rate moves in their favor, rather than
being stuck paying an above–market rate.
A
C
23)
Which of the following statements is false?
23)
A)
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.
B)
By its very nature, insurance for non diversifiable 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.
C)
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.
D)
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.
24)
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:
24)
A)
Administrative and overhead costs
B)
Adverse selection
C)
Taxation of insurance payments
D)
Agency costs
C
25)
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
25)
A)
business interruption insurance.
B)
business liability insurance.
C)
property insurance.
D)
key personnel insurance.
A
B
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%.
26)
If your firm is uninsured, the NPV of implementing the new safety policies is closest to:
26)
A)
$2.25 million
B)
$2..15 million
C)
$2.5 million
D)
–$.25 million
27)
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
27)
A)
liquidity risk.
B)
commodity price risk.
C)
speculation risk.
D)
basis risk.
28)
Which of the following statements is false?
28)
A)
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.
B)
We can measure a firm‘s sensitivity to interest rates by computing the duration of its balance
sheet.
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.
29)
Which of the following statements is false?
29)
A)
A portfolio with a negative duration is called a duration–neutral portfolio or an immunized
portfolio, which means that for small interest rate fluctuations, the value of equity should
remain unchanged.
B)
Maintaining a duration–neutral portfolio will require constant adjustment as interest rates
change.
C)
A duration–neutral portfolio is only protected against interest rate changes that affect all
yields identically.
D)
Interest rate swaps are an alternative means of modifying the firm’s interest rate risk
exposure without buying or selling assets.
30)
The risk that arises because the value of the futures contract will not be perfectly correlated with
the firm’s exposure is called
30)
A)
basis risk.
B)
speculation risk.
C)
liquidity risk.
D)
commodity price risk.
immunized portfolio, which means that for small interest rate fluctuations, the
ESSAY. Write your answer in the space provided or on a separate sheet of paper.
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%.
31)
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?
32)
What are some of the disadvantages of long–term supply contracts?
33)
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?
34)
In December 2005, the spot exchange rate for the British Pound was $1.7188/£. Suppose that at the same time
the on–year interest rate in the United States was 4.85% and the one–year interest rate in Great Britain was
3.15%. Based on these rates, what forward exchange rate is consistent with no arbitrage.
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%.
35)
What is the actuarially fair cost of full insurance?
36)
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:
Day 1 2 3 4 5
Futures Price 65 65.5 68 67.25 70
What is the daily and cumulative mark to market profit or loss (in dollars) that you will have on each of the next
five days?
37)
In December 2005, the spot exchange rate for the British Pound was $1.7188/£ and the one–year forward rate
was $1.8675/£. Suppose that at the same time Luther Industries entered into a contract to purchase goods with
a price of £375,000 to be delivered in one year. Simultaneously Luther entered into a one–year forward contract
to purchase £375,000. What is the amount of the payment in U.S. dollars that Luther Industries will have to
make in one year to pay for their goods?
38)
The Century 22 fund has invested in a portfolio of mortgaged 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?
39)
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?
Answer Key
Testname: C30
14
Answer Key
Testname: C30
15