Corporate Finance, 3e (Berk/DeMarzo)
Chapter 30 Risk Management
30.1 Insurance
Use the following information to answer the question(s) below.
Rearden Metal imports ore from South America. Rearden Metal is worried that the South
American mines may enter into a long-term contract with the Chinese to sell all of their ore
output to China, hence cutting off Rearden Metal’s supply. In the event of such a contract with
the Chinese, Rearden Metal will face much higher costs for its raw materials causing its
operating profits to decline substantially and its marginal tax rate to fall from its current level of
35% down to 10%. An insurance firm has agreed to write a trade insurance policy that will pay
Rearden Metal $2,500,000 in the event of the South American supply of ore being cut off. The
chance of the South American supply being cut off is estimated to be 20%, with a beta of -2.0.
The risk-free rate of interest is 4% and the return on the market is estimated to be 12%.
1) The actuarially fair premium for this insurance policy is closest to:
A) $417,000
B) $446,000
C) $500,000
D) $568,000
2) Rearden’s NPV for purchasing this policy is closest to:
A) $32,500
B) $56,750
C) $142,000
D) $156,250
3) 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.
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:
A) business interruption insurance.
B) property insurance.
C) business liability insurance.
D) key personnel insurance.
5) 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.
6) 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.
7) 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.
8) 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 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.
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.
9) 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.
5
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%.
10) 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
11) 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
12) What is the actuarially fair cost of full insurance?
13) 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?
14) 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?
30.2 Commodity Price Risk
Use the following information to answer the question(s) below.
d’Anconia Copper expects to produce 500 million pounds of copper next year, with production
costs of $0.75 per pound. Depending upon the economic conditions over the next year,
d’Anconia Copper expects the price of copper next year to be either $1.40, $1.50, or $1.60 per
pound, with each outcome being equally likely. d’Anconia Copper expects to sell all of its
copper at the going price.
1) If the going price next year is $1.40 per pound, d’Anconia Copper’s operating profit next year
will be closest to:
A) $325 million
B) $365 million
C) $375 million
D) $425 million
2) If the going price next year is $1.60 per pound, d’Anconia Copper’s operating profit next year
will be closest to:
A) $365 million
B) $375 million
C) $425 million
D) $800 million
3) If d’Anconia Copper enters into a contract to supply copper to end users at an average price of
$1.48 per pound, then d’Anconia Copper’s operating profit next year will be closest to:
A) $325 million
B) $365 million
C) $375 million
D) $425 million
4) 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.
5) The risk that arises because the value of the 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.
6) 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.
7) 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.
8) 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) Traders are required to post collateral, called margin, when buying or selling commodities
using futures contracts.
9) 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.
10) Which of the following statements is FALSE?
A) 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.
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.
11) What are some of the disadvantages of long-term supply contracts?
12) 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
5
Futures Price
65
65.5
68
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?
Day
profit/loss (one contract)
profit/loss (250 contracts)
125
profit/loss (one contract)
profit/loss (250 contracts)