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CHAPTER 18—DERIVATIVES AND RISK MANAGEMENT
1. One objective of risk management can be to reduce the volatility of a firm's cash flows.
a.
True
b.
False
2. In theory, reducing the volatility of its cash flows will always increase a company's value.
a.
True
b.
False
3. Interest rate swaps allow a firm to exchange fixed for floating-rate payments, but a swap cannot reduce actual net
CHAPTER 18—DERIVATIVES AND RISK MANAGEMENT
interest expenses.
a.
True
b.
False
4. Speculative risks are symmetrical in the sense that they offer the chance of a gain as well as a loss, while pure risks are
those that can only lead to losses.
a.
True
b.
False
CHAPTER 18—DERIVATIVES AND RISK MANAGEMENT
5. The two basic types of hedges involving the futures market are long hedges and short hedges, where the words "long"
and "short" refer to the maturity of the hedging instrument. For example, a long hedge might use Treasury bonds, while a
short hedge might use 3-month T-bills.
a.
True
b.
False
6. Which of the following is NOT an example of a derivative security?
a.
Futures.
b.
Options.
c.
Swaps.
d.
Forward contracts.
e.
Preferred stock.
CHAPTER 18—DERIVATIVES AND RISK MANAGEMENT
7. The value of a stock option depends on all of the following EXCEPT:
a.
Exercise price.
b.
Variability of the stock price.
c.
Length of time until option expiration.
d.
Risk-free rate of interest.
e.
Bond price.
8. Which of the following statements concerning risk management is NOT CORRECT?
a.
Risk management can reduce the volatility of cash flows, and this decreases the probability of bankruptcy.
b.
Risk management makes sense for firms directly engaged in activities that involve commodities whose values
can be hedged, but it doesn't make much sense for most other firms.
c.
Companies with volatile earnings pay more taxes than companies with more stable earnings due to the
treatment of tax credits and the rules governing corporate loss carry-forwards and carry-backs. Therefore, our
tax system encourages risk management to stabilize earnings.
d.
Risk management can reduce the likelihood of low cash flows, and therefore reduce the probability of
financial distress.
e.
Risk management involves identifying events that could have adverse financial consequences and then taking
actions to prevent and/or to minimize the damage caused by these events.
CHAPTER 18—DERIVATIVES AND RISK MANAGEMENT
9. Which of the following is NOT a way risk management can be used to increase the value of a firm?
a.
Risk management can increase debt capacity.
b.
Risk management can help a firm maintain its optimal capital budget.
c.
Risk management can reduce the expected costs of financial distress.
d.
Risk management can help firms minimize taxes.
e.
Risk management can allow managers to defer receipt of their bonuses and thus postpone tax payments.
10. An option that gives the holder the right to sell a stock at a specified price at some time in the future is called a(n)
a.
Call option.
CHAPTER 18—DERIVATIVES AND RISK MANAGEMENT
b.
Put option.
c.
Out-of-the-money option.
d.
Naked option.
e.
Covered option.
11. An option that gives the holder the right to buy a stock at a specified price at some time in the future is called a(n)
a.
Call option.
b.
Put option.
c.
Out-of-the-money option.
d.
Naked option.
e.
Covered option.
CHAPTER 18—DERIVATIVES AND RISK MANAGEMENT
12. A call option whose underlying stock value is less than the corresponding exercise price is an example of a(n)
a.
Straddle option.
b.
Put option.
c.
Out-of-the-money option.
d.
Naked option.
e.
Covered option.
13. An investor who "writes" a call option without the stock in his or her portfolio to back it up is selling a(n)
a.
Call option.
b.
Put option.
c.
Out-of-the-money option.
d.
Naked option.
e.
Covered option.
CHAPTER 18—DERIVATIVES AND RISK MANAGEMENT
14. An investor who "writes" a call option against stock held in his or her portfolio is selling a(n)
a.
Straddle option.
b.
Put option.
c.
Out-of-the-money option.
d.
Naked option.
e.
Covered option.
15. Deeble Construction Co.'s stock is trading at $30 a share. There are also call options on the company's stock, some
with an exercise price of $25 and some with an exercise price of $35. All options expire in 3 months. Which of the
following best describes the value of these options?
a.
If Deeble's stock price rose by $5, the exercise value of the options with the $25 exercise price would also
increase by $5.
b.
The options with the $25 exercise price will sell for less than the options with the $35 exercise price.
CHAPTER 18—DERIVATIVES AND RISK MANAGEMENT
c.
The options with the $25 exercise price have an exercise value greater than $5.
d.
The options with the $35 exercise price have an exercise value greater than $0.
e.
The options with the $25 exercise price will sell for $5.
16. Which of the following statements is most CORRECT?
a.
One advantage of forward contracts is that they are default free.
b.
Futures contracts generally trade on an organized exchange and are marked to market daily.
c.
Goods are never delivered under forward contracts, but are almost always delivered under futures contracts.
d.
Forward contracts are generally standardized instruments, whereas futures contracts are generally tailor-made
for the 2 parties of the contract.
e.
Essentially there are no differences between forward and futures contracts, except that forward contracts are
used only for financial assets while futures contracts are used only for commodities.
CHAPTER 18—DERIVATIVES AND RISK MANAGEMENT
17. A swap is a method used to reduce financial risk. Which of the following statements about swaps, if any, is NOT
CORRECT?
a.
A swap involves the exchange of cash payment obligations.
b.
The earliest swaps were currency swaps, in which companies traded debt denominated in different currencies,
say dollars and pounds.
c.
Swaps are very often arranged by a financial intermediary, who may or may not take the position of one of the
counterparties.
d.
A problem with swaps is that no standardized contracts exist, which has prevented the development of a
secondary market.
e.
Swaps can involve side payments in order to get the counterparty to agree to the swap.
18. A commercial bank recognizes that its net income suffers whenever interest rates increase. Which of the following
strategies would protect the bank against rising interest rates?
a.
Buying inverse floaters.
b.
Entering into an interest rate swap where the bank receives a fixed payment stream, and in return agrees to
make payments that float with market interest rates.
c.
Purchase principal only (PO) strips that decline in value whenever interest rates rise.
d.
Enter into a short hedge where the bank agrees to sell interest rate futures.
e.
Sell some of the bank's floating-rate loans and use the proceeds to make fixed-rate loans.
CHAPTER 18—DERIVATIVES AND RISK MANAGEMENT
19. Which of the following statements is CORRECT?
a.
Put options give investors the right to buy a stock at a certain exercise price before a specified date.
b.
Call options give investors the right to sell a stock at a certain exercise price before a specified date.
c.
Options typically sell for less than their exercise value.
d.
LEAPS are very short-term options that have begun trading on the exchanges in recent years.
e.
Option holders are not entitled to receive dividends unless they choose to exercise their option.
CHAPTER 18—DERIVATIVES AND RISK MANAGEMENT
20. There are call options on the common stock of XYZ Corporation. Which of the following best describes the factors
that affect call option values?
a.
The price of call options will rise if XYZ's stock price rises.
b.
The higher the strike price, the higher the call option price.
c.
Assuming the same strike price, a call option that expires in 1 month will sell for a higher price than one that
expires in 3 months.
d.
The less volatile a stock's price, the more valuable a call option on the stock is.
e.
If the risk-free rate of interest increases, the value of call options will decrease.
21. Which of the following events is likely to decrease the value of call options on the common stock of GCC Company?
a.
An increase in GCC's stock price.
b.
An increase in the exercise price of the option.
c.
An increase in the amount of time until the option expires.
d.
An increase in the risk-free rate.
e.
GCC's stock price becomes more risky (higher variance).
