Chapter Ten Principles of Risk Management This chapter contains 30 multiple choice questions,10 short problems,and 5 longer problems. Multiple Choice 1. that"matters"because if affects people's welfare. exists whenever one does not know for sure what will occur in the future. (a)Uncertainty is risk;Uncertainty (b)Risk is uncertainty;Uncertainty (c)Risk is uncertainty;Risk (d)Uncertainty is risk;Risk Answer:(b) 2. is a measure of willingness to pay to reduce one's exposure to risk. (a)Risk aversion (b)Risk avariciousness (c)Risk predilection (d)Risk inflation Answer:(a) 3.When choosing among investment alternatives with the same expected rate of return,a risk averse individual chooses the one with the risk. (a)surest (b)most uncertain (c)lowest (d)highest Answer:(c) 10-1
10-1 Chapter Ten Principles of Risk Management This chapter contains 30 multiple choice questions, 10 short problems, and 5 longer problems. Multiple Choice 1. ________ that “matters” because if affects people's welfare. ________ exists whenever one does not know for sure what will occur in the future. (a) Uncertainty is risk; Uncertainty (b) Risk is uncertainty; Uncertainty (c) Risk is uncertainty; Risk (d) Uncertainty is risk; Risk Answer: (b) 2. ________ is a measure of willingness to pay to reduce one's exposure to risk. (a) Risk aversion (b) Risk avariciousness (c) Risk predilection (d) Risk inflation Answer: (a) 3. When choosing among investment alternatives with the same expected rate of return, a risk averse individual chooses the one with the ________ risk. (a) surest (b) most uncertain (c) lowest (d) highest Answer: (c)
4. is a particular type of risk people face because of the nature of their business or pattern of consumption. (a)Operational efficiency exposure (b)Opportunity exposure (c)Risk exposure (d)Risk reduction Answer:(c) 5 are investors who take positions that increase their exposure to certain risks in the hope of increasing their wealth. (a)Operations insurers (b)Foreign exporters (c)Hedgers (d)Speculators Answer:(d) 6.The riskiness of an asset or a transaction be assessed in isolation or in the abstract. (a)can (b)cannot (c)must (d)it varies according to the situation Answer:(b) 7.By definition, are investors who take positions to reduce their exposures. (a)operations insurers (b)foreign exporters (c)hedgers (d)speculators Answer:(c) 10-2
10-2 4. ________ is a particular type of risk people face because of the nature of their business or pattern of consumption. (a) Operational efficiency exposure (b) Opportunity exposure (c) Risk exposure (d) Risk reduction Answer: (c) 5. ________ are investors who take positions that increase their exposure to certain risks in the hope of increasing their wealth. (a) Operations insurers (b) Foreign exporters (c) Hedgers (d) Speculators Answer: (d) 6. The riskiness of an asset or a transaction ________ be assessed in isolation or in the abstract. (a) can (b) cannot (c) must (d) it varies according to the situation Answer: (b) 7. By definition, ________ are investors who take positions to reduce their exposures. (a) operations insurers (b) foreign exporters (c) hedgers (d) speculators Answer: (c)
8.The risk of loss arising from obsolescence due to technological change or changes in consumer taste is an example of (a)unemployment risk (b)liability risk (c)financial-asset risk (d)d consumer-durable asset risk Answer:(d) 9.The risk arising from holding different kinds of financial assets such as equities or fixed income securities denominated in one or more currencies is an example of (a)unemployment risk (b)liability risk (c)financial-asset risk (d)consumer-durable asset risk Answer:(c) 10.Business risks of the firm are borne by its (a)shareholders (b)creditors (c)employees (d)all of the above Answer:(d) 11. consists of figuring out what the most important risk exposures are for the unit of analysis. (a)Risk assessment (b)Selection of risk management techniques (c)Implementation (d)Risk identification Answer:(d) 10-3
10-3 8. The risk of loss arising from obsolescence due to technological change or changes in consumer taste is an example of ________. (a) unemployment risk (b) liability risk (c) financial-asset risk (d) d consumer-durable asset risk Answer: (d) 9. The risk arising from holding different kinds of financial assets such as equities or fixed income securities denominated in one or more currencies is an example of ________. (a) unemployment risk (b) liability risk (c) financial-asset risk (d) consumer-durable asset risk Answer: (c) 10. Business risks of the firm are borne by its ________. (a) shareholders (b) creditors (c) employees (d) all of the above Answer: (d) 11. ________ consists of figuring out what the most important risk exposures are for the unit of analysis. (a) Risk assessment (b) Selection of risk management techniques (c) Implementation (d) Risk identification Answer: (d)
12.Which of the following is most likely to need a lot of life insurance? (a)a single person with no dependents (b)a divorced person with no dependents (c)a double-income couple with no kids (d)married person with children Answer:(d) 13. is the quantification of the costs associated with the risks that have been identified in the first step of risk management. (a)Risk assessment (b)Selection of risk management techniques (c)Implementation (d)Review Answer:(a) 14.Selling a risky asset to someone else and buying insurance are examples of (a)risk avoidance (b)loss prevention and control (c)risk transfer (d)risk retention Answer:(c) 15.One is said to a risk when the action taken to reduce one's exposure to a loss also causes one to give up the possibility of a gain. (a)insure (b)diversify (c)hedge (d)pay a premium with Answer:(c) 10-4
10-4 12. Which of the following is most likely to need a lot of life insurance? (a) a single person with no dependents (b) a divorced person with no dependents (c) a double-income couple with no kids (d) married person with children Answer: (d) 13. ________ is the quantification of the costs associated with the risks that have been identified in the first step of risk management. (a) Risk assessment (b) Selection of risk management techniques (c) Implementation (d) Review Answer: (a) 14. Selling a risky asset to someone else and buying insurance are examples of ________. (a) risk avoidance (b) loss prevention and control (c) risk transfer (d) risk retention Answer: (c) 15. One is said to ________ a risk when the action taken to reduce one’s exposure to a loss also causes one to give up the possibility of a gain. (a) insure (b) diversify (c) hedge (d) pay a premium with Answer: (c)
16.When you you pay a premium to eliminate the risk of loss and retain the potential for gain. (a)insure (b)diversify (c)hedge (d)speculate Answer:(a) 17.In order for diversification to reduce your risk exposure,the risks must be (a)less than perfectly correlated with each other (b)more than perfectly correlated with each other (c)uncorrelated (d)none of the above Answer:(a) 18.The demand for ways to manage risk has been increased by (a)increased volatility of exchange rates (b)increased volatility of interest rates (c)increased volatility of commodity prices (d)all of the above Answer:(d) 19.Moral hazard and adverse selection are examples of (a)transactions costs (b)incentive problems (c)transference costs (d)both a and b Answer:(b) 10-5
10-5 16. When you ________ you pay a premium to eliminate the risk of loss and retain the potential for gain. (a) insure (b) diversify (c) hedge (d) speculate Answer: (a) 17. In order for diversification to reduce your risk exposure, the risks must be ________ (a) less than perfectly correlated with each other (b) more than perfectly correlated with each other (c) uncorrelated (d) none of the above Answer: (a) 18. The demand for ways to manage risk has been increased by ________. (a) increased volatility of exchange rates (b) increased volatility of interest rates (c) increased volatility of commodity prices (d) all of the above Answer: (d) 19. Moral hazard and adverse selection are examples of ________. (a) transactions costs (b) incentive problems (c) transference costs (d) both a and b Answer: (b)
20. is defined as quantitative analysis for optimal risk management. (a)Portfolio theory (b)Corporate theory (c)Diversification theory (d)Probability theory Answer:(a) 21.An asset portfolio's expected return is identified with the of the distribution,and its risk with the (a)variance;average (b)mean;standard deviation (c)standard deviation;average (d)median;normal distribution Answer:(b) 22.Suppose you buy shares of RayFran stock at a price of $110 per share and intend to hold them for a year.Suppose RayFran pays a dividend of $3.50 per share over that year.Compute the total rate of return on a share of RayFran stock if at the end of the year you sell it for $122.50 per share. (a)10.20% (b)11.36% (c)13.06% (d14.55% Answer:(d) 23.The a stock's volatility,the the range of possible outcomes and the the probabilities of those returns at the extremes of the range. (a)larger;narrower;larger (b)larger;narrower;smaller (c)larger;wider;larger (d)larger;wider;smaller Answer:(c) 10-6
10-6 20. ________ is defined as quantitative analysis for optimal risk management. (a) Portfolio theory (b) Corporate theory (c) Diversification theory (d) Probability theory Answer: (a) 21. An asset portfolio's expected return is identified with the ________ of the distribution, and its risk with the ________. (a) variance; average (b) mean; standard deviation (c) standard deviation; average (d) median; normal distribution Answer: (b) 22. Suppose you buy shares of RayFran stock at a price of $110 per share and intend to hold them for a year. Suppose RayFran pays a dividend of $3.50 per share over that year. Compute the total rate of return on a share of RayFran stock if at the end of the year you sell it for $122.50 per share. (a) 10.20% (b) 11.36% (c) 13.06% (d) 14.55% Answer: (d) 23. The ________ a stock's volatility, the ________ the range of possible outcomes and the ________ the probabilities of those returns at the extremes of the range. (a) larger; narrower; larger (b) larger; narrower; smaller (c) larger; wider; larger (d) larger; wider; smaller Answer: (c)
24.Consider the probability distribution of rate of return on RayFran stock: Rate of Return Probability 40% 0.25 15% 0.55 -8% 0.20 Compute the expected rate of return on RayFran stock. (a)9.75% (b)15.60% (c)16.65% (d19.85% Answer:(c) 25.Refer to question 24.Now compute the standard deviation of RayFran stock. (a)12.95% (b)13.10% (c)16.10% (d25.90% Answer:(c) 26.Consider a stock with an expected return of 15%and a standard deviation of 8%that is normally distributed.What is the 0.95 confidence interval for this stock's rate of return? (a(7%,23%) (b)(-9%,39%) (c)(-1%,39%) (d)(-1%,31%) Answer:(d) 10-7
10-7 24. Consider the probability distribution of rate of return on RayFran stock: Rate of Return Probability 40% 0.25 15% 0.55 –8% 0.20 Compute the expected rate of return on RayFran stock. (a) 9.75% (b) 15.60% (c) 16.65% (d) 19.85% Answer: (c) 25. Refer to question 24. Now compute the standard deviation of RayFran stock. (a) 12.95% (b) 13.10% (c) 16.10% (d) 25.90% Answer: (c) 26. Consider a stock with an expected return of 15% and a standard deviation of 8% that is normally distributed. What is the 0.95 confidence interval for this stock's rate of return? (a) (7%, 23%) (b) (–9%, 39%) (c) (–1%, 39%) (d) (–1%, 31%) Answer: (d)
For questions 27 through 30,use the following table: Historical Returns Year Toys'R'Me S.A.O.Rouge 15% 13% 2 20% 17% 3 5% -7% 4 12% 8% 10% 6% 27.What are the mean returns for Toys'R'Me and S.A.O.Rouge,respectively? (a)Toys R Me:12.4%;S.A.O.Rouge:10.2% (b)Toys R Me:10.4%;S.A.O.Rouge:7.4% (c)Toys R Me:10.4%;S.A.O.Rouge:10.2% (d)Toys R Me:7.4%;S.A.O.Rouge:10.4% Answer:(b) 28.What is the standard deviation of returns for Toys R Me?For S.A.O.Rouge? (a)Toys R Me:8.4%;S.A.O.Rouge:7.4% (b)Toys R Me:8.40%;S.A.O.Rouge:8.16% (c)Toys R Me:10.4%;S.A.O.Rouge:7.4% (d)Toys R Me:10.4%;S.A.O.Rouge:8.16% Answer:(b) 29.Suppose the returns for Toys R Me and S.A.O.Rouge are normally distributed.Determine the 0.68 confidence interval for Toys R.Me. (a)(8.4%,10.4%) (b)(-14.8%,35.6%) (c)(-6.4%,27.2%) (d(2.00%,18.80%) Answer:(d) 10-8
10-8 For questions 27 through 30, use the following table: Historical Returns Year Toys’R’Me S.A.O. Rouge 1 2 3 4 5 15% 20% -5% 12% 10% 13% 17% -7% 8% 6% 27. What are the mean returns for Toys’R’Me and S.A.O. Rouge, respectively? (a) Toys R Me: 12.4%; S.A.O. Rouge: 10.2% (b) Toys R Me: 10.4%; S.A.O. Rouge: 7.4% (c) Toys R Me: 10.4%; S.A.O. Rouge: 10.2% (d) Toys R Me: 7.4%; S.A.O. Rouge: 10.4% Answer: (b) 28. What is the standard deviation of returns for Toys R Me? For S.A.O. Rouge? (a) Toys R Me: 8.4%; S.A.O. Rouge: 7.4% (b) Toys R Me: 8.40%; S.A.O. Rouge: 8.16% (c) Toys R Me: 10.4%; S.A.O. Rouge: 7.4% (d) Toys R Me: 10.4%; S.A.O. Rouge: 8.16% Answer: (b) 29. Suppose the returns for Toys R Me and S.A.O. Rouge are normally distributed. Determine the 0.68 confidence interval for Toys R. Me. (a) (8.4%, 10.4%) (b) (–14.8%, 35.6%) (c) (–6.4%, 27.2%) (d) (2.00%; 18.80%) Answer: (d)
30.Determine the 0.95 confidence interval for S.A.O.Rouge. (a)(7.14%,8.16%) (b)(-0.76,15.56%) (c)(-8.92,23.72%) (d)(-17.08,31.88%) Answer:(c) Short Problems 1.Briefly distinguish between the three methods available to transfer risk:hedging,insuring and diversifying. Answer: Hedging:One is said to hedge a risk when the action taken to reduce one's exposure to a loss also causes one to give up the possibility of a gain. Insuring:Insuring means paying a premium to eliminate the risk of loss and retain the potential for gain. Diversifying:Diversifying means holding similar amounts of many risky assets instead of concentrating all ofyour investment in only one.Diversification thereby limits your exposure to the risk of any single asset. 2.Outline the steps in the risk-management process. Answer: The risk management process can be broken down into five steps: 1.Risk identification 2.Risk assessment 3.Selection of risk management techniques 4.Implementation 5.Review 10-9
10-9 30. Determine the 0.95 confidence interval for S.A.O. Rouge. (a) (7.14%, 8.16%) (b) (–0.76, 15.56%) (c) (-8.92, 23.72%) (d) (–17.08, 31.88%) Answer: (c) Short Problems 1. Briefly distinguish between the three methods available to transfer risk: hedging, insuring and diversifying. Answer: Hedging: One is said to hedge a risk when the action taken to reduce one’s exposure to a loss also causes one to give up the possibility of a gain. Insuring: Insuring means paying a premium to eliminate the risk of loss and retain the potential for gain. Diversifying: Diversifying means holding similar amounts of many risky assets instead of concentrating all of your investment in only one. Diversification thereby limits your exposure to the risk of any single asset. 2. Outline the steps in the risk-management process. Answer: The risk management process can be broken down into five steps: 1. Risk identification 2. Risk assessment 3. Selection of risk management techniques 4. Implementation 5. Review
3.Think of a bookstore.What risks is such a business exposed to,and who bears them? Answer: Major risks: Risk that inventory will not arrive on time Risk that employees will be late or absent Risk that computers/registers will break down Risk of new competition in the area (especially-the "superstores") Risk that distributors'prices will increase dramatically These risks are borne by shareholders,owners,employees,creditors,customers, suppliers. 4.Explain why the sale/purchase of a house is similar to a forward contract in nature. Answer: Both parties eliminate the uncertainty associated with price volatility in the housing market during the months of settling the contract between them.Even though the transfer of ownership for the house won't happen for many months,the buyer and seller of a house can contractually settle on a transaction price for the house. 5.Explain the difference between insuring and hedging. Answer: When you hedge,you eliminate the risk of loss by giving up the potential for gain. However,when you insure,you pay a premium to eliminate the risk of loss and retain the potential for gain. 6.Discuss the two factors limiting the efficient allocation of risks. Answer: Transactions costs and incentive problems are the two key factors limiting the efficient allocation ofrisks.Transactions costs include the costs ofestablishing and running institutions such as insurance companies or securities exchanges and the costs of writing and enforcing contracts. Moral hazard and adverse selection are examples of incentive problems,which stand in the way of the development of institutions for efficient risk sharing.Moral hazard exists when having insurance against some risk causes the insured party to take greater risk or to take less care in preventing the event that gives rise to the loss. The problem with adverse selection relates to the fact that those who purchase insurance against risk are more likely than the general population to be at risk. 10-10
10-10 3. Think of a bookstore. What risks is such a business exposed to, and who bears them? Answer: Major risks: Risk that inventory will not arrive on time Risk that employees will be late or absent Risk that computers/registers will break down Risk of new competition in the area (especially - the “superstores”) Risk that distributors' prices will increase dramatically These risks are borne by shareholders, owners, employees, creditors, customers, suppliers. 4. Explain why the sale/purchase of a house is similar to a forward contract in nature. Answer: Both parties eliminate the uncertainty associated with price volatility in the housing market during the months of settling the contract between them. Even though the transfer of ownership for the house won't happen for many months, the buyer and seller of a house can contractually settle on a transaction price for the house. 5. Explain the difference between insuring and hedging. Answer: When you hedge, you eliminate the risk of loss by giving up the potential for gain. However, when you insure, you pay a premium to eliminate the risk of loss and retain the potential for gain. 6. Discuss the two factors limiting the efficient allocation of risks. Answer: Transactions costs and incentive problems are the two key factors limiting the efficient allocation of risks. Transactions costs include the costs of establishing and running institutions such as insurance companies or securities exchanges and the costs of writing and enforcing contracts. Moral hazard and adverse selection are examples of incentive problems, which stand in the way of the development of institutions for efficient risk sharing. Moral hazard exists when having insurance against some risk causes the insured party to take greater risk or to take less care in preventing the event that gives rise to the loss. The problem with adverse selection relates to the fact that those who purchase insurance against risk are more likely than the general population to be at risk