DERIVATIVES AND RISK MANAGEMENT
Please see the preface for information on the AACSB letter indicators (F, M, etc.) on the subject lines.
(24.1) Risk management FP
Answer: a EASY
One objective of risk management can be to reduce the volatility of a firm’s cash flows.
(24.4) Swaps FP
Answer: b EASY
Interest rate swaps allow a firm to exchange fixed for floating-rate payments, but a swap cannot reduce actual net interest expenses.
(24.5) Speculative versus pure risk FP
Answer: a EASY
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.
(24.6) Risk management FP
Answer: b EASY
In theory, reducing the volatility of its cash flows will always increase a company’s value.
(24.6) Futures market hedging FP
Answer: b MEDIUM
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.
Multiple Choice: Conceptual
(24.1) Risk management CP
Answer: d MEDIUM
Which of the following are NOT ways risk management can be used to increase the value of a firm?
Risk management can help a firm maintain its optimal capital budget. b.
Risk management can reduce the expected costs of financial distress. c.
Risk management can help firms minimize taxes.
Risk management can allow managers to defer receipt of their bonuses and thus postpone tax payments. e.
Risk management can increase debt capacity.
(24.1) Interest rate and reinvestment rate risk CP
Answer: a MEDIUM 7.
Which of the following statements about interest rate and reinvestment rate risk is CORRECT?
Interest rate price risk exists because fixed-rate debt securities lose value when interest rates rise, while reinvestment rate risk is the risk of earning less than expected when interest payments or debt principal are reinvested. b.
Interest rate price risk can be eliminated by holding zero coupon bonds. c.
Reinvestment rate risk can be eliminated by holding variable (or floating) rate bonds. d.
Interest rate risk can never be reduced.
Variable (or floating) rate securities have more interest rate (price) risk than fixed rate securities.
(24.4) Swaps CP
Answer: c MEDIUM
A swap is a method used to reduce financial risk. Which of the following statements about swaps, if any, is NOT CORRECT?
The earliest swaps were currency swaps, in which companies traded debt denominated in different currencies, say dollars and pounds. b.
Swaps are very often arranged by a financial intermediary, who may or may not take the position of one of the counterparties. c.
A problem with swaps is that no standardized contracts exist, which has prevented the development of a secondary market. d.
A company can swap fixed interest payments for floating interest payments. e.
A swap involves the exchange of cash payment obligations.
(24.4) Forwards vs. futures CP
Answer: a MEDIUM 9.
Which of the following statements is most CORRECT?
Futures contracts generally trade on an organized exchange and are marked to market daily. b.
Goods are never delivered under forward contracts, but are almost always delivered under futures contracts. c.
There are futures contracts for currencies but no forward contracts for currencies. d.
Futures contracts don’t have any margin requirements but forward contracts do. e.
One advantage of forward contracts is that they are default free.
(24.6) Hedging CP
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