Unit 12: Fundamentals of Economics, Microeconomics, Macroeconomics and types of Economics
Chapter 2 -How Do Firms Manage Financial Risk
1. Which of the following is NOT a primary risk management strategy?
A. Accept the risk
B. Avoid the risk
C. Transfer the risk
D. Eliminate the risk
The four primary risk management strategies are Accept, Avoid, Mitigate, and Transfer. "Eliminate the risk" is not a recognized strategy.
2. Why might a firm choose to accept a risk rather than mitigate it?
A. Because it is a core risk essential for business survival
B. Because it is unavoidable
C. Because managing the risk may be more costly than its potential impact
D. Because risks cannot be transferred
Firms may accept risk if the cost of managing it is higher than the potential impact or if the risk can be passed to customers through pricing.
3. Which of the following scenarios best represents risk avoidance?
A. A mining company hedging its gold price exposure
B. A firm shutting down a risky business unit that is unrelated to its core operations
C. A company buying insurance to cover potential losses
D. A retailer accepting minor currency fluctuation risks
Risk avoidance involves stopping or eliminating a risk altogether, such as selling or shutting down an unrelated business unit to prevent financial exposure.
4. Which of the following is an example of risk retention?
A. A gold mining company choosing not to hedge its exposure to gold prices
B. A firm purchasing insurance to cover potential losses
C. A company exiting a business unit due to excessive risk
D. A business outsourcing its high-risk operations
Risk retention occurs when a firm willingly keeps exposure to a risk. A gold mining company not hedging its gold price exposure is an example of this.
5. What is the primary reason a firm might choose to transfer risk?
A. To eliminate the risk entirely
B. To pass the risk to customers through pricing
C. To reduce operational complexity
D. To shift financial responsibility to another party, such as an insurer
Risk transfer involves shifting financial responsibility for a risk to another party, often through insurance or contracts.
6. How did General Electric respond to excessive risk exposure in its financial services unit during the 2007-2009 financial crisis?
A. It increased investment in the financial unit to stabilize it
B. It decided to sell parts of the business to avoid risk
C. It transferred the risk to its suppliers
D. It hedged all financial exposures using derivatives
General Electric sold parts of its financial services unit to avoid risks that were unnecessary for its core industrial business.
7. Which risk management strategy is most suitable when a risk is essential to business operations and cannot be eliminated?
A. Avoiding the risk
B. Transferring the risk
C. Mitigating the risk
D. Ignoring the risk
When a risk is essential and cannot be avoided, mitigation (reducing its impact through controls and strategies) is the best approach.
8. What is a key advantage of risk avoidance?
A. It completely removes the potential for loss
B. It allows firms to benefit from risk exposure
C. It ensures all risks are transferred to third parties
D. It always improves business profitability
Risk avoidance removes the potential for losses by eliminating exposure to the risk entirely.
9. How can a bank mitigate credit risk?
A. By offering loans at lower interest rates
B. By providing longer loan maturities
C. By requiring higher collateral and shorter maturities
D. By eliminating all loan offerings
Banks mitigate credit risk by setting higher interest rates, shorter maturities, and requiring stronger collateral.
10. Which of the following is an example of risk mitigation?
A. Purchasing insurance for cyber threats
B. Investing in automation to reduce labor costs
C. Hedging fuel prices with derivatives
D. Selling a business unit due to high risk
Risk mitigation involves taking proactive steps to reduce risk impact, such as automation to offset rising labor costs.
11. Why might a company choose to transfer risk?
A. To completely eliminate risk exposure
B. Because it is always the least expensive option
C. To increase counterparty risk
D. To shift financial responsibility to another party
Companies transfer risk to shift financial responsibility, usually through insurance or derivatives, though this comes at a cost.
12. What is a key disadvantage of risk transference?
A. It introduces counterparty risk
B. It eliminates all exposure to the risk
C. It requires the firm to handle risk internally
D. It always results in higher costs
When a company transfers risk, it depends on a third party, introducing counterparty risk if the third party fails to fulfill obligations.
13. What should a firm consider when deciding how to manage a risk?
A. The firm should always transfer the risk
B. The firm should avoid all risks
C. A thorough cost-benefit analysis
D. Only the financial impact of the risk
Companies should perform a cost-benefit analysis to determine whether risk retention, mitigation, or transfer is the best approach.
14. In the example of a cyber threat, why might a firm combine mitigation and risk transference?
A. Because mitigation is always ineffective
B. To balance costs while reducing risk exposure
C. Because risk transference eliminates all risks
D. To completely avoid the cyber threat
A mix of mitigation and transference allows a firm to manage costs while reducing overall risk exposure effectively.
15. What is the first step in the risk management process?
A. Identify risk appetite
B. Map known risks
C. Implement a plan
D. Monitor and adjust the plan
The risk management process begins with identifying risk appetite, which defines the level of risk a firm is willing to retain.
16. What are the two key subcomponents of risk appetite?
A. Risk control and risk estimation
B. Risk capacity and regulatory risk
C. Risk willingness and risk ability
D. Risk exposure and risk retention
Risk appetite consists of risk willingness (desire to take risks) and risk ability (capacity to take risks based on controls and regulations).
17. What factor can limit a firm's risk willingness?
A. Market competition
B. Economic growth
C. Investment strategies
D. Regulatory constraints
Regulatory constraints, such as capital requirements for banks, can restrict a firm's ability to take on risk, regardless of its willingness.
18. Why should actual risk levels be set below a firm's total risk capacity?
A. To maximize profit potential
B. To allow for potential estimation errors
C. To increase risk-taking opportunities
D. To align with industry-level risk appetite
Firms set risk levels below their full capacity to accommodate estimation errors and unforeseen risks.
19. How does industry-level risk appetite differ from a firm’s risk appetite?
A. Firm-level risk appetite is based on economic conditions
B. Industry risk appetite is more important for individual firms
C. Industry risk appetite reflects general market sentiment, while firm-level appetite is set by leadership
D. There is no difference between the two
Industry-level risk appetite is a broad measure of market sentiment, while a firm’s risk appetite is an internal decision made by senior leadership.
20. What is one of the key responsibilities of the Board of Directors in risk management?
A. Define and communicate the firm's risk appetite
B. Manage daily risk exposures
C. Approve all individual risk-taking decisions
D. Set interest rates for loans
The Board of Directors is responsible for defining and communicating the firm’s risk appetite to ensure alignment with business strategy.
21. What is one method firms use to communicate risk appetite quantitatively?
A. Risk retention policies
B. Corporate mission statements
C. Value at Risk (VaR)
D. Brand reputation metrics
Value at Risk (VaR) is a quantitative measure used to express the maximum loss a firm can tolerate within a certain confidence level and time period.
22. How does stress testing help in risk management?
A. It eliminates all risks from the business
B. It helps assess the firm's exposure under severe negative scenarios
C. It increases the firm's profitability
D. It ensures compliance with accounting standards
Stress testing evaluates how a firm would perform under extreme adverse conditions, helping management decide whether to retain, mitigate, or transfer risks.
23. Why do debtholders prefer minimizing risk compared to shareholders?
A. They benefit from higher equity returns
B. They prefer risk-taking for higher growth
C. They hold ownership in the firm
D. Their potential gains are limited to interest payments
Debtholders prefer minimizing risk because their returns are limited to fixed interest payments, while shareholders can benefit from high-risk, high-reward strategies.
24. What is the purpose of an internal detailed risk statement?
A. To communicate risk appetite to external investors
B. To increase stock market performance
C. To guide risk managers and business decision-making
D. To create a company’s annual report
A detailed internal risk statement helps risk managers and business leaders align with enterprise-wide risk expectations.
25. According to HSBC’s 2016 Annual Report, which of the following is NOT one of its broad risk categories?
A. Credit risk
B. Marketing risk
C. Regulatory risk
D. Financial crimes risk
HSBC’s 2016 Annual Report listed several risk categories, including credit, regulatory, and financial crimes risk, but marketing risk was not one of them.
26. What is the primary challenge in maintaining unity of risk appetite across different risk types?
A. All risk types have the same level of impact
B. Risk types are not correlated with each other
C. Market risk is always more significant than other risks
D. Different risk types may require different levels of risk appetite
Different risk types, such as market, credit, liquidity, and operational risks, may require varying levels of risk appetite, making it challenging to maintain unity.
27. Why might a firm deliberately assume more risk in a specific category?
A. To reduce overall operational efficiency
B. To align with regulatory restrictions
C. To gain a competitive edge
D. To increase compliance burden
Some firms may take on more risk in certain areas to create a competitive advantage, such as investing in high-growth but volatile markets.
28. What is a key challenge associated with correlated risks?
A. They are easy to hedge completely
B. One type of risk may amplify another
C. They do not impact overall risk exposure
D. They always result in financial losses
Correlated risks can amplify each other, such as operational risks in a foreign subsidiary also increasing foreign currency risk.
29. Why is it important for the board to decide between hedging short-term and long-term risks?
A. Hedging future risks may affect short-term profitability
B. Long-term risks are easier to predict
C. Short-term risks do not impact stock price
D. Risk hedging only applies to short-term risks
Hedging long-term risks can require significant cash outlays, potentially reducing short-term profitability, which may concern investors.
30. How can risk tolerance bands benefit managers?
A. They eliminate all business risks
B. They restrict decision-making flexibility
C. They provide flexibility while maintaining clear expectations
D. They replace the need for risk appetite statements
Risk tolerance bands allow managers some flexibility in decision-making while ensuring they operate within clearly defined risk limits.
31. Why is reputational impact an important consideration in risk appetite?
A. It affects only internal operations
B. Reputation is not linked to risk management
C. It does not influence stakeholders
D. Stakeholders assess a firm’s risk appetite based on its reputation
A firm’s approach to risk-taking influences its reputation and can affect investor confidence, customer trust, and regulatory perception.
32. Why is it difficult to measure firm-level risk with a single value?
A. VaR can fully capture all risks
B. Risk is multidimensional and requires multiple metrics
C. Notional limits always provide a complete risk picture
D. Stress testing alone is sufficient
Risk management involves multiple dimensions, requiring firms to use a combination of VaR, stress testing, and notional limits rather than relying on a single measure.
33. What is the primary objective of risk mapping in a firm?
A. To eliminate all known risks
B. To focus only on financial risks
C. To classify risks without considering cash impact
D. To systematically identify and analyze all risks with a cash impact
Risk mapping helps a firm systematically identify and analyze all risks that could impact cash flow, allowing better decision-making.
34. Why is it important to consider the correlation between different risks during risk mapping?
A. Because all risks are independent of each other
B. To increase the number of identified risks
C. To understand how one risk might amplify or offset another
D. To avoid assessing low-probability risks
Some risks are correlated, meaning that one risk event may increase or decrease the impact of another. Understanding this is crucial for effective risk management.
35. What key details should be considered when analyzing commodity risk exposure in a firm?
A. Only the current market price of the commodity
B. Magnitude, timing, and location of the need
C. The availability of futures contracts alone
D. Historical price trends
A firm must consider how much of a commodity is needed, when it is needed, and where it must be delivered to effectively assess commodity risk exposure.
36. How can a firm manage foreign currency risk effectively?
A. By considering only current sales in foreign markets
B. By ignoring currency fluctuations
C. By using a single risk mitigation approach
D. By evaluating sales, estimated future sales, and operational currency needs
Managing foreign currency risk requires analyzing not just current sales but also projected sales and operational needs to determine risk exposure and hedging strategies.
37. What is the relationship between risk mapping and risk mitigation?
A. Risk mapping helps firms decide whether to retain, avoid, mitigate, or transfer risks
B. Risk mapping eliminates the need for risk mitigation
C. Risk mapping focuses only on documenting risks
D. Risk mapping does not contribute to strategic decisions
A thorough risk map enables management to make informed decisions on whether to retain, mitigate, avoid, or transfer risks.
38. Why is granularity of inputs important in risk mapping?
A. It complicates the risk management process
B. It increases the number of risks to manage
C. It enhances the accuracy of risk assessment
D. It reduces the need for future risk reviews
More granular inputs provide a clearer picture of the firm’s risk landscape, leading to more effective risk management strategies.
39. What is one of the key financial benefits of hedging risk exposures?
A. Lowering the cost of capital
B. Increasing earnings volatility
C. Reducing access to investment opportunities
D. Increasing regulatory restrictions
Hedging can reduce the cost of capital by lowering earnings volatility and improving financial stability, making the firm more attractive to investors and lenders.
40. How can hedging improve a firm’s debt capacity?
A. By increasing operational risks
B. By introducing more financial distress
C. By reducing volatility in earnings and cash flows
D. By increasing regulatory burdens
A firm with stable earnings and cash flows is perceived as lower risk by lenders, which can lead to increased debt capacity and better borrowing terms.
41. What is a potential cash flow advantage of hedging?
A. Increasing tax liabilities
B. Decreasing investment opportunities
C. Reducing operational efficiency
D. Smoothing revenues and costs, leading to lower tax liabilities
By stabilizing revenues and costs, hedging can reduce tax liabilities, directly improving a firm’s cash flow.
42. How does hedging influence a firm’s reputation?
A. It makes the firm appear riskier to investors
B. It signals financial stability to stakeholders
C. It decreases stock price stability
D. It increases regulatory scrutiny
Stability in a firm’s operations due to hedging signals strength to stakeholders, positively affecting its reputation and stock price.
43. Why might managers favor hedging strategies?
A. It simplifies business planning
B. It increases risk exposure
C. It reduces market efficiency
D. It eliminates all financial risks
Hedging allows managers to control financial risks, making business planning easier and allowing them to lock in strong margins.
44. Why might hedging with derivatives be preferable to purchasing insurance?
A. Insurance policies always have higher payouts
B. Insurance is more flexible than derivatives
C. Derivatives can be a cheaper alternative to insurance
D. Hedging with derivatives eliminates all risks
The total cost of insurance over time may exceed potential losses, making derivatives like swaps and options a cost-effective alternative.
45. According to Modigliani and Miller (1958), why is hedging theoretically unnecessary in perfect capital markets?
A. Firms and individuals can perform the same financial transactions at the same cost
B. Hedging always reduces firm value
C. Hedging eliminates systematic risk
D. Hedging is only beneficial for large corporations
Modigliani and Miller (1958) argued that in perfect capital markets, firms and individuals could execute the same transactions at equal cost, making corporate hedging redundant.
46. According to William Sharpe’s CAPM (1964), which type of risk should firms be most concerned about?
A. Idiosyncratic risk
B. Firm-specific risk
C. Systematic risk
D. Operational risk
According to the Capital Asset Pricing Model (CAPM), firms should be concerned with systematic risk (beta risk) because unsystematic risk can be diversified away by investors.
47. Why is the assumption that derivatives pricing fully reflects all risk factors unrealistic?
A. It does not consider investor sentiment
B. Derivatives pricing is more complex and less accurate than equity and bond pricing
C. All risks are always priced perfectly in financial markets
D. Derivatives eliminate all risks
Unlike equities and bonds, derivatives are complex financial instruments, and their pricing does not always fully capture all risk factors.
48. What is one potential hidden cost of hedging?
A. It always reduces firm value
B. It guarantees higher profits
C. It eliminates financial distress
D. It may divert management focus from core business activities
One hidden cost of hedging is that management may focus excessively on risk management rather than core business operations, potentially missing profit opportunities.
49. How can hedging increase compliance costs?
A. By reducing financial reporting requirements
B. By simplifying risk assessment
C. By introducing additional auditing, disclosure, and monitoring costs
D. By eliminating the need for regulatory oversight
Hedging often requires compliance with regulatory frameworks, leading to additional costs related to audits, financial disclosures, and monitoring.
B. Leverage in derivatives can amplify financial risks
C. It eliminates financial risk entirely
D. Hedging only reduces stock market volatility
Derivatives often involve leverage, which can increase a firm's exposure to certain financial risks instead of reducing them.
51. Why does the use of derivatives sometimes reveal private operational information?
A. Hedging decisions signal the firm's risk concerns to the market
B. It always misprices the firm’s assets
C. Derivatives are not regulated
D. It automatically increases stock prices
The use of derivatives for hedging may indicate specific risk exposures, revealing strategic or operational concerns to competitors and market participants.
52. What is one potential challenge firms face when hedging risk exposures?
A. Misunderstanding risk exposures during risk mapping
B. Guaranteeing profits through hedging
C. Eliminating all financial risks
D. Avoiding compliance requirements
Misunderstanding risk exposures during the risk mapping process can lead to incorrect hedging strategies, resulting in excessive or insufficient notional values on derivatives.
53. Why is market trend volatility a challenge in risk hedging?
A. It allows firms to predict future market movements with certainty
B. Rapid changes in commodity prices, forex rates, and interest rates can make risk management difficult
C. It makes hedging unnecessary
D. It eliminates the need for active risk management
Market variables such as commodity prices, exchange rates, and interest rates are highly dynamic. If a firm cannot adjust its hedging strategy quickly, it may incur unexpected losses.
54. How did poor communication contribute to the collapse of MG Refining and Marketing (MGRM)?
A. The company failed to hedge its risks
B. The firm used the wrong financial instruments
C. Management did not effectively communicate its hedging strategy to its parent company
D. The company refused to adjust its risk management strategy
MGRM's management failed to communicate their hedging strategy properly. This led to the parent company closing all hedging positions prematurely, which resulted in significant losses.
55. What was one major factor that increased MGRM’s financial losses?
A. The firm used long-term hedging instruments
B. The firm hedged against all possible risks
C. The oil markets remained stable
D. The parent company closed all hedging positions before markets reversed
The parent company closed all hedging positions prematurely due to large margin calls. Later, when the oil markets reversed, MGRM faced additional unhedged losses.
56. How can firms address the challenge of lacking internal expertise in hedging?
A. Avoid hedging altogether
B. Outsource hedging activities to a third-party risk manager
C. Reduce their business operations
D. Invest in more speculative derivatives
If a firm lacks internal expertise in hedging, it can hire a third-party risk manager to manage hedging activities effectively.
57. What is one effective way to build a strong internal risk culture?
A. Regularly communicate risk goals and warning signs
B. Ignore minor risk breaches
C. Avoid training staff on risk management
D. Focus only on regulatory compliance
A strong risk culture can be built by regularly communicating risk goals and warning signs when risk limits are about to be breached.
58. Why should key staff understand the consequences of breaching risk limits?
A. So they can ignore minor risks
B. To increase financial speculation
C. To rely solely on external risk managers
D. To ensure they take proactive risk mitigation actions
Key staff should understand the potential consequences of breaching risk limits so they can take proactive actions to mitigate risks before they escalate.
59. What is one key responsibility of the Board of Directors in risk management?
A. Manage daily trading activities
B. Set individual hedging decisions for each department
C. Be able to articulate the firm's top-10 risks
D. Focus only on maximizing profits
The Board of Directors should have a clear understanding of the firm’s top-10 risks to ensure effective oversight of risk management strategies.
60. What is the primary distinction between operational risk and financial risk?
A. Operational risk relates to balance sheet items, while financial risk relates to income statement items.
B. Operational risk relates to income statement items, while financial risk relates to balance sheet items.
C. Operational risk is always easier to hedge than financial risk.
D. Financial risk does not impact a firm's revenue or expenses.
Operational risk affects a firm’s production and sales, impacting the income statement, while financial risk impacts assets and liabilities, affecting the balance sheet.
61. What is the primary purpose of hedging pricing risk?
A. To protect against fluctuations in the cost of inputs.
B. To eliminate foreign currency risk.
C. To increase profitability through speculation.
D. To increase expenses to reduce tax liabilities.
Hedging pricing risk allows firms to secure input costs in advance using forwards or futures contracts, preventing unexpected cost fluctuations.
62. How can a firm hedge foreign currency risk for future revenue?
A. By investing in foreign government bonds.
B. By holding more cash reserves in foreign currency.
C. By using currency put options or forward contracts.
D. By increasing prices for foreign customers.
A firm can hedge foreign currency risk by using put options to set a minimum return or forward contracts to fix an exchange rate in advance.
63. Why might a firm choose not to hedge all of its foreign currency positions?
A. Because foreign exchange rates are always stable.
B. Because hedging increases foreign currency risk.
C. Because all firms must hedge 100% of their exposure.
D. Because hedging can be cost prohibitive.
Hedging incurs costs, and sometimes firms may leave certain foreign currency positions unhedged if the cost outweighs the benefits.
64. What is a natural hedge against a decrease in the value of a firm’s foreign investment (asset)?
A. Purchasing more foreign assets.
B. Holding foreign currency debt (liability).
C. Issuing domestic currency bonds.
D. Increasing equity financing.
A firm can use foreign currency debt as a natural hedge, since the liability would also decrease in value, offsetting losses from the foreign investment.
65. Which of the following is a key consideration when selecting a hedging strategy for foreign currency risk?
A. The firm's domestic market share.
B. The number of foreign customers.
C. The cost of hedging and currency volatility.
D. The number of employees in foreign branches.
When selecting a hedging strategy, firms must consider both the cost of hedging and the volatility of the foreign currency to determine feasibility.
66. What is the primary goal of hedging interest rate risk?
A. To control the firm's net exposure to unfavorable interest rate fluctuations
B. To increase the firm's borrowing costs
C. To eliminate all interest rate risks completely
D. To maximize speculative trading profits
Hedging interest rate risk helps firms manage exposure to fluctuations in interest rates while maintaining financial stability.
67. Which of the following financial instruments can be used to hedge interest rate risk?
A. Equity shares
B. Foreign currency options
C. Interest rate swaps or swaptions
D. Corporate bonds
Interest rate swaps and swaptions are common instruments used to hedge against unfavorable interest rate fluctuations.
68. What is a key difference between static and dynamic hedging strategies?
A. Static hedging requires continuous monitoring and adjustment
B. Dynamic hedging requires continuous monitoring and adjustment
C. Static hedging is costlier than dynamic hedging
D. Dynamic hedging eliminates all risks completely
Dynamic hedging requires frequent adjustments as the risk profile changes, making it more complex and costlier than static hedging.
69. Which of the following is a challenge in implementing a dynamic hedging strategy?
A. It completely removes all risks
B. It does not require monitoring
C. It has no impact on transaction costs
D. It requires significant monitoring and transaction costs
Dynamic hedging involves continuous adjustments, which require monitoring and can lead to higher transaction costs.
70. Why must firms consider time horizons when implementing a hedging strategy?
A. To eliminate all risks completely
B. To maximize speculative profits
C. To align hedging performance with financial goals
D. To reduce regulatory compliance requirements
Firms must match hedging strategies with time horizons to ensure they meet financial goals and risk management objectives.
71. What is a major financial accounting implication of hedging with derivatives?
A. If not an exact match, hedging can result in gains or losses reported on the income statement
B. Hedging eliminates all financial reporting concerns
C. Hedging is not recorded in financial statements
D. Hedging only impacts the balance sheet
If a hedge does not perfectly offset the underlying risk, gains or losses must be recorded on the firm's income statement.
72. How does taxation impact derivative hedging strategies?
A. Taxes have no effect on hedging decisions
B. Complex tax rules can increase hedging costs
C. Hedging with derivatives is tax-free in all countries
D. Tax laws related to derivatives are uniform worldwide
Taxation of derivatives is complex and varies by jurisdiction, which can increase costs and require additional compliance efforts.
73. What is the primary purpose of stop-loss limits in risk management?
A. To prevent losses from escalating beyond a set threshold
B. To eliminate all financial risks
C. To ensure future profitability
D. To maximize returns
Stop-loss limits help control losses by setting a threshold beyond which losses cannot escalate, but they do not eliminate future risks entirely.
74. What is a potential weakness of notional limits in risk management?
A. They do not consider transaction maturity
B. They do not help in stress testing
C. The notional amount may not accurately reflect the actual risk
D. They cannot be aggregated at the enterprise level
Notional limits set exposure parameters but may not always align with the actual risk, making them less effective as a sole risk management tool.
75. Why can risk-specific limits be difficult to implement at the enterprise level?
A. They do not address liquidity risk
B. They do not consider counterparty concentration
C. They do not account for price fluctuations
D. They require specialized skills and may not be easily aggregated
Risk-specific limits focus on particular risks (e.g., liquidity or currency risk), making them difficult to consolidate at the enterprise level and requiring specialized expertise.
76. What is the main function of maturity/gap limits?
A. To prevent losses from hedging activities
B. To minimize the number of transactions maturing within a short period
C. To limit exposure to a single currency
D. To reduce reliance on derivatives
Maturity/gap limits aim to spread out transaction maturities over time to smooth operational risks but do not directly address price risk.
77. What is a key limitation of concentration limits?
A. They do not fully mitigate correlation risk
B. They do not consider market fluctuations
C. They require advanced technology
D. They are only useful for small firms
Concentration limits control exposure to a particular counterparty or asset, but they do not fully account for correlated risks.
78. What do Greek limits in risk management refer to?
A. Limits on international market exposure
B. Risk control measures for sovereign bonds
C. Limits related to option Greeks such as delta, gamma, and vega
D. Measures used only in commodity trading
Greek limits control exposure to option risks by setting thresholds based on option Greeks (delta, gamma, theta, vega).
79. What is a major weakness of Value at Risk (VaR) as a risk management tool?
A. It is not widely used in financial institutions
B. It always overestimates risk
C. It ignores historical data
D. It does not measure losses beyond the risk threshold
VaR provides a risk threshold but does not account for extreme losses beyond that threshold, making it susceptible to underestimating tail risks.
80. What is the key advantage of stress testing in risk management?
A. It eliminates all market risks
B. It evaluates risk exposures under extreme scenarios
C. It ensures full compliance with risk limits
D. It minimizes all financial losses
Stress testing helps firms understand risk exposures under extreme conditions but does not eliminate risk entirely.
81. Which of the following is NOT a common goal of a firm's risk management program?
A. Minimizing negative financial effects
B. Using risk management as a profit center
C. Completely eliminating all risks
D. Allocating risk management costs properly
Risk management aims to minimize or mitigate risks, but eliminating all risks is impossible in business.
82. What is the main advantage of exchange-traded derivatives over OTC derivatives?
A. Higher customization
B. Lower counterparty risk
C. Less basis risk
D. Direct counterparty negotiations
Exchange-traded derivatives reduce counterparty risk since a financial intermediary clears the trades.
83. Which of the following best describes a forward contract?
A. An OTC agreement between two counterparties
B. A standardized, exchange-traded derivative
C. A contract requiring daily margin settlements
D. An option contract with a premium payment
A forward contract is a privately negotiated OTC contract with customized terms.
84. How does a swap contract typically work?
A. A buyer has the right to purchase an asset at a fixed price
B. A seller has the right to sell an asset at a fixed price
C. It requires daily margin settlements
D. It involves exchanging cash flows between two parties
Swap contracts involve counterparties exchanging cash flows, such as fixed vs. floating interest payments.
85. What is the primary risk associated with OTC derivatives?
A. High transaction fees
B. Lack of standardization
C. Counterparty default risk
D. Daily margin settlement risk
OTC contracts expose parties to counterparty default risk since they are not cleared through an exchange.
86. Which risk is faced by airlines using crude oil derivatives instead of jet fuel contracts?
A. Liquidity risk
B. Basis risk
C. Settlement risk
D. Credit risk
Airlines using crude oil derivatives for jet fuel hedging face basis risk due to price differences between crude oil and jet fuel.
87. What was Delta Airlines’ unique approach to managing jet fuel price risk?
A. Buying an oil refinery
B. Using only futures contracts
C. Avoiding risk management entirely
D. Using options contracts exclusively
Delta Airlines attempted to control jet fuel costs by vertically integrating and purchasing an oil refinery.
88. Why might an investor choose a swaption contract?
A. To eliminate counterparty risk
B. To hedge against commodity price fluctuations
C. To enter a swap contract immediately
D. To have the right, but not the obligation, to enter a swap later
A swaption gives an investor the right (but not the obligation) to enter into a swap at a future date.
89. What is counterparty risk in the context of risk transfer?
A. The risk that a firm will have to accept additional risks
B. The risk of losing all financial assets
C. The risk that the third party responsible for taking on the transferred risk may default
D. The risk of operational failure within the firm
Counterparty risk arises when a firm transfers risk to another entity, such as through insurance or derivatives, and there is a possibility that the other party may default on its obligations.
90. What is the primary factor influencing a firm’s risk appetite?
A. The economic cycle
B. The firm’s willingness to retain risk
C. The number of competitors in the industry
D. The availability of derivatives
A firm's risk appetite is its willingness to retain risk and is influenced by decision-makers at all levels, from line managers to the board of directors.
91. Which of the following is a disadvantage of hedging?
A. It helps in reducing costs
B. It enhances business planning
C. It smoothens operational performance
D. It may introduce new risks in an attempt to minimize others
While hedging has advantages such as cost reduction and operational stability, it can also introduce new risks that may not have been present initially.
92. Which of the following is an example of operational risk hedging?
A. Hedging input costs through long-term supply contracts
B. Purchasing an insurance policy for property damage
C. Using interest rate swaps to hedge loan obligations
D. Selling a division to avoid exposure to market fluctuations
Operational risk hedging involves managing risks related to business operations, such as securing stable input costs through long-term contracts.
93. What is a key consideration when deciding to hedge financial risks?
A. The impact of currency fluctuations
B. Whether to hedge in a static or dynamic manner
C. The number of shareholders affected
D. The tax implications for employees
When hedging financial risks, firms must decide whether to use a static hedge (single transaction) or a dynamic approach that adjusts over time.
94. Which of the following is a derivative instrument used for risk management?
A. Common stock
B. Corporate bonds
C. Swap contracts
D. Government grants
Swap contracts are a type of derivative used to manage financial risk, such as interest rate or currency risk.
