CHAPTER 2 HOW DO FIRMS MANAGE FINANCIAL RISK?

2.1. If a risk exists then the firm should always hedge it.
A. True
B. False
2.2. Risk appetite refers to the total amount of risk
A. the firm could bear without becoming insolvent.
B. the firm is taking today.
C. the amount that it would be happy to bear at any one time.
D. none of the above.
2.3. Risk capacity refers to the total amount of risk
A. the firm could bear without becoming insolvent.
B. the firm is taking today.
C. the amount that it would be happy to bear at any one time.
D. none of the above.
2.4. Transferring risk to a third party includes:
A. insurance contracts.
B. financial derivatives.
C. all of the above.
D. none of the above
2.5. Once the firm/bank makes a risk appetite statement
A. it is committed to follow it for at least three years.
B. it must report it in their annual financial report.
C . the board must approve it.
D. all of the above.
2.6. Allen Richards sits on the board of directors of a Canadian financial institution.
Richards read the following statements in a presentation made to the board of
directors by management on the institution's enterprise risk management strategies:
Statement 1: "To manage undesirable risks, the institution could use third-part
protection, including insurance products.

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Statement 2: "Although third-part protection is expensive, this is a cost of business,
and it is not possible to reduce these costs.
He believes both of these statements are incorrect. His assessment is accurate with
respect to:
A. Statement 1 only B. Statement 2 only.
C. Both statements. D. Neither statement.
2.8. Consider a portfolio invested in Canadian dollars and euros. x 1 describes the
payoff on the Canadian dollar, with μ1=0.00 ,σ 1=5.00, and σ 21=25. For the euro,
μ2=1.00 , σ 2=9.95 and σ 22=99. The covariance was computed as σ 12=15.00 , with the
correlation ρ=0.30 . If we have 60 % invested in Canadian dollars and 40 % in euros,
what is the portfolio volatility?
2.9. Consider a stock with an initial price of $ 100. Its price one year from now is given
by S=100× exp ⁡( r) , where the rate of return r is normally distributed with a mean of 0.1
and a standard deviation of 0.2 . With 95 % confidence, after rounding, S will be
between
a. $ 67.57 and $ 147.99
b. $ 70.80 and $ 149.20
c. $ 74.68 and $ 163.56
d. $ 102.18 and $ 119.53
2.10. A high growth stock has a daily return volatility of 1.60%. The returns are
positively autocorrelated such that the correlation between consecutive daily returns
is +0.30. What is the two-day volatility of the stock?
A) 1.800%
B) 2.263%
C) 2.580%
D) 3.200%
2.11. A three-bond portfolio contains three par $100 junk bonds with respective
default probabilities of 4%, 8% and 12%. Each bond either defaults or repays in full
(three Bernoulli variables). The bonds are independent; their default correlation is
zero. Finally, for convenience, recovery is assumed to be zero (LGD = 100%). What is,
respectively, the mean value of the three-bond portfolio and the standard deviation of
the portfolio's value?
a) mean $276.00 and StdDev $46.65
b) mean $276.00 and StdDev $139.94
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c) mean $276.00 and StdDev $2,176.45
d) mean $313.00 and StdDev $94.25
2.12. A risky bond has a (Bernoulli) probability of default (PD) of 7.0% with loss given
default (LGD) of 60.0%. The LGD has a standard deviation of 40.0%. The correlation
between LGD and PD is 0.50. What is the bond's expected loss, E[L] = E[PD* LGD]?
a) 3.1%
b) 4.2%
c) 7.5%
d) 9.3%

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