Flashcards in STUDY UNIT FIVE FINANCIAL RISK MANAGEMENT Deck (10):

1

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An entity with a long position in an asset can mitigate the risk of the asset’s value falling by entering into a short hedge

True.

False.

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True.

Your answer is correct.

An entity with a long position in an asset profits when the asset’s value increases and incurs a loss when the asset’s value decreases. The entity would thus like to mitigate the risk of the asset’s value decreasing. The entity therefore takes a short position in a financial instrument that is almost perfectly correlated with the original asset but in the opposite direction.

2

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The time premium (extrinsic value) of an option decreases as the exercise date approaches.

True.

False.

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True.

Your answer is correct.

The time premium (extrinsic value) of an option is the extra amount investors are willing to pay for the added protection provided by an option over a straightforward long or short position in the underlying. The size of the time premium is in direct proportion to the length of time remaining until exercise. As the exercise date approaches, uncertainty diminishes, and the time premium decreases.

3

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The value of a put option will decrease as the price of the underlying decreases.

True.

False.

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False.

Your answer is correct.

The intrinsic value of a put option is the amount by which exercise price is greater than the current price of the underlying. The value of a put option will decrease as the price of the underlying increases since there is no advantage in selling at a lower-than-market price.

4

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If a call option is “out-of-the-money,”

A It is worth exercising.

B The value of the underlying asset is more than the exercise price.

C It is not worth exercising because the value of the underlying asset is less than the exercise price.

D The option no longer exists.

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C It is not worth exercising because the value of the underlying asset is less than the exercise price.

This answer is correct.

When the value of the asset underlying a call option is less than the exercise price of the option, the option is “out-of-the-money,” which means it is not worth exercising.

5

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The difference between the required rate of return on a given risky investment and that on a riskless investment with the same expected return is the

A Risk premium.

B Standard deviation.

C Beta coefficient.

D Coefficient of variation.

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A Risk premium.

This answer is correct.

The required rate of return on equity capital in the capital asset pricing model is the risk-free rate (determined by government securities) plus the product of the market risk premium times the beta coefficient (beta measures the firm’s risk). The market risk premium is the amount above the risk-free rate that will induce investment in the market. The beta coefficient of an individual stock is the correlation between the volatility (price variation) of the stock market and that of the price of the individual stock.

6

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A put is an option that gives its owner the right to do which of the following?

A Buy a specific security at a fixed price for an indefinite time period.

B Sell a specific security at fixed conditions of price and time.

C Sell a specific security at a fixed price for an indefinite time period.

D Buy a specific security at fixed conditions of price and time.

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B Sell a specific security at fixed conditions of price and time.

This answer is correct.

A put option gives the buyer the right to sell the underlying asset at a fixed price. An option has an expiration date after which it can no longer be exercised.

7

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An analyst covering Guilderland Mining Co. common stock estimates the following information for next year:

Expected return on the market portfolio 12%

Expected return on Treasury securities 5%

Expected beta of Guilderland 2.2

Using the CAPM, the analyst’s estimate of next year’s risk premium for Guilderland’s stock is closest to

A 15.4%

B 21.4%

C 10.4%

D 7.0%

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A 15.4%

This answer is correct.

According to the capital asset pricing model, the risk premium of a particular stock is the excess of the market rate of return over the risk-free rate weighted by the stock’s beta coefficient. For Guilderland Mining, this calculation is

Stock’s risk premium

= 2.2 × (12% – 5%)

= 2.2 × 7%

= 15.4%

8

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A measure that describes the risk of an investment project relative to other investments in general is the

A Expected return.

B Beta coefficient.

C Coefficient of variation.

D Standard deviation.

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B Beta coefficient.

This answer is correct.

The required rate of return on equity capital in the capital asset pricing model is the risk-free rate (determined by government securities), plus the product of the market risk premium times the beta coefficient (beta measures the firm’s risk). The market risk premium is the amount above the risk-free rate that will induce investment in the market. The beta coefficient of an individual stock is the correlation between the volatility (price variation) of the stock market and that of the price of the individual stock.

9

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To assist in an investment decision, Gift Co. selected the most likely sales volume from several possible outcomes. Which of the following attributes would that selected sales volume reflect?

A The median.

B The expected value.

C The midpoint of the range.

D The greatest probability.

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D The greatest probability.

This answer is correct.

Probability is important to management decision making because of the uncertainty of future events. Probability estimation techniques assist in making the best decisions in the face of uncertainty. Consequently, the most likely sales volume is the one with the greatest probability.

View Subunit 5.2 Outline

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