Finance 4630 Ch. 1

Describe the alternatives available to people and firms across the globe to protect themselves from adverse loss exposures.

1) retention, best for exposures with small potential financial consequences 2) personal insurance protection, best for exposures with significant potential financial consequences 3) employee benefits plans, targeted to specific exposures such as retirement and health care expenses 4) corporate risk management, appropriate to a firm with significant loss exposures.

Financial advisors encourage investors to hold a well-diversified portfolio of investments. Explain whether this level of diversification can protect an investor if: a. one of her stock holdings is a firm with an unsuccessful new product launch, or b. the global economy falls into a recession.

A) a well-diversified investor would normally be protected. B) the investor faces market risk, a condition that might affect all of her holdings.

Auto collision claims are an example of which of the following? a. Pure risks that can be diversified across a large group of drivers b. Speculative risks than can be diversified across a large group of drivers c. Pure risks that cannot be diversified across a large group of drivers d. Speculative risks that cannot be diversified across a large group of drivers

A. Pure risks that can be diversified across a large group of drivers

Describe the difference between pure and speculative risks. Provide an example of each

Pure risks involve only the possibility of loss. Ex) loss of a building to fire, premature death of a family head. Speculative risks involve the possibility of gain as well as loss. Ex) gambling, investing in the stock market, and starting a business

Describe the concept of risk aversion. Is it an equally appropriate strategy for dealing with pure and speculative risks?

Risk aversion causes one to shy away from risk. It can be an equally appropriate strategy for dealing with both pure and speculative risk, although with pure risk one gives up any opportunity for gain.

Describe the process of risk diversification, noting the two conditions that must exist for diversification to be effective

Risk diversification involves spreading the losses in a group among all the members of the group. Must be a large number of members, and the potential that a loss will affect more than a few members of the group at one time must be small.

Which of the following statements about insurance is correct? a. Insurance is available in all countries across the world. b. Insurance is a common technique used by individuals to protect against risk. c. Private insurance is available for non-diversifiable risks like unemployment. d. a and b are correct. e. b and c are correct.

d. a and b are correct.

Describe the three broad categories of risk-handling techniques used by risk managers. provide at least two specific examples of each technique.

1) Avoidance or loss control—trying to affect the frequency or severity of losses. Ex) loss prevention, loss reduction, and salvage. 2) Transfer—trying to get some other entity to bear the loss. Ex) are contractual provisions such as hold-harmless and indemnity agreements. 3) Financing—trying to offset or share losses. Ex) are insurance and self-insured retentions (SIRs).

List and briefly describe the five steps in the risk management process.

1) Formulate risk management objectives. 2) Identify loss exposures. 3) Measure potential loss severity. 4) Choose risk-handling techniques. 5) Implement techniques and monitor their effectiveness.

List and describe the four areas of risk encompassed in an enterprise risk-management program. For each risk area, provide an example of a recent risk event that has been described in the popular business media.

1) Pure risk, for example the explosion that damaged the BP oil well that spilled oil in the U.S. Gulf Coast 2) Financial risk, for example the major derivatives losses at some of the most respected investment brokers 3) Operational risk, for example the loss of business for BP after the oil spill because they could not pump as much oil

Describe four different types of risk that need to be addressed by the risk manager in a typical corporation. Discuss whether each of these four types of risk are equally important across different industries.

1) Pure risks—those where only loss is possible 2) Financial risks—such as currency exchange risk 3) Operational risks—such as supply chain exposures or critical dependencies 4) Strategic risks—such as product development and construction delays No, these are not equally important across different industries. For an importer, currency exchange risk might be the most significant exposure. For a local restaurant, this is unlikely to be a problem

Explain why it is necessary to monitor the effectiveness of the chosen risk-handling techniques of the risk management process on a continuous basis

2 questions need to be asked: 1) Is it effective in reducing or financing losses? 2) Is it cost effective? If these cannot be answered in the affirmative, then the risk manager must go in another direction.

Explain why interest in risk management has increased dramatically in the United States in recent years.

Catastrophic events such terrorist attacks, corporate financial failures, and shrinking employee benefits.

Which of the following is not a speculative risk? a. An investor who invests in common stock b. An entrepreneur who starts a new company c. A business that develops a new product line d. A lawsuit filed against a firm by a client who slips on the firm's icy steps

D. A lawsuit filed against a firm by a client who slips on the firm's icy steps

Which of the following have led to a growing interest in risk management? a. The terrorist attacks of September 11, 2001 b. Corporations that filed fraudulent financial statements that overstated earnings c. Shrinking wages and employee benefit plans during the 2008 recession d. All of the above

D. all the above

Describe the difference between loss frequency and loss severity

Frequency is the number of losses that occur Severity is the financial consequences of the losses. Together, these make up the expected value of an entity's losses.

How did the corporate scandal at Enron prompt the accounting profession to take a leading role in the call for improvements in corporate risk management?

The use of fraudulent financial statements to increase the market value of Enron stock. Then the company failed and the fraud came to light, and there were calls for not only better accounting procedures but also better management oversight.

Explain why auto and life insurance are two types of risk that are well suited to diversification by insurers through the use of risk pooling

There is a very large number of exposure units and a very small probability that multiple members of the group will suffer loss at the same time.

Explain why damage from floods and wars are two types of risk that are not well suited to diversification by insurers through the use of risk pooling.

These are not well-suited because there is a large probability that numerous members of the group will be subject to loss at the same time.

Describe how the scope of risks encompassed in enterprise risk management differs from those of traditional corporate risk management

Traditional risk management had a focus on pure risks only, things that could be insured. Enterprise risk management has a broader scope, taking into consideration financial risks, operational risks, and strategic risks.

Describe four characteristics that commonly are attributed to a well-designed ERM program.

Well-designed ERM programs have these characteristics: 1) They have a top-down focus 2) they are broad in scope 3) they have a portfolio perspective 4) they involve a systematic process of exposure identification, assessment, and treatment.

Which of the following is not a characteristic of an ERM program? a. The decisions of the ERM department are monitored by the firm's board of directors. b. The ERM program focuses only on pure risk. c. The ERM department evaluates the loss exposures of the firm as a portfolio of risk. d. The ERM department typically uses a systematic process modeled after the risk management process to identify, assess, and treat the firm's risks.

b. The ERM program focuses only on pure risk.

Risk aversion I. is the tendency of a person to prefer less risk instead of more risk when faced with risky decisions. II. is a more appropriate strategy for pure risks than for speculative risks. a. I only b. II only c. Both I and II d. Neither I nor II

c. Both I and II

A building's owner inserts a provision in the lease that makes the tenant legally responsible for clearing snow and ice from the building's sidewalks. This provision is an example of which of the following? a. Loss prevention b. Loss reduction c. Loss transfer d. Self-insurance

c. Loss transfer

ACA is a leading global automaker. ACA has to stop production of a popular vehicle when a labor strike shuts down the factories of BBB Company, the sole supplier of auto transmissions to ACA. The lost production resulting from this supply chain disruption is an example of a(n) __________ that is borne by ACA. a.hazard risk b.financial risk c. operational risk d.strategic risk

c. operational risk

Which of the following is a step in the risk-management process? a. Identifying all possible sources of financial loss b. Setting the goals of the risk management program c. Choosing the most efficient ways to handle the firm's loss exposures d. Measuring the frequency and severity of all loss exposures e. All of the above

e. All of the above