FIN 540 – Homework Chapter 23  

1. Which of the following are NOT ways risk management can be used to increase the value of a firm?

a. 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.

d. Risk management can allow managers to defer receipt of their bonuses and thus postpone tax payments.

e. Risk management can increase debt capacity.  

Option d is correct.

Risk management can allow managers to defer receipt of their bonuses and thus postpone tax payments. Hence, this can increase the value of the firm.

2. Which of the following statements about interest rate and reinvestment rate risk is CORRECT?

a. 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.

e. Variable (or floating) rate securities have more interest rate (price) risk than fixed rate securities.  

Option a. 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.

3. A swap is a method used to reduce financial risk. Which of the following statements about swaps, if any, is NOT CORRECT?

a. 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.  

Option c is correct.

A problem with swaps is that no standardized contracts exist, which has prevented the development of a secondary market.

4. Which of the following statements is most CORRECT?

a. 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.  

Option a. is correct.

Futures contracts generally trade on an organized exchange and are marked to market daily.

5. A commercial bank recognizes that its net income suffers whenever interest rates increase. Which of the following strategies would protect the bank against rising interest rates?

a. Entering into an interest rate swap where the bank receives a fixed payment stream, and in return agrees to make payments that float with market interest rates.

b. Purchase principal only (PO) strips that decline in value whenever interest rates rise.

c. Enter into a short hedge where the bank agrees to sell interest rate futures.

d. Sell some of the bank’s floating-rate loans and use the proceeds to make fixed-rate loans.

e. Buying inverse floaters.

Option c is correct.

Enter into a short hedge where the bank agrees to sell interest rate futures.