Chapter 1 Risk and Its Management

Chapter 1 Risk and Its Management Multiple Choice 1. The major types of business risk include all of the following except: a. b. c. d. price risk diversification risk pure risk credit risk Answer: b Type: K 2. Credit risk is: a. b. c. d. the risk that a firm’s borrowers will not make promised payments. the risk that a firm will not be able to get credit from lenders. the risk that a firm will not have sufficient funds to make payments to their creditors. the risk due to changes in output and input prices. Answer: a Type: K 3. All of the following are types of price risk except: a. b. c. d. commodity price risk exchange rate risk stock price risk interest rate risk Answer: c Type: K 4. Which of the following is not an example of a direct loss from pure risk? a. b. c. d. loss of profit damage to assets cost of paying and defending liability claims employee turnover Answer: a Type: A 126 5. Gallagher Winery is attempting to identify its pure risks. Which of the following is an example of an indirect loss for Gallagher? a. b. c. d. Loss of grapevines due to hail. Employee health problems due to insecticide usage. Loss of profit due to bad publicity about a liability claim. Cost of replacing equipment after a fire. Answer: c Type: A 6. Which of the following is not a method of loss financing? a. b. c. d. diversification retention insurance hedging Answer: a Type: K 7. Driving at lower speeds in order to reduce the probability of having an automobile accident is an example of: a. b. c. d. loss financing loss control internal risk reduction hedging Answer: b Type: A 8. What impact does routine inspection of aircraft for mechanical problems have on the risk of airplane crashes for United Airlines? a. b. c. d. reduced frequency of crashes reduced magnitude of loss if the crash occurs eliminate airplane crashes no impact on risk of airplane crashes Answer: a Type: A 127 9. An advantage of centralizing the function of risk management in the organization is: a. Reduced concern for risk management by managers and employees in the firm’s various operating units. Reduced diversification. Economies of scale in arranging loss financing. Less effective interaction between the risk manager and senior management. b. c. d. Answer: c Type: K 10. Vickie’s Vanities, Inc. is a small boutique that sells expensive designer clothing. Which one of the following is not a pure risk to the owner? a. b. c. d. losses due to theft of inventory loss of revenue due to recession liability claims for customer injury in the store risk of a liability claim for injury to an employee Answer: b Type: A 11. Which one of the following is not an example of a personal earnings risk? a. b. c. d. death stock dividends unemployment disability Answer: b Type: K 12. Ted’s Brewery imports beer from Thailand to the U.S. To facilitate the transactions Ted’s Brewery holds large amounts of Thai currency (baht). The uncertainty that Ted faces regarding the U.S. dollar value of his holdings of Thai currency is an example of a. b. c. d. price risk credit risk international risk pure risk Answer: a Type: A 128 13. Longevity is a major type of personal risk. The longevity risk refers to possibility that a person will a. b. c. d. hold an investment too long be unable to retire die before reaching retirement age outlive his (or her) financial resources Answer: d Type: K 14. Which one of following is not a major method of managing risk? a. b. c. d. loss control loss identification loss financing internal risk reduction Answer: b Type: K 15. Prairie Flowers sells fresh flowers at a curbside outlet. The owners know the expected level of daily sales as well as the variability of daily sales. They are trying to decide how large of a supply to provide at the outlet each day. Too few flowers results in lost sales, too many flowers results in spoilage (or wilting). This is an example of a. b. c. d. pure risk indirect loss credit risk the costliness of risk Answer: d Type: A I. Fill-Ins 1. The risk that a firm’s customers and parties to which it has lent money will fail to make promised payments is known as credit risk. 2. The three major risk management methods are financing , and internal risk reduction 3. Reducing the level of risk activity and increasing precautions against the loss are the two major approaches to loss control . 129 loss control . , loss 4. Three methods of financing losses are: retention , insurance , and hedging . (Answer could also include other contractual risk transfers.) 5. The major types of risk that produce fluctuations in cash flows and business value are price risk, credit risk, and pure risk. II. Problems and Short Answer Questions 1. What are the most important characteristics of pure risk as compared to other types of risk? Answer: The most important characteristics of pure risk include: a) the losses have the potential to be large relative to the business’ resources; b) the underlying causes are company-specific and the firm can take actions to reduce frequency and severity; c) they are often insurable; and d) there are not usually any offsetting gains to other parties. Type: K 2. Provide a brief outline of the steps in the risk management process. Answer: The key steps in the risk management process are: a) identify the risks; b) evaluate the potential frequency and severity of the losses; c) select the risk management methods to be used; d) implement the risk management methods; and e) monitor the risk management program on a regular basis. Type: K 3. Rocky’s Bagels, Inc. is a small bagel sandwich restaurant. Rocky is concerned about the risk of employees cutting themselves on the job. Assuming that Rocky has no interest in expanding his operation, which of the major risk management methods are likely to be most important to Rocky? Which will not be appropriate for Rocky? Explain. Answer: Rocky will need to focus on loss control. He can take increased precautions such as providing employees with instruction on cutting bagels or he can invest in equipment that does not require employees to be near the blades. Loss financing through insurance or retention can be used to cover the cost of losses that do occur but generally insurance for small regular losses will be too expensive. Internal risk reduction will be the least useful, since Rocky cannot diversify away this risk and additional information is not likely to reduce the losses. Type: A 130 4. Explain how the two major approaches to loss control (reducing the risky activity and increasing precautions) could reduce McDonald’s risk of customer burns due to hot coffee. Answer: Although McDonalds would not want to reduce coffee sales, they could reduce the risk by reducing the temperature of the coffee they serve. Increased precautions could include warning labels on cups and on coffee urns. Type: A 5. Fraternities on college campuses are exposed to significant risks from serving alcohol at social functions. What are some of the direct and indirect costs of this risk? Answer: Direct costs include damage to fraternity property or guests during parties, potential liability for injuries caused by party attendees, costs of fines imposed. Indirect costs include potential loss of charter from national fraternity or the sponsoring university, reduced membership if reputation of fraternity is damaged. Type: A 131