AIM 3: Discuss the development and implementation steps of an enterprise risk management system.

1、Risk management:

A) exacerbates the need for a firm to hold a reserve of liquid assets.
 
B) has no effect on the need for the firm to hold liquid assets.
 
C) has no impact on the expected costs of financial distress.
 
D) is a substitute for investing equity capital in liquid assets. 

The correct answer is D

A company with liquid assets sufficient to fund all of its positive NPV projects would not be exposed to the underinvestment problem when it encountered cash flow deficits. Alternatively, the company can institute a risk management program to insure (at some level of statistical significance) that its operating cash flow will not fall below the level needed to fund valuable projects. Thus, risk management can be viewed as a substitute for investing equity capital in liquid assets.

2、The goal of enterprise risk management is to:

A) optimize total risk by trading off the expected returns from risk taking with the expected costs of financial distress.
 
B) eliminate total risk.
 
C) keep a liquid asset buffer of size sufficient to fund all positive NPV projects.
 
D) make sure that projects are never passed up because of shortfalls in operating cash flow.

The correct answer is A

The goal of ERM is to optimize (not eliminate) total risk by trading off the expected returns from taking risks with the expected costs of financial distress, where financial distress is defined as circumstances where the firm must forego positive NPV projects. Optimizing this tradeoff maximizes firm value.

3、The primary function of corporate risk management is to:

A) optimize the level of a firm’s nondiversifiable risk.
 
B) minimize diversifiable risk. 
 
C) protect the company’s strategic plan.
 
D) reduce the likelihood of a hostile takeover.

The correct answer is C

The primary function of risk management is to protect the company’s strategic plan by choosing a total risk level that trades off the benefits of risk taking and the expected costs of the underinvestment problem.

AIM 6: Explain the use of economic capital in the corporate decision making process.

1、Which of the following statements about economic capital is (are) TRUE?

The economic capital system provides an appropriate level of capital to meet any potential disaster.
The economic capital system ensures that the firm is not overcapitalized.
The economic capital system properly manages the risk of the firm.
The economic capital system makes sure capital is efficiently utilized.
A) I only.
 
B) II and IV only.
 
C) I and III only.
 
D) I, II, III, and IV.

The correct answer is D

All of the statements concerning the economic capital system are accurate.

AIM 7: Discuss why corporations can keep or offload various operational risks.

1、Core business and strategic risks:

A) should be retained because the firm has a comparative advantage in bearing these risks.
 
B) can be cost effectively transferred to other parties by hedging.
 
C) are more easily assessed by outsiders than by the firm’s management.
 
D) should always be hedged to minimize their contribution to the firm’s systematic risk.
 

The correct answer is A

A company has a comparative advantage in bearing its strategic and business risks, because it knows more about these risks than do outsiders. Because of this informational advantage, the firm cannot transfer these risks cost effectively.

2、Which of the following is a system designed to capture risks of all types through an organization?

A) Complete risk formulation (CRF).
 
B) CreditMetrics.
 
C) Monte Carlo simulation.
 
D) Enterprisewide risk management (ERM).
 

The correct answer is D

An enterprisewide risk management (ERM) system is designed to capture and manage all types of risk exposures throughout an organization.