Sample Questions-2017

Along with all the examples covered in-class, the following are some extra questions
which can be used when revising the course. ( N.B. The questions listed below
should be considered as parts to Questions rather than whole Questions.)

Risk and Risk Management

1. Outline how a consumer and an entrepreneur can use the money market to
achieve their objectives. (The Separation Principle). Graphically illustrate your
answer.

2. Peter Pan and Mary Murphy are security analysts. They frequently discuss their
personal viewpoints on various investment opportunities, compare their
conclusions, and offer each other suggestions on how to improve their
investment decision-making skills. Peter has the following logarithmic utility
function U=Ln(r), where r = rate of return. In contrast, Mary has the following
logarithmic utility function U= √r. Peter and Mary have been arguing over
whether the White Corporation’s stock or Zebra Inc.’s stock is the most desirable
investment. Peter and Mary have argued on the following probability
distributions of returns for White and Zebra, but they disagree about which is the
better investment: White or Zebra. Explain your choice.

Rate of Probability
Return, r

White 5.0% 0.25

10.0% 0.50
20.0% 0.25

Zebra 10.0% 0.25

20.0% 0.50
40.0% 0.25

3. Assuming that you have a logarithmic utility function U(W)=Ln(W), and that
you are exposed to a situation that results in a 50/50 chance of winning/losing
£1,000. However, you can buy insurance that completely removes the risk for a
fee of £284.
(a)(i) If your current level of wealth is £7,000 would you buy the insurance or take
the gamble? Show your work using the Arrow-Pratt approach.
(ii) What if your wealth is £6,000, in this case would you buy the insurance? Show
your work using the Markowitz approach.
(iii) What can you say about your willingness to accept risky gambles as your wealth
increases? How does your answer compare to a person facing the same risky
gambles who has a power utility function, U(W)=-2W-2 ?

4. “A risk–averse investor who makes an investment choice based on the expected

utility of the return on his investment portfolio is equivalently making
investment choices based on the expected return and variance of the portfolio.”
[Blake, D. (1999) Financial Market Analysis. Wiley, pg. 465]
Prove or disprove this statement.

5. Why are most investors risk averse? Explain your answer.

6. Write a brief note explaining the equity premium puzzle.

A phenomenon that describes the anomalously higher historical real

returns of stocks over government bonds. The equity premium, which is
defined as equity returns minus bond returns, has been about 6% on
average for the past century. It is supposed to reflect the relative risk of
stocks compared to "risk-free" government bonds, but the puzzle arises
because this unexpectedly large percentage implies a suspiciously high
level of risk aversion among investors.

- 1.5
7. You have a power utility function U(W) = -1.5W , and your current level
of wealth is €10,000.
(i) Suppose you are exposed to a situation that results in a 50/50 chance of winning
or losing €1,000. If you can buy insurance that completely removes the risk for a fee
of €300, will you buy it or take the gamble?
(ii) Suppose, you accept the gamble in (i) and win and your wealth is increased to
€12,000. If you are faced with the same gamble and have the same offer of insurance
as before, will you buy the insurance the second time round?
(iii) As your wealth increases, will more, the same, or less money be invested in
risky assets? Explain why or why not.

8. You have a logarithmic utility function U(W) = Ln(W), and your current level
of wealth is €8000.
(i) Suppose you are exposed to a situation that results in a 50/50 chance of winning
or losing €1,000. How much will you pay to avoid this risk?
(ii) How much would you pay if your level of wealth were €800000?

9. “Investing with certainty is now a redundant concept in today’s turbulent

markets.” Discuss.

10. Analyse the following utility function:

U(W)= Ln(W)
 a. Draw a graph of the function.
b. Is marginal utility increasing, constant or decreasing?
c. What is the function’s absolute risk aversion (ARA)?
d. What is the function’s relative risk aversion (RRA)?
e. As the investor’s wealth increases, will more, the same, or less money
be invested in risky assets?
f. As the investor’s wealth increases, will a larger, the same, or a smaller
proportion of the investor’s total wealth be invested in risky assets?

11. Explain how the concept of utility is linked to the risk and return of an
investment.

12. “In general, the Markowitz measure of a risk premium is superior for large or
asymmetric risks. This does not mean that the Arrow-Pratt definition of risk
aversion is not useful.” (Copeland, 1992).
Do you agree/ disagree with this statement. Explain your answer.

1. Give some examples of how someone would demonstrate that they are:
- a risk lover
-risk averse

13. There are many theories that describe decisions between alternatives that
involve risk. Briefly outline 4 of these theories, giving examples.

14. Discuss the concept of Behavioural Finance and how it can impact on investor
attitudes to risk.
The area of finance dealing with the implications of investor reasoning errors on
investment decisions and market prices.

【Prospect theory】
Mental Accounting :
It is human nature to mentally account for gains and loses by equating stock price to
purchase price. How you feel about investment depends on whether you are ahead
or behind.
When you engage in mental accounting unknowingly have personal relationship
with each of your stocks.

House Money :
Casinos have found the gamblers are far more likely to take big risk if only they have
won from the casino.
I.e. house money

【Overconfidence】
Trading frequency :
male traders buy and sale very frequently .
Females are likely buy and hold it longer and sale.
Diversification :
It was classic example of overconfidence. Investors tend to invest to heavily in
company which they working and also local company.

【Misperceiving Randomness】
‘Hot hands’
Clustering \\not really randomness
Gambler’s Fallacy
Risk seeking behavior \\lottery
Risk aversion
Portfolio return
i.e. investors demand higher return than it necessary to compensate for taking on
risk.

People are much more risk averse than they admit to, or that the models account for.
Our current asset pricing models are wrong.

15. Explain a firm’s reasons for managing risk.

Reduce the volatility of earning

Reduce the cash flow from operations.
Firm has more control over earnings volatility and thus performance.
(more early achieve its goals)
Reduce likelihood that a financial institution will fail.
Financial system is safer and less prone to disruption.
(too big to fail)

16. ‘The whole idea of trying to manage risk in today’s ever changing environment
is a useless pursuit.’ Discuss this statement.

17. All firms face business risk and market risk. Explain the difference between
them and list their components.
market risk/system risk
business risk/can control
 Interest rate risk  Model risk
 Foreign exchange risk  Operational risk
 Commodity price risk  Legal risk
 Liquidity risk
 Credit risk
 18. Describe some analysis tools used in risk management.

VaR

19. Describe the steps for creating a risk policy.

20. What is the purpose of a risk management policy?

1. to protect the shareholders of the firm from the management of the firm.
2. protect the managers from themselves by outlining the specific actions that may
or may not be taken. The policies force managers to work together within a
unified framework toward a common goal.
3.The policy statement is designed so a well-informed independent reviewer can
understand why something was done and the way it was done.
4.The policy should be developed by senior management under the supervision of
the Board of Directors.
5.The policy statement is designed so a well-informed independent reviewer can
understand why something was done and the way it was done.
The policy should be developed by senior management under the supervision of
the Board of Directors.

21. What is the VaR (Value-at-Risk) measure and why is it used?

VaR is a currency based measure of maximum expected loss under a normal market
condition, over an given investment period, in a pre-determined level of confidence.
…
There are several reasons why we use VaR to measure risk:
1. Value At Risk is easy to understand: VAR is just one number giving you a rough
idea about the extent of risk in the portfolio. This makes VAR very easy to interpret
and to further use in analyses.
2. Comparing VAR of different assets and portfolios: You can measure and compare
VAR of different types of assets and various portfolios. Value At Risk is applicable to
stocks, bonds, currencies, or any other assets with price. VAR can be used to
compare profitability and risk of different units and allocate risk.
3. VAR is often available in financial software: Value At Risk is a frequent part of
various types of financial software. Availability is a big advantage of VAR.

22. ‘Risk Management is simply a process of determining the risk involved in

a project before it begins.’ Discuss
 23. Discuss Operational Risk, making reference to its four components, causes
of operational risk, and managing it.

24. ‘Since you can never predict every threat, risk management is a waste of
time. ‘Discuss.

25. Why is the management of risk so important?

26. Discuss the evaluation of risk management performance.

Objective 1: Achieve a financial target where the goal to as close as possible to

the target.
Objective 2: Achieve a financial target but undershoot the target.
Objective 3: Achieve a financial target subject to a minimum acceptable result.
Objective 4: Achieve a financial target subject to a maximum acceptable result.
Objective 5: Maintain the status quo.

27. ‘Risk management is not rocket science-it cannot be, since the past does
not repeat itself on a sufficiently reliable basis. Future risks cannot be
understood without examining the economic forces that shape
them…..However, understanding risks makes sense only if that
understanding is used to create value. This means that risk management
cannot be done independently of an understanding of the profits that come
from taking risks.’ [Rene Stultz, ‘Why Risk Management is not a Rocket
Science’, Financial Times, 27 June 2000]
Do you agree/ disagree with this statement. Explain your answer.

28. ‘An inadequate risk management function can lead to disaster.’ Discuss
this statement with reference to a company you have studied.

29. Explore the concept of business risks, giving specific examples.

Business risk has five component parts.

First, operational Risk is the risk of the failure of the internal systems that manage a
business.
Second, Legal Risk is the risk that contracts are not enforced.
Thirdly, Credit Risk is when a party to a financial transaction does not have the
ability to make the required payments under the contract.
And Liquidity Risk is the need to sell (unwind) an asset at an unfavorable price
because of a very near-term need for cash.
At last, Model Risk is that financial models may not do what a person excepts or
needs them to do.
…
 30. What lessons can be learned from the many well-documented examples of
risk management failures?

31. Briefly outline some frameworks you have looked at to assess operational
risk.

32. Discuss in detail the important business risks identified by the Ernst and
Young risk survey you studied, giving examples.

33. In the wake of the recent economic crisis, has risk management practices
and attitude to risk changed?

34. Discuss what you know about the management of Fraud Risk.

Identify Risk
An enterprise risk assessment process identifies and prioritizes a company’s risks,
providing quality inputs to decision makers for the purpose of formulating effective risk
responses including information about the current state of capabilities around
managing the priority risks.
Source Risk
Once priority risks are identified, they are traced to their root causes. If management
understands the drivers of risk, it is easier to design risk metrics and proactive risk
responses at the source.
Measure Risk
Measurement methodologies may be simple and basic, e.g., risk rating or scoring, claims
exposure and cost analysis, sensitivity analysis, stress testing and tracking key variables
relating to an identified exposure. More complex methodologies for companies with
more advanced capabilities might include value at risk, earnings at risk, rigorous
analytics that are proprietary to the company and risk-adjusted performance
measurement.
Evaluate Risk
The organization first decides whether to accept or reject a risk based on an assessment
of whether the risk is desirable or undesirable. A desirable risk is one that is inherent in
the entity’s business model or normal future operations and that the company believes
it can monitor and manage effectively. An undesirable risk is one that is off-strategy,
offers unattractive rewards or cannot be monitored or managed effectively.
Mitigate Risk
Depending on the risk response selected, management identifies any gaps in risk
management capabilities and improves those capabilities as necessary to implement the
risk response. Over time, the effectiveness of risk mitigation activities should be
monitored.
Monitor Risk
Models, risk analytics and web-enabled technologies make it possible to aggregate
information about risks using common data elements to support the creation of a risk
management dashboard or scorecard for use by risk owners, unit managers and
executive management.

35. What are the key elements of good Fraud Risk Management?

Hegde Funds and Restructuring

1. Why is it difficult to access hedge fund data? Why might it matter?

Big-name hedge funds like Third Point Capital, Paulson & Co, Pershing Square
Capital Management, and Eton Park Capital Management have made it tougher
for investors to see fund performance, using complex password-protected
websites and putting in settings that forbid things like printing, forwarding, and
copying and pasting.

2. How do hedge funds differ from other types of funds you might have studied
(i.e. mutual funds)?
 mutual funds
They invest in publicly traded securities (stocks & bonds), and anyone is
allowed to join. To protect general public investors, Mutual Funds are
heavily regulated and restricted in what they can invest into.

 hedge funds
Hedge Fund is an investment partnership restricted to "sophisticated
investors" - people who have enough experience to protect themselves.
Hedge Funds are not allowed to accept capital from general public; in
exchange, they don't have restrictions on what they can invest into.
• relative return
• Short and long positions in shares

3. How do hedge fund managers deal with the complexities of investing in very
illiquid assets?
Side pocket accounts are exclusively used in the hedge
fund industry by hedge fund managers. Their purpose is
to separate illiquid, hard-to-value assets from liquid
assets.
 Investors who leave the hedge fund may not be able to
redeem their side pocket investment from the fund, but
they still receive a share of the value when it gets
realized.

4. ‘The fee structure of the hedge fund industry can encourage managers to take
undue risks. 过度风险 ’ Do you agree with this statement? Explain your answer.

Fee structure: Instead of charging an expense ratio only,

hedge funds charge both an expense ratio and
a performance fee. The common fee structure is known as
"Two and Twenty" - a 2% asset management fee and then
a 20% cut of any gains generated.
…
Tactical Diversification
Hedge funds are best utilized in the context of an overall investment
plan, where they can increase diversification or enhance an asset
allocation strategy. Hedge funds are managed to act as a non-
correlating asset that can complement an equity portfolio.
Portfolios that are heavy with equities could use short-biased
or market neutral funds as a hedge, and portfolios weighted
toward fixed-income investments may want to add a fixed-
income arbitrage fund to counter rising interest rates. The key
to matching the right type of hedge fund to an asset allocation
strategy is understanding the fund’s objective and its return
and risk aim.

5. ‘The performance of hedge funds is very hard to evaluate’. Discuss this

statement.
1. Investment Risk
2. Fraud Risk
3. Operational Risk

6. Discuss some hedge fund strategies you have studied.

• Arbitrage
• Long/short strategy (relative value)
– Equity long/short
– Dedicated short bias
• Market-neutral
• Fixed-income relative value/fixed-income arbitrage
• Convertible bond (warrant) arbitrage.
 • Event-driven
• Merger arbitrage
• Activist strategy
• Global macro
• Fundamental growth
• Fundamental value
• Multi strategy.

7. Discuss the concept of bankruptcy and outline its advantages and disadvantages.

Bankruptcy is a legal proceeding involving a person or

business that is unable to repay outstanding debts. All of
the debtor's assets are measured and evaluated, and the
assets may be used to repay a portion of outstanding
debt.

Bankruptcy is the primary instrument for reallocating means of production

from inefficient to efficient firms. Bankruptcy offers an individual
or business a chance to start fresh by forgiving debts that
simply cannot be paid, while offering creditors a chance to
obtain some measure of repayment based on the
individual's or business' assets available for liquidation.
…
Advantages
1. Most creditors must stop their collection efforts. In addition, the bankruptcy
process is quite fast. Thus, the debtor can begin rebuilding his credit.
2.Ruins a debtor's credit for a number of years and may cause embarrassment.
3.Filing for bankruptcy will allow many debtors to get started sooner on rebuilding
their credit in peace.
Disadvantages
1.Losing credit cards and non-essential possessions.
2.A record of bankruptcy is maintained on your credit file for at least half a
dozen years.
3.Tax refunds from federal, state or local governments may be denied based
upon your bankruptcy.
4.Some employers may frown upon your record, especially if the debtor works
in the financial field.
5.Forbidden from being a director for limited liability companies

2. Discuss the personal implications of declaring bankrupt.

As an investor, you are between a rock and a hard place if
your company faces bankruptcy. you are accepting this added
risk.
When a company is going through bankruptcy proceedings,
its stocks and bonds usually continue trading, albeit at
extremely low prices. Generally, if you are a shareholder, you
will usually see a substantial decline in the value of your
shares in the time leading up to the company's bankruptcy
declaration.
When your company goes bankrupt, there is a very good
chance you will not get back the full valueof your investment.
In fact, there is a chance you won't get anything back.

3. What are the main causes of bankruptcy?

 Ill conceived strategy
 Badly implemented strategy
 Market Changes
 Cost problems

4. ‘Bankruptcy is a process that only has the survival of the firm as its objective. ‘
Discuss
o Paying-down the liabilities of the firm
o Minimising the disruptive impact on the industry
o Minimising the social impact

5. ‘Bankruptcy is the only option for an insolvent firm in today’s turbulent market.’
Discuss

6. Discuss the implications of bankruptcy on financial theory.

o The Efficient Markets Hypothesis
In the efficient markets hypothesis, bankruptcy is nothing more than a reallocation
of assets and liabilities to more efficient companies. It should not have an impact
on investor wealth, because investors all hold perfectly diversified portfolios.
Bankruptcy, therefore, is simply a recomposition of the portfolio
o Signal Theory and Agency Theory
The possibility of bankruptcy is a key element of signalling theory. An aggressive
borrowing strategy sends a positive signal to the market, because company
managers are showing their belief that future cash flows will be sufficient to meet
the company s commitments. But this signal is credible only because there is also
the threat of sanctions: if managers are wrong, the company goes bankrupt and
incurs the related costs.
 o Free riders 搭便车
Lastly, a company in financial difficulties gives rise to the free rider problem. For
example, a small bank participating in a large syndicated loan may prefer to see
the other banks renegotiate their loans, while keeping the terms of its loan remain
unchanged.
o The limits of limited Liability
Modern economies are based largely on the concept of limited liability, under
which a shareholder s commitment can never exceed the amount invested in the
company. It is this rule that gives rise to the conflicts between creditors and
shareholders and all other theoretical ramifications on this theme.

7. “Bankruptcy always ultimately leads to the death of the company.” Discuss this
statement with reference to some cases you have studied.

8. Compare and contrast the three key areas of corporate restructuring, with
reference to some cases you have examined.

9. Compare and contrast the three types of liquidations we have studied.

There are three types of liquidation: members' voluntary liquidation, creditors'

voluntary liquidation and lastly compulsory liquidation.

The first one is members' voluntary liquidation agreement, this form of liquidation
occurs when the company has enough money in order to pay off all the debts owed.
This is usually the chosen method for shareholders when an important person dies
or the company no longer sees a future for itself. Although the downfall of any
business is bad, by doing a voluntary members' liquidation agreement, the company
can ensure that it fulfils its obligations within good faith.

The second is the creditors' voluntary liquidation agreement, they unfortunately

have very little and as such it tends to be the debtors that enforce their rights in
order to send the company into voluntary liquidation in order to fulfil its debts.
However, it is important to note that it is still the shareholders that decide whether
to keep the business running or not.

The third type of voluntary liquidation is, as earlier mentioned, compulsory

liquidation. Compulsory liquidation is when a winding up petition has been issued
and the court has found in favour of the debtors, this is probably the less likely
occurrences as business prefer to be paid in full rather then shut a company down in
order to recover less than it wants to due to the business simply not having the
money to pay.
10. Discuss the role of the liquidator, including the appointment, the duties of a
liquidator, and the powers of a liquidator.

11. Discuss the role of the receiver, including the appointment, the duties of a
receiver, and the powers of a receiver.

12. Briefly discuss some of the informal process available to firms in trouble.

13. ‘Informal resolution processes are useless to a firm in trouble in today’s

turbulent market place.’ Discuss this statement.