Chapter 27

Enterprise Risk Management: A Case Study

(Several of these questions apply specifically to the United Grain Growers (UGG) case.)

I. Multiple Choice

1. Enterprise risk management is the process of identifying and managing

a. a firm’s expected profit sources

b. all of a firm’s commodity risks
c. all of a firm’s risk exposures within a unified framework
d. a firm’s exchange rate and interest rate risks

Answer: c
Type: K

2. Potential benefits of enterprise risk management include

a. risk managers obtaining a broad understanding of the risks facing the firm
b. better decision-making with regards to financial risks and pure risks
c. a unified set of methods and terminology for handling risks of all types
d. all of the above

Answer: d
Type: K

3. In the UGG case, the frequency of losses from counterparty risk was modeled with
the

a. normal distribution
b. poisson distribution
c. lognormal distribution
d. all of the above

Answer: b
Type: K

4. In the UGG case, the severity of losses from counterparty risk was modeled with the

a. normal distribution
b. poisson distribution
c. lognormal distribution
d. all of the above

Answer: c

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Type: K

5. Which risk exposure was identified as UGG’s main source of unmanaged risk?

a. counterparty risk
b. commodity price and basis risk
c. environmental liability
d. weather effects on grain volume

Answer: d
Type: K

6. Analysts for UGG concentrated on six major risk exposures. Probability distributions
were used to model (and quantify) each exposure’s

a. total losses
b. impact on UGG’s return on equity
c. impact on UGG’s earning before interest and taxes
d. all of the above

Answer: d
Type: K

7. In addition to modeling each of UGG’s six major risk exposures with probability
distributions, analysts also

a. computed the correlations between these major sources of risk

b. quantified the impact of combinations of these risks
c. modeled the impact of these risks on UGG’s financial performance
d. all of the above

Answer; d
Type: K

8. Why was it appropriate for the UGG analysts to use a time trend variable in a
regression equation modeling crop yields?

a. because crop yields vary from year-to-year

b. to capture productivity increases over time
c. to measure the length of the growing season
d. to adjust for annual crop quality

Answer: b
Type: A

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9. Analysts for UGG performed regression analysis with assorted dependent variables,
e.g. wheat from Alberta. In addition to a time trend variable, what other two
variables were used as explanatory variables?

a. average June temperature and average July precipitation

b. average June temperature and average fertilizer application in May
c. average July precipitation and average fertilizer application in May
d. average fertilizer application in May and average length of the growing season

Answer: a
Type: K

10. If average temperature and average precipitation variables in Alberta are highly
correlated with the respective variables in Saskatchewan, geographic diversification
will

a. do little to reduce the exposure to weather risk

b. provide some reduction in the exposure to weather risk
c. effectively eliminate the exposure to weather risk
d. none of the above (correlation dos not impact the effects of diversification)

Answer: a
Type: A

11. In the years just prior to their enterprise risk management endeavor, UGG had
undertaken a significant increase in capital expenditures (mostly on large grain
elevators). These expenditures, as well as plans to undertake more, create a big
disadvantage for which of the following risk management approaches?

a. retention
b. weather derivatives
c. insurance contract
d. both (a) and (b)

Answer: a
Type: A

12. The main advantage of UGG retaining the weather risk is

a. being able to hold extra equity capital

b. stability of cash flows
c. not having to pay the cost of shifting the risk to someone else
d. all of the above

Answer: c
Type: K

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13. Which of the following is a potential underlying variable for a weather derivative
used by UGG to manage its exposure to weather risk is

a. heat index
b. average temperature
c. average rainfall
d. all of the above

Answer: d
Type: K

14. UGG’s managers thought it might be possible to design an insurance contract that
paid out when grain shipments were abnormally low (the main affect of the weather
risk). A problem with this approach is moral hazard. A proposed solution to moral
hazard was to base the contract payouts on

a. a competitor’s grain shipment volume

b. the industry-wide volume of grain shipments
c. the correlation between the industry shipments and UGG’s shipments
d. UGG’s market share

Answer: b
Type: K

15. While hedging weather risk using derivatives is technically feasible, a major problem
remains with implementation due to the difficulty of

a. structuring a contract and specifying payoffs

b. collecting consistent data (each year)
c. predicting the weather and grain shipments
d. controlling moral hazard

Answer: a
Type: A

II. Fill-Ins

1. The new position established by some corporations to facilitate enterprise risk

management is the chief risk officer .

2. UGG’s main source of unmanaged risk was weather exposure .

3. The correlation coefficient helps quantify the impact of combinations

of risk exposures.

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4. The uncertainty of suppliers and customers not fulfilling their contracts
is known as counterparty risk.

5. The two main variables used by the UGG analysts to explain the volatility of crop
yields were average June temperature and average July precipitation
.

III. Problems and Short Answer Questions

1. A risk management committee for United Grain Growers identified 47 exposure

areas. From this list they chose the top six exposures – list these six risk exposures
faced by UGG.

Answer:

• environmental liability
• weather effects on grain volume
• counterparty risk (suppliers and customers not fulfilling contracts)
• credit risk
• commodity price and basis risk
• inventory risk (physical damage)

Type: K

2. What was the value of computing the correlations between the six major sources of
risk?

Answer: Computing these correlation coefficients helped quantify the impact of these
risks in combination. If two risk exposures are highly correlated, diversification
gains from combining these risks will be minimal.

Type: A

3. UGG can potentially hedge their weather risk with the use of weather derivatives. In
the context of the UGG case, describe the hedging instrument and the basis risk of
such a derivative.

Answer: The hedging instrument (or variable) would be some sort of weather variable,
such as average rainfall or temperature. The basis risk of a weather derivative
would be a function of the relationship between the weather variable and UGG’s
weather induced fluctuations of crop production.

Type: A

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4. How can the payouts from a weather derivative work to hedge UGG’s exposure to
weather risk?

Answer: Weather conditions influence crop production and, ultimately, the revenue from
grain shipments. A weather derivative can counterbalance any fluctuations in
revenue by generating a payoff when revenue from grain shipments is low. The
graph below displays the derivative payoff being positive when the unhedged profits
are negative.
Payoff Profits
DerivativeUnhedged

Weather Index

Weather Index

Type: A

5. Explain the moral hazard problem of forming an insurance contract that has payouts
triggered by UGG’s level of grain shipments. How does using the industry-wide
level shipments mitigate this problem?

Answer: Using the level of UGG’s grain shipments has a policy trigger is the classic
moral hazard example of loss occurrence being under the control of the insured. The
incentive to optimize shipments is absent if the insurance contract will payout in the
case of a low level of shipments.

Using the industry-wide level of shipments mitigates this problem because there
should be high degree of correlation between the level of UGG shipments and the
industry-wide level, yet because of its relatively small market share, UGG will be
unable to influence the industry-wide level of shipments.

Type: A

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