A firm’s Default Risk, the Measurement of the Chances of the Event GMAT Reading Comprehension

Reading Passage Question:

A firm’s default risk, the measurement of the chances of the event in which the company will be unable to make the required payments on its debt obligations, reflects not only the likelihood that the firm will have bad luck but also the risk that the firm’s managerial decisions will lead the firm to default. Such management risk occurs because the impact of management on the firm’s value is uncertain, and this uncertainty affects the market’s perception of a firm’s risk. Uncertainty about management is likely to be the highest when there is a new management team and should decrease over time as management’s ability becomes known more precisely. In particular, when the new CEO is not considered an “heir apparent” prior to getting the position, or when he comes from outside of the company, or when the new CEO is younger, the market is expected to perceive relatively high uncertainty about the CEO’s ability or future actions. Accordingly, it comes as no surprise that the CDS spread, a measure of a firm’s expected default risk, is about 35 basis points higher when a new CEO takes office than three years into his tenure. The CEO, however, is not the only member of the management team who is relevant for decision making in the firm. Chief Financial Officers (CFOs) have a large role in financial decision-making, so uncertainty about new CFOs could also affect the firm’s default risk and cost of borrowing.

Now, a central feature of financial markets is that the interest rate a firm pays on debt increases with an increase in the market’s perception of the firm’s risk. This risk occurs because of factors that affect the value of the firm’s underlying assets and because of uncertainty about how these assets will be managed. The literature on debt pricing typically does not distinguish between these types of underlying risks. However, all risks, including those generated by uncertainty about management, affect the likelihood of default. Consequently, a rational market should incorporate managerial-generated uncertainty into its assessment of a firm’s risk when pricing its securities. Also since uncertainty about management affects firms’ costs of borrowing and consequently their financial policies, the value of maintaining transparency in managerial policies and communicating them to the marketplace should be realized.

‘A firm’s default risk, the measurement of the chances of the event’ is a GMAT reading comprehension passage with answers. Candidates need a strong knowledge of English GMAT reading comprehension.

This GMAT Reading Comprehension consists of 7 comprehension questions.

The GMAT Reading Comprehension questions are designed for the purpose of testing candidates’ abilities in understanding, analyzing, and applying information or concepts. Candidates can actively prepare with the help of GMAT Reading Comprehension Practice Questions.

Questions and Solutions

1. Which of the following statements would the author most likely agree with?

1. Even though uncertainty about a new CEO’s ability has more impact on a firm’s default risk, uncertainty about a new CFO could affect the rate at which the firm is lent money and its default risk
2. The uncertainty about a new CEO is likely to be comparably lower when an expected candidate takes over the position vis-à-vis an unexpected one.
3. Because the literature on debt pricing normally does not differentiate between the types of risks, sometimes the default risk is not calculated thoroughly.
4. As the tenure of a new CEO progresses, the uncertainty regarding his ability decreases considerably.
5. By maintaining transparency in managerial policies, a firm can successfully negotiate its terms in the market.

2. The author is primarily concerned with

1. highlighting the importance of a risk factor that is normally not easily understood in the business world
2. discussing how a particular factor, though important, gets neglected most of the time
3. describing how a risk factor in the business world gets more importance in some situations than in others
4. explaining how different risk factors need to be given importance as per their relative weightage
5. discussing the relevance of a risk factor that affects more than one aspect of the business world

3. Which of the following CANNOT be inferred from the passage?

1. Market’s perception of the firm’s risk is minimal when the new CEO is an “heir apparent” or is from within the existing management team.
2. The uncertainty regarding a new CEO is likely to be more in the first years of his tenure than in the fourth year.
3. The default risk of a firm represents more than one thing about the firm.
4. It is unusual for a piece of literature on debt pricing to differentiate between the risk generated from the factors affecting a firm’s asset and one generated from how these assets will be managed.
5. Uncertainty about management affects a firm’s financial policies.

4. Which of the following is mentioned in the passage?

1. The default risk, as per the CDS spread, is highest when the new CEO of a firm is younger than an average CEO.
2. Besides the CFO and the CEO, there are other members in a firm whose decisions could affect default risk.
3. The literature on debt pricing normally ignores underlying risks.
4. As the perception of the market regarding a firm’s risk increases, the rate at which the firm pays interest on debt also increases.
5. The uncertainty surrounding the perception of a firm’s risk leads to management risk.

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