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business
principles of risk management

Questions and Answers of Principles Of Risk Management

List the bankruptcy costs incurred by the company in Business Snapshot 1.1.AppendixLO1
The return from the market last year was 10% and the risk-free rate was 5%.A hedge fund manager with a beta of 0.6 has an alpha of 4%. What return did the hedge fund manager earn?AppendixLO1
Suppose that one investment has a mean return of 8% and a standard deviation of return of 14%. Another investment has amean return of 12% and a standard deviation of return of 20%. The correlation
The expected return on the market is 12% and the risk-free rate is 7%. The standard deviation of the return on the market is 15%. One investor creates a portfolio on the efficient frontier with an
A bank estimates that its profit next year is normally distributed with a mean of 0.8% of assets and the standard deviation of 2% of assets. How much equity(as a percentage of assets) does the
A portfolio manager has maintained an actively managed portfolio with a beta of 0.2. During the last year, the risk-free rate was 5% and major equity indices performed very badly, providing returns
How did concentration in the U.S. banking system change between 1984 and 2010?AppendixLO1
What government policies led to the large number of small community banks in the United States?AppendixLO1
What risks does a bank take if it funds long-term loans with short-term deposits?AppendixLO1
Suppose that an out-of-control trader working for DLC bank (see Tables 2.2 and 2.3) loses $7 million trading foreign exchange. What do you think would happen?AppendixLO1
What is meant by net interest income?AppendixLO1
Which items on the income statement of DLC bank in Section 2.2 are most likely to be affected by (a) credit risk, (b) market risk, and (c) operational risk AppendixLO1
Explain the terms “private placement” and “public offering.” What is the difference between “best efforts” and “firm commitment” for a public offering?AppendixLO1
The bidders in a Dutch auction are as follows:Bidder Number of Shares Price A 20,000 $100.00 B 30,000 $93.00 C 50,000 $110.00 D 70,000 $88.00 E 60,000 $80.00 F 10,000 $105.00 G 90,000 $70.00 H 80,000
What is the attraction of a Dutch auction over the normal procedure for an IPO? In what ways was Google’s IPO different from a standard Dutch auction?AppendixLO1
Management sometimes argues that poison pills are in the best interests of shareholders because they enable management to extract a higher price from would-be acquirers. Discuss this
Give three examples of the conflicts of interest in a large bank. How are conflicts of interest handled?AppendixLO1
A loan for $10 million that pays 8% interest is classified as nonperforming.What is the impact of this on the income statement?AppendixLO1
Explain how the loan loss provision account works.AppendixLO1
What is the originate-to-distribute model? Why was it not used in the period following July 2007?AppendixLO1
Regulators calculate that DLC bank (see Section 2.2) will report a profit that is normally distributed with a mean of $0.6 million and a standard deviation of$2.0 million. How much equity capital in
Explain the moral hazard problems with deposit insurance. How can they be overcome?AppendixLO1
The bidders in a Dutch auction are as follows:Bidder Number of Shares Price A 60,000 $50.00 B 20,000 $80.00 C 30,000 $55.00 D 40,000 $38.00 E 40,000 $42.00 F 40,000 $42.00 G 50,000 $35.00 H 50,000
An investment bank has been asked to underwrite an issue of 10 million shares by a company. It is trying to decide between a firm commitment where it buys the shares for $10 per share and a best
What is the difference between term life insurance and whole life insurance?Explain the tax advantages of whole life insurance.AppendixLO1
Explain the meaning of variable life insurance and universal life insurance.AppendixLO1
A life insurance company offers whole life and annuity contracts. In which contracts does it have exposure to (a) longevity risk, (b) mortality risk?AppendixLO1
“Equitable Life gave its policyholders a free option.” Explain the nature of the option.AppendixLO1
Use Table 3.1 to calculate the minimum premium an insurance company should charge for a $1 million two-year term life insurance policy issued to a woman aged 50. Assume that the premium is paid at
From Table 3.1, what is the probability that a man aged 30 will live to 90?What is the same probability for a woman aged 30?AppendixLO1
What features of the policies written by a property-casualty insurance company give rise to the most risk?AppendixLO1
Explain how CAT bonds work.AppendixLO1
Consider two bonds that have the same coupon, time to maturity and price.One is a B-rated corporate bond. The other is a CAT bond. An analysis based on historical data shows that the expected losses
How does health insurance in the United States differ from that in Canada and the United Kingdom?AppendixLO1
An insurance company decides to offer individuals insurance against losing their jobs. What problems is it likely to encounter?AppendixLO1
Why do property-casualty insurance companies hold more capital than life insurance companies?AppendixLO1
Explain what is meant by “loss ratio” and “expense ratio” for a propertycasualty insurance company. “If an insurance company is profitable, it must be Insurance Companies and Pension Plans
What is the difference between a defined benefit and a defined contribution pension plan?AppendixLO1
Suppose that in a certain defined benefit pension plan(a) Employees work for 40 years earning wages that increase with inflation(b) They retire with a pension equal to 75% of their final salary. This
Use Table 3.1 to calculate the minimum premium an insurance company should charge for a $5 million three-year term life insurance contract issued to a man aged 60. Assume that the premium is paid at
An insurance company’s losses of a particular type per year are to a reasonable approximation normally distributed with a mean of $150 million and a standard deviation of $50 million. (Assume that
During a certain year, interest rates fall by 200 basis points (2%) and equity prices are flat. Discuss the effect of this on a defined benefit pension plan that is 60% invested in equities and 40%
Suppose that in a certain defined benefit pension plan(a) Employees work for 45 years earning wages that increase at a real rate of 2%(b) They retire with a pension equal to 70% of their final
Go to the Insurance Information Institute's Web site at www.iii.org and use the following steps to find the most recent data on the largest life insurance companies by total revenue. Click on "ALL
Go to the Federal Reserve Board's Web site at www.federal reserve.gov and find the most recent distribution of life insurance industry assets for Table 3-2. Click on "Economic Research and Data."
An insurance company collected $3.6 million in premiums and disbursed $1.96 million in losses. Loss adjustment expenses amounted to 6.6 percent and dividends paid to policyholders totaled 1.2
a. What is the combined ratio for a property insurer that has a loss ratio of 73 percent, a loss adjustment expense of 12.5 percent, and a ratio of com- missions and other acquisition expenses of 18
An insurance company's projected loss ratio is 77.5 percent and its loss adjust- ment expense ratio is 12.9 percent. The company estimates that commission payments and dividends to policyholders will
Consider the data in Table 3-6. Since 1980, what has been the necessary invest- ment yield for the industry to enable the operating ratio to be less than 100 in each year? How is this requirement
What is the investment yield on premiums earned? Why has this ratio become so important to property-casualty insurers? LO.1
How is the combined ratio defined? What does it measure? LO.1
What does the expense ratio measure? Identify and explain the two major sources of expense risk to a property-casualty insurer. Why has the long-term trend in this ratio been decreasing? LO.1
What does the loss ratio measure? What has been the long-term trend of the loss ratio? Why? LO.1
Insurance companies will charge a higher premium for which of the insurance lines listed below? Why?a. Low-severity, high-frequency lines versus high-severity, low-frequency lines.b. Long-tail lines
Identify the four characteristics or features of the perils insured against by property-casualty insurance. Rank the features in terms of actuarial predict- ability and total loss potential. LO.1
How do unexpected increases in inflation affect property-casualty insurers? LO.1
What are the three sources of underwriting risk in the property-casualty insurance industry? LO.1
Contrast the balance sheet of a property-casualty insurance company (Table 3-5) with the balance sheet of a commercial bank (Table 2-5). Explain the balance sheet differences in terms of the
How have the product lines of property-casualty insurance companies changed over time? LO.1
What are the two major activity lines of property-casualty insurance firms? LO.1
How do state guarantee funds for life insurance companies compare with deposit insurance for depository institutions? LO.1
How does the regulation of insurance companies differ from the regulation of depository institutions? What are the major pieces of life insurance regulatory legislation? LO.1
How would the balance sheet of a life insurance company change if it offered to run a private pension fund for another company? LO.1
How do life insurance companies earn a profit? LO.1
Using the data in Table 3-2, how has the composition of assets of U.S. life insurance companies changed over time? LO.1
Contrast the balance sheet of a life insurance company (Table 3-3) with the balance sheet of a commercial bank (Table 2-5) and with that of a savings institution (Table 2-9). Explain the balance
a. Suppose a 65-year-old person wants to purchase an annuity from an insurance company that would pay $20,000 per year until the end of that person's life. The insurance company expects this person
You deposit $10,000 annually into a life insurance fund for the next 10 years, after which time you plan to retire.a. If the deposits are made at the beginning of the year and earn an interest rate
a. Calculate the annual cash flows of a $1 million, 20-year fixed-payment annu- ity earning a guaranteed 10 percent per year if payments are to begin at the end of the current year.b. Calculate the
Explain how life insurance and annuity products can be used to create a steady stream of cash disbursements and payments to avoid paying or receiving a sin- gle lump-sum cash amount. LO.1
Explain how annuity activities represent the reverse of life insurance activities. LO.1
What are the similarities and differences among the four basic lines of life insur- ance products? LO.1
What is the adverse selection problem? How does adverse selection affect the profitable management of an insurance company? LO.1
What is the primary function of an insurance company? How does this function compare with the primary function of a depository institution? LO.1
What is a principal only (PO) strip? What causes the price-yield profile of a PO strip to have a steeper slope than a normal bond? LO.1
What is an interest only (IO) strip? How do the discount effect and the prepay- ment effect of an IO create a negative duration asset? What macroeconomic effect is required for this negative duration
What are four reasons why an FI may prefer the use of either pass-through securities or CMOs to the use of MBBs? LO.1
From the perspective of risk management, how does the use of MBBS by an FI assist the FI in managing credit and interest rate risk? LO.1
What are mortgage-backed bonds (MBBS)? How do MBBS differ from pass- through securities and CMOs? LO.1
Why would buyers of class C tranches of collateralized mortgage obliga- tions (CMOS) be willing to accept a lower return than purchasers of class A tranches? LO.1
How does a class Z tranche of a CMO differ from a class R tranche? What causes a Z class to have characteristics of both a zero-coupon bond and a regu- lar bond? What factors can cause an R class to
What is a collateralized mortgage obligation (CMO)? How is it similar to a pass-through security? How does it differ? In what way does the creation of a CMO use market segmentation to redistribute
What conditions would cause the yield on pass-through securities with pre- payment risk to be less than the yield on pass-through securities without pre- payment risk? LO.1
How does the price on a GNMA bond relate to the yield on a GNMA option from the perspective of the investor? What is the option-adjusted spread (OAS)? LO.1
What is the goal of prepayment models that use option pricing theory? How do these models differ from the PSA or empirical models? What criticisms often are directed toward these models? LO.1
What is the burnout factor? How is it used in modeling prepayment behavior? What other factors may be helpful in modeling the prepayment behavior of a given mortgage pool? LO.1
What factors may cause the actual prepayment pattern to differ from the assumed PSA pattern? How would an FI adjust for the presumed occurrence of some of these factors? LO.1
What does an FI mean when it states that its mortgage pool prepayments are assumed to be 100 percent PSA equivalent? LO.1
Explain precisely the prepayment assumptions of the Public Securities Asso- ciation prepayment model. LO.1
What is the difference between the yield spread to average life and the option adjusted spread on mortgage-backed securities? LO.1
A FI originates a pool of 500 30-year mortgages, each averaging $150,000 with an annual mortgage coupon rate of 8 percent. Assume that the GNMA credit risk insurance fee is 6 basis points and that
If 150 $200,000 mortgages in a $60 million 15-year mortgage pool are expected to be prepaid in three years and the remaining 150 $200,000 mortgages are to be prepaid in four years, what is the
What is the weighted-avera LO.1 ge life (WAL) of a mortgage pool supporting pass- through securities? How does WAL differ from duration? LO.1
What are the benefits of market yields that are less than the average rate in the GNMA mortgage pool? What are the disadvantages of this rate inversion? To whom do the good news and the bad news
Under what conditions do mortgage holders have a call option on their mort- gages? When is the call option in the money? LO.1
What specific changes occur on the balance sheet at the completion of the securitization process? What adjustments occur to the risk profile of the FI? LO.1
How are investors in pass-through bonds protected against default risk ema- nating from the mortgagees and the FI/trustee? LO.1
Consider the FI in problem 6.a. What additional risk exposure problems does the FI face?b. What are some possible solutions to the duration mismatch and the illiquidity problems?c. What advantages
An FI is planning to issue $100 million in BB rated commercial loans. The FI BB rated will finance the loans by issuing demand deposits.a. What is the minimum amount of capital required by the Basel
What three levels of regulatory taxes do Fls face when making loans? How does securitization reduce the levels of taxation? LO.1

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