B, C and D

(b) Explain how you could combine the risk-free instrument and a risky portfolio with an expected return of 20% to obtain an expected return of 34%. Assume the risk-free rate of interest is 6%. [5 marks] (c) Suppose an insurance company has 350 million in capital available. The gain from an investment portfolio of this bank during 12-month period is normally distributed with a mean of 70 million and a standard deviation rate of 160 million. The insurance company considers 99% 12-month value at risk (a=2.33) for setting its economic capital. Assume the 1% tail of the loss distribution has the following values: 0.6% probability corresponds to a 700 million loss and 0.4% probability corresponds to a 20 million loss. Calculate annual risk-adjusted return on capital (RAROC) of the investment portfolio, which considers the expected tail loss. [8 marks] (d) Suppose a project initially costs 900 million and generates cash flows of 350 million per year for three consecutive years. Cash flows are realised at the end of each year. The firm could decide to close down the project immediately after inception and would recover 800 million. The firm could also choose to abandon the project and sell off assets at the beginning of year 2 and recover 700 million with 40% chance or 400 million with 60% chance. The firm also could sell off assets at the beginning of year 3 and realise 300 million with 40% chance or 100 million with 60% chance. Assume the discount rate is 5%. Advise the firm whether and when it should exercise the option (i.e. abandon the project) and calculate the value of the option. [8 marks]