FIN 555, Spring 2019 Risk Management and Insurance

Homework #3
Due Tuesday, April 9, 2019

– SOLUTION –

1. A pharmaceutical firm recalls a popular drug after a study reveals that it causes deadly side
effects and later announces that it will no longer sell the drug. This decision is an example of
which of the following?
a. Avoidance
b. Self-insurance
c. Loss prevention
d. Contractual transfer

2. Insurance is frequently used as a risk-handling technique for ____________ losses.

a. high frequency, high severity
b. high frequency, low severity
c. low frequency, high severity
d. low frequency, low severity

3. Cellar-Dwellers, Inc. is a construction firm that specializes in building residential basements.

The firm estimates that thieves steal 1,000 cement blocks from the firm’s work sites each
year, which it pays for out of its current cash accounts. This financing arrangement
exemplifies which of the following?
a. Loss reduction
b. Loss prevention
c. Risk retention
d. Self-insurance

4. Jim S. buys a $50,000 car. Rather than buying insurance on the car, he sets aside $30,000 in
a savings account to cover possible losses due to an accident. He is ____________.
a. self-insuring
b. a moral hazard
c. assuming risk
d. decreasing his risk of physical loss

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FIN 555, Spring 2019 Risk Management and Insurance

5. Opportunities for risk reduction are greatest when the correlations among exposure units in a
portfolio are which of the following?
a. 1.0
b. –1.0
c. 0
d. Slightly less than zero

6. A(n) ____ is not a risk-bearing financial institution.

a. insurance company
b. mutual fund
c. pension
d. limited liability partnership (LLP)

7. Which of the following does not affect the risk in a portfolio consisting of two stocks?
a. The weighting, or percentage of the portfolio, for each stock
b. The standard deviation of the returns earned on the two stocks
c. The correlation of the returns of the two stocks
d. All of the above affect the risk in the portfolio.

8. For insurance risk pools in which exposure units exhibit a 0.1 correlation, which of the
following is true?
I. As the size of the risk pool increases, the standard deviation of the mean loss decreases.
II. As the size of the risk pool becomes extremely large, the standard deviation of the mean
loss equals zero.
a. I only
b. II only
c. Both I and II
d. Neither I nor II

9. For Problem 10 of Homework #2, you downloaded from Yahoo Finance daily prices for the
SPDR S&P 500 ETF (ticker = SPY) during July 1 to December 31, 2016 and then calculated
daily returns during this period. Using the actual daily return data (not assuming a normal
distribution), calculate the 5% Value at Risk (VaR) and the 5% Expected Shortfall (ES).

There are 126 daily returns in our data set, and 5% of 126 returns is 6.3. First, we find the
seven lowest daily returns as follows:

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FIN 555, Spring 2019 Risk Management and Insurance

–2.3935%, –1.4376%, –1.2630%, –0.9047%, –0.8265%, –0.8254%, –0.8102%

5% VaR = –0.8254% + 0.3 × (0.8254% – 0.8102%) = –0.8209%

5% ES = [(–2.3935%) + (–1.4376%) + (–1.2630%) + (–0.9047%) + (–0.8265%) +

(–0.8254%) + 0.3 × (–0.8209%)] / 6.3 = –1.2535%

Same as the result in Example 3.3, we again have 5% VaR > 5% ES.

10. You have $50,000 in cash and you would like to allocate it between the common stock of
Coca-Cola (KO) and Exxon Mobil Corp (XOM). You know the risk-free rate is 1% and the
market return is 9%. In addition, you have the following information about the two stocks:

Coca-Cola (KO) Exxon (XOM)

Mean Return 12.0% 20.0%
Standard Deviation 21.0% 42.0%
Cov(KO, XOM) –0.0010

1) If your goal is to minimize your portfolio risk, how much of your money (in dollar
amount) should be invested in Coca-Cola and Exxon Mobil, respectively?

Portfolio weights for minimum-variance portfolio is:

𝜎𝜎22 −𝐶𝐶𝐶𝐶𝐶𝐶(𝑟𝑟1 ,𝑟𝑟2 )
𝑤𝑤1 = =, 𝑤𝑤2 = 1 − 𝑤𝑤1
𝜎𝜎1 +𝜎𝜎22 −2𝐶𝐶𝐶𝐶𝐶𝐶(𝑟𝑟1 ,𝑟𝑟2 )
2

0.422 +0.0010
𝑤𝑤KO = 0.212 +0.422 +2×0.0010 = 79.73%

𝑤𝑤XOM = 1 − 79.73% = 20.27%

Coca-Cola: $50,000 × 79.73% = $39,865.17

Exxon Mobil: $50,000 × 20.27% = $10,134.83

2) What is the mean return and variance of the minimum-variance portfolio in part 1)?

Portfolio Return = 0.7973 × 12% + 0.2027 × 20% = 13.62%

Portfolio Variance = 0.79732 × 21%2 + 0.20272 × 42%2 + 2 × 0.7973 × 0.2027×(–0.0010)

= 0.0350

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FIN 555, Spring 2019 Risk Management and Insurance

3) Instead of minimizing your portfolio risk, you decide to invest your money in the optimal
risky portfolio that maximizes your return per unit of risk, i.e., the Sharpe ratio. How
much of your money (in dollar amount) should now be invested in Coca-Cola and Exxon
Mobil, respectively?

Portfolio weights for optimal risky portfolio is:

(0.12−0.01)×0.422 −(0.20−0.01)×(−0.0010)
𝑤𝑤KO = (0.12−0.01)×0.422+(0.20−0.01)×0.212 −[(0.12−0.01)+(0.20−0.01)]×(−0.0010) = 69.77%

𝑤𝑤XOM = 1 − 68.91% = 30.23%

Coca-Cola: $50,000 × 69.77% = $34,885.87

Exxon Mobil: $50,000 × 30.23% = $15,114.13

4) What is the mean return and variance of the optimal risky portfolio in part 3)?

Portfolio Return = 0.6977 × 12% + 0.3023 × 20% = 14.42%

Portfolio Variance = 0.69772 × 21%2 + 0.30232 × 42%2 + 2 × 0.6977 × 0.3023×(–0.0010)

= 0.0372

11. As the owner of a concession booth in a major airport, you decide to purchase insurance that
will pay $2 million in the event the airport terminal is destroyed by terrorists. Suppose the
likelihood of such a loss is 0.05%, the risk-free interest rate is 3%, and the expected return of
the market is 8%. If the risk has a beta of zero, what is the actuarially fair insurance
premium? What is the premium if the beta of terrorism insurance is –3?

The expected loss is 0.05% × $2 million = $1,000.

If the risk has a beta of zero, rL = rf = 3%. Then, the actuarially fair insurance premium =
($1,000) / (1 + 3%) = $970.87.

If the beta of terrorism insurance is –3, we use the CAPM to estimate the appropriate cost of
capital for the insured risk. That is, rL = rf + βL × (rmkt – rf) = 3% – 3 × (8% – 3%) = –12%.
In this case, the actuarially fair insurance premium = ($1,000) / (1 – 12%) = $1,136.36.
Although now the insurance premium exceeds the expected loss, it is a fair price given the
negative beta of the insured risk.