7.

Solution:

(i) The assumption implies that the claims occurred in the past does not affect the probability
of the future claims. Each time interval has an independent chance of claims which is only
determined by the Poisson distribution.

(ii) Whether this assumption is reasonable for the insurer depends on the nature of the
insurance which is offered and the risk factors involved.

For some types of insurance such as auto insurance or property insurance, where the
occurrence of 1 claim might not significantly increase the likelihood of another claim in the
near future, Therefore this assumption might be reasonable to some extent.

In cases where there is strong dependence between the future and the past claims, this
assumption might not be reasonable. If the insurer’s actions in the response to the previous
claims affects or influences the future claim behaviour of the insurer, then this assumption
might not be valid. For example: If the insurer rises the premiums highly after the claim, it
may discourage the policyholders from making future claims even though they are legitimate

(iii)

t=5Premium income=100 at t=0Claim amount =40The number of claims N(t) follows a

poisson distn with parameters λt , where λ=0.2

Ruin occurs if 40 × N ( 5 )> 100→ N ( 5 ) >2.5

The probability of ruin is:

P ( Ruin )=P( N ( 5 )>100)

Since N(5) follows a poisson distribution with parameters lambda(5) = 0.25 = 1, we get:

P ( Ruin )=1−P ( N ( 5 ) ≤ 2 ) P ( Ruin )=1−¿P ( Ruin )=1−¿P ( Ruin )=0.0803

6. Solution:

(i) The expected return of the portfolio is given by:

E p =x A × E A + x B × EB

The variance of the portfolio is given by:

V p=x A × V A + x B ×V B +2 x A x B × ρ× √ V A × √ V B ρ is thecorrelation between returns A∧B

2 2

V A ∧V B are the variances of securities A∧B

Need to minimize V_p with respect to x_A + x_B = 1

Substituting x_B = 1 – x_A and E_B=4E_A into the var and exp returns equations:

V p=x A × V A + ( 1−x A ) × 4 V A +2 × x A × ( 1− x A ) × ρ × √ V A × √ 4 V A E p =x A × E A + ( 1−x A ) × 4 E A

2 2

After simplifying both the above equations:

V p=x 2A × V A + ( 1−2 x A + x2A ) × 4 V A + 4 × x A × ( 1−x A ) × ρ ×V A E p =x A × E A + 4 E A −4 x A × E A

Simplifying them more:

2 2 2
V p=x A × V A + 4 V A −8 x A × V A + 4 x A ×V A + 4 x A ×V A × ρ−4 × x A ×V A × ρ
E p =4 E A−3 x A × E A

(a) ρ=0V p=5 x 2A ×V A−4 x A ×V A + 4 v A

Differentiating with respect to x_A and setting it equal to 0:
dV p 2
=10 x A ×V A −4 V A =010 x AA × V A =4 V A x A=
d xA 5
As x_A + x_B = 1 , x_B = 3/5
Substituting the both values in exp returns equation:

E p =4 E A−3 × ( 25 ) × E ¿ 4 E − 65 × E E = 145 × E
A A A p A

(b) ρ=1

2 2 2
V p=5 x A ×V A−4 x A ×V A + 4 V A + 4 × x A × V A −4 × x A × V A¿ x A ×V A + 4 V A
Differentiating with respect to x_A and setting it equal to 0:
 dV p
=2 x A ×V A =0 x A=0
d xA
Hence x_B = 1
Substituting these values in expected returns equation:
E p =4 E A−3 × 0 × E A E p =4 E A

(ii) x_A = 0 and x_B = 1 :

Substituting these in var equation with rho = 1
V p=0 × V A +1 ×4 V A +2 ×0 ×1 ×1 × √ V A × √ 4 V A ∴ V p=4 V A
2 2
5. Solution:

Profit of 25 with prob p

Loss of 25 with prob (1-p)

b, c are the parameters of the utility function

U(w) =bw + cw^2

(i)
Absolution Risk Aversion:
''
' '' −U ( w ) −2 c
U ( w ) =b+2 cwU ( w )=2 c ARA= ' =
U ( w) b+2 cw
Relative risk aversion:
RRA=−w ×U (w)/U'(w)=-2cw/(b+2cw)

(ii) This implies that they are risk averse. Since the investor requires a higher
probability of winning (p>0.5) in order to accept gamble, it indicates they are
willing to forego some potential gains to avoid the risk of losses.

(iii) U ( 150 )=67506750=b ×150+ c ×150 26750=15 b+22500 c 2

3 b 3
= + × c−−−(1)
10 100 2

At p = 0.54167, the investor is indifferent between taking and not taking the
gamble.
0.54167 × U (175 )+ ( 1−0.54167 ) × E (125 )=U ( 150 )Substituting the utility
functions and the values:
0.541675 ( 175 b+30625 c ) +0.45833 × ( 125 b+15625 c )=6750
94.79225 b+ 16572.96875 c+57.29125 b+ 7160.15625 c=6750
152.0835 b+23733.125 c =67500.304167 b+ 0.4746625 c=0.135−−−(2)
Expressing b in c terms from equation (1)
b 3 3
= − c b=30−150 c
100 10 2
Substituting this value in equation (2):
 0.304167 × ( 30−150 c ) +0.4746625 c=0.135
9.12501−45.62505 c +0.4746625 c=0.13545.1503875 c=−8.99001c=0.199114
Substituting this value back into the equation for b:
b=30−150 × 0.199114b=0.1335

'
(iv) U ( w ) =b+2 cw> 0
Substituting values of b and c:
0.133+2 × 0.199114× w> 00.3928228 × w>−0.133w >−0.3339
Since wealth cannot be negative, the maximum wealth for which the function
U(w) satisfies the principle of non satiation is infinity.

(v) After winning the gamble , the wealth of the investor increases to 175
(vi) We can expect that the minimum value of p at which the investor will accept the
gamble will now be more than 0.54167. This is mainly because the investor is risk
averse as established earlier . Also wih the increase in wealth they have more to
lose. Also a risk averse investor becomes even more cautious when they have
more to lose.
Hence, they would require a higher probability of winning to compensate for the
increased potential losses
8. Solution:

(i) Bond Price=( 1−PD ) × PV of Nominal at risk free rate+ PD × PV of recovery amount

For zero coupon bond, the recovery amount in case of default = (1-LGD) × Nominal value

(a) Let PD_1 be the prob of default for the 1 year bond
Nominal Value = 100
Recovery amount = (1-0.5)×100 = 50
PV of Nominal at risk free rate = 100×e^(-0.05×1)
PV of recovery amount = 50×e^(-0.05×1)

Substituting these values in the equation, we get:

−0.05 ×1 −0.05 ×1 −0.05
85.61=( 1−P D1 ) × 100 ×e + P D1 × 50× e 85.61=e × ( 100−50 × P D1 )
85.61
−0.05
=100−50 × P D 190=100−50 × P D150 × P D1=10P D1=0.2
e
(b) T = 2
Let PD_2 be the prob of default for the 2 year bond

× [ 100−50 × P D2 ]
−0.05 ×2 −0.05 ×2 −0.1
76.91=( 1−P D2 ) × 100× e + P D2 × 50× e 76.91=e
76.91
−0.1
=100−50 × P D 285=100−50 × P D250 × P D2=15P D2=0.3
e

(ii) Price = Nominal Value × e^(-YTM×T)

(a) 85.61=100× e−YT M ×t e−YT M =0.8561−YT M 1=ln ( 0.8561 )YT M 1=0.154

1 1

(b)

=0.7691−2 ×YT M 2=ln ⁡¿YT M 2=0.135

−YT M 2 ×2 −2 ×YT M2
76.91=100 × e e

(iii) The yields in part (ii) are consistent with the default probabilities in part (i) because:

The 2 year bond has a higher probability of default i.e 30% compared to 1 year bond i.e 20%.
To compensate for this additional risk, 2 year bond offers a higher yield i.e. 13.5% than the
year bond i.e. 15.4% .

This shows that the risk is associated with the higher expected returns. Investors demand a
higher yield for taking on the increased risk of the 2 year bond.
9. Solution:

(i) the insurer may use a utility function with a discontinuity at w = x to represent a minimum
acceptable level of wealth.

(ii)

(a) For w>= x:

The utility function U(w) = (w/100)^0.5 is concave upward in this region, this is
because it’s 2nd derivative U’’(w) = -0.005/w^1.5 is negative for w>=x. this indicated
risk aversion.
For w<x:
The utility is constant (zero), so the risk aversion doesn’t apply in this region.
Overall the utility function shows risk aversion for wealth levels above the threshold
‘x’

(b) For w>=x:

The first derivative U’(w) = 0.005/w^0.5 is positive for w >=x. this shows that the
insurer always prefer more wealth to less wealth in this region, this satisfies the
principle of non – satiation
For w<x, the non – satiation does not apply in this region
Overall it satisfies the principle of non – satiation for wealth levels above threshold
‘x’

(iii)

w_0=100

x=90

Claim prob=0.25

Claim amt=50

( )
0.5
100
U ( w )= =10
100

P is the premium charged

Wealth if no claim = w_0 + P

Wealth if claim = w_0 + P – 50

Expected utility =0.75 ×U ¿

Expected utility will be needed to be higher than the current utility:

0.75 ×U ¿

Case 1: W_0 + P – 50<x

0.75 × U(w_0 +P) > 1

0.75((110+p)/100)^0.5 >1

((100+P)/100)^0.5>4/3
(100+P)/100>16/9

100+P>177.78

P>77.78

With that w_0 +P-50<x

100+P-50<90

P<40

As the prob are contradictory we will discard this case

Case 2: W_0 + P – 50>=x

0.75×((w_0+P)/100)^0.5+0.25×((w_0+P-50)/100)^0.5>1

0.75×(1(100+P)/100)^0.5+0.25×((50+P)/100)^0.5>1

P>39.95

Also:

100+P-50>= 90

P>=40

Hence the minimum premium that should be charges is 40

(iv) The premium might be significantly higher than what other insurers are charging for
similar policies, hence it might make it uncompetitive in the market.

A high premium can trigger the issue of adverse selction, as only individuals who perceive a
very high risk of claim will be willing to pay such high premium
1. Solution:
R−μ
(i) Let Z= Z N (0 , 1)
σ

P ( R<t )=P ( R−μ

σ ) σ
<
t−μ
=P (Z <
σ )
t−μ
=0.05 P ( Z ←1.64458 ) is≈0.05

t−μ
=−1.64485t−μ=−1.64485 σt=μ−1.64485 σ
σ
Since 95% VaR = -t
95% VaR = 1.64485σ −μ

(ii) 95 % Tail VaR=E [−R|R ←VaR ] Subbstituting the value of VaR in the terms of
the standard normal variable Z:
95 % Tail VaR=E [ −( μ +σZ )|Z ←1.64485 ] =−μ−σE [ Z|Z ←1.64485 ]
−1.64485
E [ Z|Z ←1.64485 ] =
1
(
P ( Z ←1.64485 ) ) ∫
∞
z × f 0 , 1 ( z ) dz

−1.64485
¿ ( ) ∫ −ddz f ( z ) dz
1
0.05 −∞
0 ,1

¿ ( )
−1
0.05
[
−1.64485
f 0 , 1 ( z ) ]−∞ ( 0.05 )
−1
[ f ( −1.64485
0 ,1 ) −0 ] ¿−
f 0 ,1 (−1.64485 )
0.05
Substiting this in tail Var expression:
f 0 ,1 (−1.64485 ) σ
95 % Tail VaR=−μ−σ ×− = × f (−1.64485 )−μ
0.05 0.05 0 ,1

(iii) (a)
95% Var = 1.64485σ −μ
95% VaR=1.64485×0.07746-0.04
95% VaR=0.0851

(b)
σ
95% Tail VaR = × f (−1.64485−μ ) f 0 ,1=0.1031
0.05 0 , 1
 95% Tail Var = 0.07746/0.05 ×0.1031 – 0.04
95% Tail Var = 0.1199

(iv) Benefits:
VaR provides a single number that represents the potential loss at a given
confidence level. Hence, it makes easy to understand and communicate
Tail VaR provides information about the expected loss in the worst case
scenarios which is crucial for risk management
Limitations:
VaR only focuses on the threshold loss and do not provide information about
severity of losses beyond point
Tail Var is highly dependent on the assumed distribution of returns,
particularly in the tails, inaccurate assumptions might lead to results which are
very misleading
2. Solution:
PD = N(-d_2)
2
σ
d_2 = (ln(V/F) + (r- ¿ T ¿ /(σ √ T )
2
(i) Company A:
d_2 = (ln(60/50)+(0.03-0.25^2/2)2)/(0.25√ 2 ¿
d_2 = 0.5543
PD_A=N(-0.5543) i.e. approx. 0.29

Company B:
d_2 = (ln(80/50)+(0.03-0.25^2/2)3)/(0.25/√ 3)
d_2 = 1.531
PD_B=N(-1.531) i.e. approx. 0.063

(ii) Put call parity = C 0−P0=S 0−K ×e−rT

−0.03 ×2
65.60−35.20=S 0−100 ×e S0 =124.5765

E = No. of shares × Share price

=100000×124.5765
=12457650

D=V-E
=60000000-12457650
=47542350
Debt value per 100 nominal = (D/F)/100
=(47542350/50000000)*100
=95.08

(iii) (a)Delta E = Delta V × N(d_1)

d 1=d 2+ σ √ T ¿ 0.5543+ 0.25× √ 2 ¿ 0.9086
Delta E = 1000000×N(0.9086) = 1000000×0.8186=818600
Change in share price = Delta E / No. of shares= 818600/100000=8.19
(b) Change in debt value = 1000000-818600=181400
Change in debt value per 100 nominal = (delta D/F)×100
 =(181400/50000000)×100=0.36

(iv) The change in share price is significantly larger than the change in debt value
per 100 nominal. This is mainly because the equity holders have a residual
claim on the company’s assets. When the value of the company increases trhe
equity share holders gets benefitted more as they capture the upside potential
after debt holders are paid
4. Solution:

(i) p= Risk neutral prob of up step

1-p = “” “” “” of down step

u = 1+0.15=1.15

d=1-0.1=0.9

−r
S0 =e × [ p × S0 ×u+ ( 1−p ) × S 0 × d ]
12

r/12 is the monthly risk free rate

−0.06
× [ 115 p+ 90−90 p ]100=0.995012× [ 25 p+ 90 ]25 p=10.4987
−0.005
100=e 12
× ¿100=e
p=0.41995

(ii) t=0, S_0 = 100

T=1:

Up step = S_u= 100×1.15=115

Down step= S_d=100*0.9=90

At t=2:

Up-up=115*1.15=132.25

Up down=115×0.9=103.5

Down down=90×0.9

=81

Payoffs at maturity (t=2):

C uu=132.25−125=7.25C ud=0C dd=0

 −0.005
C u=e × ¿¿ 2.99

× [ 0.41995 × 0+ ( 1−0.41995 ) × 0 ]C d=0

−0.005
C d=e

× ( 0.41995 ×2.99+ ( 1−0.41995 ) ×0 )C 0=1.23

−0.005
C 0=e

(iii) ∆ : no . of shares of the stock B: Amount invested ∈risk free bonds

At t=1

Up-node

r
C u=∆ × S u +B × e 12 115 ∆+1.005012 B=2.99−−−(1)
Down node:
90 ∆+1.005012 B=0−−−(2)
Solving both the equations we get:
B = -10.71

At t=2

100 ∆+ B=1.23100 ×0.1196 + B=1.23B=−10.73

(iv)The value of the replicating portfolio at t=0 is approximately 1.23, which is same as the
option value calculated in part (ii)