Cost per year

1.

Surplus Annual Premium

Whole life insurance (sometimes referred to as permanent life insurance) provides

protection for the life of the policyholder. The policyholder is required to make regular
monthly or annual payments until his or her death. The annual premium for a year can be
compared with the cost of providing term life insurance for that year. The cost of a one-year
policy continues to rise as the individual gets older so that at some stage it is greater than the
annual premium. The surplus during the early years is used to fund the deficit during later
years. There is a savings element to whole life insurance. In the early years, the part of the
premium not needed to cover the risk of a payout is invested on behalf of the policyholder by
the insurance company.

2. The CAPM formula is

ERi=Rf +(ERm-Rf)i
If the project with the beta of 2.0 cannot earn a rate of return of 11%, you should not take this
project and instead return the money to your investors.
Your project would add too much risk for its reward.
Your investors have better opportunities elsewhere.

3.
a. The CAPM formula is often graphed as the security market line (SML), which shows the
relationship between the expected rate of return of a project and its beta.
Because all assets properly follow the CAPM formula in our example, they must lie on a
straight line. The slope of this line is the equity premium, ERm-Rf and the intercept is the risk-
free rate, Rf.
b.

c. shows conditional rates of return.

Assets with positive betas have higher expected rates of return when the market does better.
Assets with negative betas have higher expected rates of return when the market does worse.
If the stock market turns in the same rate of return as the risk-free asset, beta does not matter.
The graph also shows that stocks with negative betas tend to offer lower expected rates of
return than stocks with positive betas.

4. Explain what is meant by loss ratio and expense ratio for a property casualty
insurance company. If an insurance company is profitable, it must be the case that
the loss ratio plus the expense ratio is less than 100%. Discuss this statement.
Ans:
 Loss ratio is the difference between the ratios of premiums paid to an insurance
company and the claims settled by the company. The loss ratio is the total losses paid by an
insurance company in the form of claims. The losses are added in the adjustment expenses
and then divided by total earned premiums.
The expense ratio is a measure of profitability calculated by dividing the expenses
associated with acquiring, underwriting and servicing premiums by the net premium earned
by the insurance company. The expenses can include advertising, employee wages and
commissions for the sales force. The expense ratio signifies an insurance companys
efficiency before factoring in claims on its policies and investment gains or losses.
Insurance profit = 100% - loss ratio expense ratio
Therefore, if the loss ratio plus expense ratio is below than 100% then the insurance
company is still get profit.

5. What is the difference between a defined benefit and a defined contribution

pension plan?
Ans:
Defined benefit plan
Typically, it is calculated by a formula that is based on the number of years of
employment and the employees salary. For example, the pension per year might
equal the employees average earnings per year during the last three years of
employment multiplied the number of years of employment multiplied by 2%. The
employees spouse may continue to receive a (usually reduced) pension if the
employee dies before the spouse.
Defined contribution plan
In a defined contribution plan the employer and employee contributions are invested
on behalf of the employee. When employees retire there are typically a number of
options open to them.

6. a. What is volatility?
b. What is normal distribution? What is the definition and purpose of z-value?
c. What are the differences between leptokurtic distribution, platykurtic
distribution and mesokurtic distribution?
Ans:
A. Volatility is defined as the standard deviation of the return provided by the variable
per unit of time when the return is expressed using continuous compounding.
B. Normal distribution has a set of characteristics that helps us develop insights into the
data set. The normal distribution curve can be fully described by two numbers the
distributions mean (average) and standard deviation.
Z value is the number of standard deviations from the mean a data point is. But more
technically it's a measure of how many standard deviations below or above the
population mean a raw score is.
c. Leptokurtic is a statistical distribution where the points along the X-axis are
clustered, resulting in a higher peak, or higher kurtosis, than the curvature found in a
normal distribution. This high peak and corresponding fat tails mean the distribution
is more clustered around the mean than in a mesokurtic or platykurtic distribution and
 has a relatively smaller standard deviation. A distribution is leptokurtic when the
kurtosis value is a large positive.
Platykurtic describes a statistical distribution with extremely dispersed points along
the X-axis that results in thinner tails than a normal distribution. Because this
distribution has thin tails, it is less clustered around the mean than are mesokurtic and
leptokurtic distributions. The prefix of the term, platy, means broad, and
distributions are deemed platykurtic when the excess kurtosis value is negative owing
to the fact that the distribution has more data in its tails and less data in its peak.
Mesokurtic is a term used in a statistical context where the kurtosis of a distribution
is similar, or identical, to the kurtosis of a normally distributed data set. Kurtosis is a
measure of a distribution's peak, which means how much of the distribution is
centered on the distributions mean.

7. If you believe that the risk-free rate is 3% and the expected A first quick use of
the CAPM rate of return on the stock market is 7%, then by using the CAPM
formula, please calculate the expected rate of return with:
=0.5
=2

ERi= 3% + (7% 3%) . i

ERi = 3% + 4% . i

Therefore, a project with a beta of 0.5 should have a cost of capital of 3% + 4% . 0.5
= 5%.
Project with a beta of 2.0 should have a cost of capital of 3% + 4% . 2.0 = 11%.

8. The volatility of an asset is 2% per day. What is the standard deviation of the
percentage price change in three days?
Ans:
2% x 3 = 3.46%

9. The volatility of an asset is 25% per annum. What is the standard deviation of
the percentage price change in one trading day? Assuming a normal distribution
with zero mean, estimate 99% confidence limits for the percentage price change
in one day.
Ans:

Therefore, the standard deviation of the percentage price change in one trading day is
1.57%.

Therefore, the 99% confidence limits for the percentage price change in one day are
from -4.04% to 4.04%.
10. Observations on a stock price (in dollars) are as follows: 30.2, 32.0, 31.1, 30.1,
30.2, 30.3, 30.6, 30.9, 30.5, 31.1, 31.3, 30.8, 30.3, 29.9, 29.8. Estimate the daily
volatility.
Ans: