Question

A firm has an investment project that will cost the firm $30 million but will generate $2 million of NPV. Also there is a 5% chance that the firm will lose a lawsuit to employees, and be forced to pay damage of $30 million. Suppose that a liability insurance policy with a $30 million limit has a premium equal to $1.5 million.

Compute expected claim cost

Compute the amount of loading on the policy

Compute the expected cost of not pursuing this project

Should the firm purchase this insurance or not? Why or why not?

There is a portfolio whose current value is $2 million. Its daily return is normally distributed with a mean of 2% and a standard deviation of 0.7.

Compute the daily 99% and 95% VaRs of a portfolio

Interpret the results

A firm has an investment project that will cost the firm $30 million but will generate $2 million of NPV. Also there is a 5% chance that the firm will lose a lawsuit to employees, and be forced to pay damage of $30 million. Suppose that a liability insurance policy with a $30 million limit has a premium equal to $1.5 million.

Compute expected claim cost

Compute the amount of loading on the policy

Compute the expected cost of not pursuing this project

Should the firm purchase this insurance or not? Why or why not?

There is a portfolio whose current value is $2 million. Its daily return is normally distributed with a mean of 2% and a standard deviation of 0.7.

Compute the daily 99% and 95% VaRs of a portfolio

Interpret the results

Answer 1

Standard deviation = 0.7%

Mean = 2%

For 99% VaR:

=NORMSINV(99%) = 2.33

VaR = X(0)[2.33*standard deviation - mean]

VaR = 2.33*0.007 - 0.02

= -0.00369

Current price = $2 million

VaR = -0.00369 * 2

= - 0.00738 million or $7,380

negative implies profit. There is a 1% chance that the daily profits will be less than $7,380.

VaR at 95%:

=NORMSINV (95%) = 1.65

VaR = X(0)[1.65*standard deviation - mean]

VaR = 1.65*0.007 - 0.02

= -0.00845

Current price = $2 million

VaR = -0.00845 * 2

= - 0.0169 million or $16,900

negative implies profit. There is a 5% chance that the daily profits will be less than $16,900.