Brehm Ch. 2

Question 1

Three evolutionary steps of the decision analysis process

Answer 1

Deterministic project analysis (uncertainty handled judgmentally), risk analysis (MC sim), certainty equivalent (quantifies risk judgment using utility function)

Question 2

How efficient market theory removes need for certainty equivalent step

Answer 2

Efficient market theory can ignore risk premium

Question 3

Two counterarguments to efficient market theory removing need for certainty equivalent step

Answer 3

Difficult to differentiate which risks are firm-specific vs. systematic; market-based risk signals often lack refinement needed to mitigate/hedge risk

Question 4

Corporate risk tolerance

Answer 4

Organization’s size, resources, ability and willingness to tolerate volatility

Question 5

How an efficient frontier can be used to select an insurance portfolio

Answer 5

Change risk or return on sub-optimal portfolios

Question 6

Determining Risk-Adjusted Return On Captial (RAROC)

Answer 6

Allocate risk capital to portfolio elements, then multiply allocated risk capital by hurdle rate

Question 7

How RAROC is used

Answer 7

Calculate economic value added (EVA) by subtracting RAROC from the NPV; want EVA > 0

Question 8

Assuming risk capital allocated, how cost-benefit analysis can be used

Answer 8

Pursue activities where benefit > costs of implementation

Question 9

Assuming cost of capital allocated, how cost-benefit analysis can be used

Answer 9

Pursue activities with positive EVA

Question 10

Four advantages of using economic capital for ERM analysis

Answer 10

Provides unifying measure for all risks; more meaningful to management; forces firm to quantify risks and combine in a probability distribution; provides framework for setting acceptable risk levels

Question 11

Why 1-in-4000 VaR target capital is used when currently holding 1-in-4256 VaR

Answer 11

Round number and requires slightly less capital