Chapter 8 Flashcards
How is the variance calculated?
Add the squared difference between each period’s return and the mean return
Divide by (n-1)
Measures deviation of actual return from average return over a specific period.
Variance
What is a downside to using the variance to measure deviation of actual return?
May be difficult to interpret due to squaring
How is the standard deviation calculated.
Square root of the variance
Why is standard deviation a good way to measure deviation of actual return from the average return?
In the same units
Same number of days points as variance
What is a drawback to using standard deviation?
The larger the values in the data set the larger the standard deviation
How is the coefficient of variation calculated?
Standard deviation / expected (or mean) return
What does the coefficient of variation measure?
Risk per unit of return
This provides an indication of the dollar amount involved in a risk being assessed; items not provided by standard deviation or coefficient of variation
Value at risk
What is this an example of? An investment portfolio might have a 6% one-day, _____ of $400,000
Value at risk
What are the advantages of VaR?
Expresses the loss in monetary terms that are easy to understand
Quantities in numerical terms the potential loss associated with a decision
Requires only two inputs
What is the disadvantage of VaR?
The extent to which a loss exceeds the VaR threshold is not accurately measured.
What does beta represent?
An assets market risk; the extent to which a change in the overall marketplace can affect a particular asset.
What is the beta of the market?
1.0
What does a beta of 1.1 mean?
Asset is more volatile than the market
This theory indicates that asset allocation can optimize risk and return
Modern portfolio theory
What type of risk cannot be diversified away?
Market risk/systematic risk
What type of risk can be diversified away?
Company-Specific (business risk, default risk)
What is a major benefit of investing internationally?
Diversification
This can allow an investor to achieve higher return for a given risk level than can be achieved with a single asset
Diversification
Does another investment need to have a negative correlation to reduce risk through diversification?
No. Just cannot be perfectly correlated.
Is there a limit to the benefit of diversification?
Yes. There is an optimum mix
What is efficient frontier?
Portfolio with the highest return for a given level of risk
What is the most important objective of an insurance company when investing in long-term bonds?
To match timing of investment cash inflows with expected cash outflows of the company
What are the three risks bonds have?
Credit risk (can eliminate through diversification)
Interest rate risk (cannot eliminate)
Reinvestment rate risk
What type of risk does cash matching eliminate?
Interest rate risk
What is cash matching?
Matching the maturity of bonds with the expected time losses must be paid
What are the limitations of cash matching?
Insurer must purchase correct amount of bonds to offset loss payments
Insurer must find zero-coupon bonds that mature at the exact time losses are paid.
What types of bonds expose an insurer to reinvestment rate risk?
Coupon rate bonds
What does duration of a bond represent?
Amount of time required to recover the true cost.
What is the duration of a zero coupon bond?
Maturity
What are the uses of bond duration?
Compare volatility of bonds
Estimate price changes when YTM changes
Immunize a portfolio
Who regulates insurer investments?
The state
What types of assets are permitted on a balance sheet?
Money market investments Treasury bills and commercial paper High quality bonds Common and preferred stock Real estate and mortgages
What is the primary goal of state regulators?
Ensuring solvency and liquidity of an insurer
What types of restrictions are placed in insurers with regard to investments.
Can’t put too many eggs in one type of basket
Can’t put too many eggs in one basket
Cannot own too much stock in another company
What do investment restrictions usually lead insurers to invest in?
High quality bonds
