Cummins Capital

Question 1

Sources of Frictional Costs (aka Costly Capital)

Answer 1

Agency and informational costs (manager goals may not equal owners value maximization)

Double taxation (investing in insurer securities less attractive)

Regulation (may lead to inefficient portfolios)

Question 2

Problems with CAPM

Answer 2

1. Reflects systematic risk, but not risk of extreme events
2. LOB betas difficult to estimate
3. Ignores drivers of rate of return (other than beta)

Question 3

Problems with Value at Risk Allocation

Answer 3

1. Firm may not have enough capital to ensure all LOBs meet specified exceedance prob
2. Standalone exceedance probs don’t reflect diversification of LOBs
3. Ignores tail risk

Question 4

Advantage of EPD/Insolvency Put Method over VaR

Answer 4

Over VaR: Considers tail risk

Also consistent with theory around pricing risky contracts

Question 5

Pros of Merton-Perold Method

Answer 5

-Reflects diversification (unit allocated capital less than standalone)

-Unallocated capital results in higher RAROC and EVA by unit, profitable projects approved that might be rejected under other methods

Question 6

Merton-Perold vs Myers-Read

Answer 6

M-P:
-Macro marginal allocation (margin by adding entire LOBs to firm)
-Unallocated portion
-Method better when adding new LOBs

M-R:
-Micro (margin by determining effects of small changes for each LOB)
-Full allocation
-Method better bc aligns more closely with normal operations (small changes)