Lesson 3 & 4

Question 1

Risk pooling

Answer 1

• Risk pooling is a risk management strategy that involves combining similar risks to reduce the impact of any one risk
• Insurance companies pool risks to protect against catastrophic events like floods or earthquakes. In health insurance, risk pooling combines the medical costs of individuals to calculate premiums. This allows the higher costs of less healthy individuals to be offset by the lower costs of healthier individuals.

Question 2

Law of large numbers

Answer 2

As n gets large, SD approaches zero

Question 3

SD of fraction of policies that result in a claim

Answer 3

root [p(1-p)/n]

Question 4

Moral Hazard

Answer 4

People knowing they are insured take more risks

Question 5

Selection bias

Answer 5

Selection bias occurs when the selection of subjects into a study (or their likelihood of remaining in the study) leads to a result that is systematically different to the target population.

Question 6

National Flood Insurance Act

Answer 6

• Buy flood insurance and government will subsidize it but it will be priced appropriately
• Buying house in a flood prone area = higher money to pay for insurance

Question 7

Henry Hyde’s contribution to insurance

Answer 7

• Sales appeal of having insurance with a large cash value

Question 8

Hedge Funds

Answer 8

Hedge funds are investment funds that pool money from investors to invest in a variety of assets

Question 9

Unemployment Insurance

Answer 9

Unemployment insurance, also known as redundancy insurance, is a short-term policy that provides a monthly payment to replace part of your income if you are made redundant through no fault of your own. It can help you maintain your essential expenses while you look for a new job

Question 10

Capital Asset Pricing Model

Answer 10

• Asserts that all investors hold their optimal portfolio
• All investors hold same portfolio of risky assets
• Tangency portfolio = Market portfolio

Question 11

Tangency Portfolio

Answer 11

A tangency portfolio is a portfolio of risky assets that offers the best risk-adjusted return for a given level of risk

Question 12

Mutual Fund

Answer 12

A mutual fund is a company that pools money from many investors and invests the money in securities such as stocks, bonds, and short-term debt. The combined holdings of the mutual fund are known as its portfolio. Investors buy shares in mutual funds.

Question 13

Why does Gold have negative beta?

Answer 13

• It’s very safe; it always remains despite stock market

Question 14

What is the use of negative beta assets

Answer 14

• Helps reduce the overall variance
• Offsets other risks

Question 15

Credit Default Swap

Answer 15

A credit default swap (CDS) is a financial derivative that allows an investor to swap or offset their credit risk with that of another investor. To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse them if the borrower defaults.

Question 16

How is insurance regulated

Answer 16

By the state government

Question 17

Buying negative qty of stock

Answer 17

Borrow the shares and sell them
You owe the shares to someone else

Question 18

Why buy negative qty of stock?

Answer 18

• A negative stock price can also occur if you buy a stock and the price declines. For example, if you bought Walmart stock at $157 and it fell to $150, you will see -5% for this stock in your account. This doesn’t mean that you lost money, you only fix the loss if you sell it
• Investors can use buy-minus orders to purchase securities at a price lower than the last traded price. This can be useful when the market is volatile or when the investor expects a temporary price drop

Question 19

Why does CAPM not support short sale

Answer 19

• If everyone bougght negative qty no stock could have an optimal holding
• On average it is not possible

Question 20

Suppose if you put x dollars in a risky asset and 1-X in a riskless. What’s the expected return?

Answer 20

r = xr1 + (1-x)rf

Question 21

How does ‘leveraging up to the hilt’ give you any expected return

Answer 21

Playing it smart is what matters but comes with the cost of risk

Question 22

Relation between covariance and variance

Answer 22

+ covariance = assets moving in same direction = higher variance
- covariance = assets in different direction = lower variance

Question 22

Efficient Portfolio Frontier

Answer 22

Expresses standard deviation of portfolio in terms of r of the expected return on the portfolio

Question 23

Dominated

Answer 23

Hope curve below the minimum variance point
Never invest stocks in that

Question 23

Gordon Growth Model

Answer 23

Present value = x / (r - g)

Question 24

How to make money off declining industries

Answer 24

Buying them less than the present value