Risk Transfer

Question 1

What is the idea of risk transfer?

Answer 1

Risk transfer stands for a transfer of risk to a third party by means of a contract.

A distinction is made between the following alternatives for risk transfer.

• Insurance risk transfer
• non-insurance risk transfer

Question 2

Please explain the business model of an insurance company.

Answer 2

The business model of an insurance company is based on a insurance contractual agreement between a policy holder and a insurance company whereby the insurance company has to pay a claim to the policy holder if the insured event occurs. In return the policy holder pays a regular insurance premium to the insurance company.

Question 3

Insurance companies will not insure any risk. What prerequisites typically have to be met before an insurance company would consider offering protection?

Answer 3

There is a sufficiently large number of policy holders that the expected values of the possible losses can be predicted with sufficient reliability.

Question 4

How to determine the gross premiums?

Answer 4

Net Risk Premium
+Contingency Provision
=Gross Risk Premium
+Cost Markup
+Profit Markup
= Gross Premium

Question 5

Please explain the importance of the size of the insurance collective for the competitiveness of an insurance policy.

Answer 5

The size of the collective is important for the competitiveness of an insurance policy because the larger the collective the less the difference between actual loss and expected
loss, i.e. the lower the unexpected average loss per policy holder (law of large numbers).

Thus, a larger insurance collective typically implies a smaller contingency provision and – as a consequence – a smaller gross premium.

(a) neglects this fact by assuming a contingency provision which is a constant percentage of the net risk
premium. Thus, in A and B the gross premium is identical.

However, in B the insurance
collective is larger and (b) illustrates the typical effect of the larger collective on the contingency provision and the gross premium. In B Hazard Inc would be able to charge a significantly smaller premium. Thus, larger insurance companies could in principle offer
lower gross premiums.

Question 6

Briefly describe the contingency provision

Answer 6

The unexpected average damage

Question 7

What are derivatives?

Answer 7

Derivatives are instruments whose value depends of another asset (underlying).

Question 8

What are motivations for trading derivatives?

Answer 8

-Hedging (hedging against rising or falling prices)
-Speculation (Betting on increasing/falling prices)
- Arbitrage (exploit potential mispricing)

Question 9

What are Futures?

Answer 9

Future represent a firm, unconditional obligation between the contracting parties

Question 10

Why do market participants trade futures?

Answer 10

Future are used to in risk management for

-Hedging (hedging against rising or falling prices)
-Speculation (Betting on increasing/falling prices)
- Arbitrage (exploit potential mispricing)

Question 11

Describe a Future Transaction

Answer 11

The buyer of a future enters a firm commitment to buy
* on a certain future date (maturity T)
* a specific quantity (contract size S)
* of a specified asset (underlying)
* at an agreed price (delivery price, future price or forward price Ft)
from the seller of the future. The seller, of course, enters the laterally reversed commitment.

Question 12

Please describe the Call Option from the perspective of buyer of the call option.

Answer 12

The buyer of a call option receives the right to buy
* on a specific future date (maturity T)
* a specific quantity (contract size S)
* of a specified asset (underlying)
* at predetermined price (strike price x )
from the seller of the option.

For that right the buyer pays to the seller an option premium.

Question 13

Please describe the Put Option from the perspective of buyer of the put option.

Answer 13

The buyer of a put option receives the right to sell
* on a specific future date (maturity T)
* a specific quantity (contract size S)
* of a specified asset (underlying)
* at predetermined price (strike price x )
to the seller of the option.

For that right the buyer pays to the seller an option premium.

Question 14

When will the buyer decide to exercise the European call option?

Answer 14

The buyer of a European call option will exercise the option if at maturity T the strike price X is lower than the current spot price of the underlying U(T)

Question 15

When will the buyer decide to exercise the European pit option?

Answer 15

The buyer of a European put option will decide to exercise the option if at maturity the strike price x is higher than the current price U(T).

Question 16

Please describe the difference between European Option and American Option

Answer 16

European Option: Maturity day, is only one day to decide to exercise or not

American Option: you could exercise the option already before the expiration date, which offers more flexibility

Question 17

What are components of the premium price/ option price?

Answer 17

The Premium is the sum of the intrinsic value and the time value

Question 18

Explain the intrinsic value

Answer 18

Result from the fact, that the options offers the opportunity to buy the underlying asset cheaper(call) or sell the asset dearer (put) compared to the current price of the underlying.

Question 19

Explain the time value

Answer 19

The time value represents the value of the chance that the intrinsic value may increase until maturity

At maturity the time value is 0.

Question 20

What is the use for the firms which hedge by buying call options?

Answer 20

Long Call:
-To buy a call option makes sense if the firm wants to hedge against potential losses from increasing prices.

Short Call: A short call as a hedge against against falling prices is of limited use and implies unlimited risks, because the protection against falling prices is limited to the option premium. It does not increase with the fall in price and the risk of the seller is unlimited. The better alternative is a long put.

Question 21

What is the use of a put option?

Answer 21

Long Put: The company hedges by buying put options.

A long put is relevant risk response strategy to hedge against falling prices because the payoff of a long put increases with falling prices. This rising payoff contributes to reducing losses on underlying asset position.

The respective strategy is called protective put

A short put as a hedge against rising prices is of limited use, because it implies unlimited risks.

Question 22

What are the main differences between the two instruments in the context of risk management?

Answer 22

Futures represents a firm, unconditional obligation between the contracting parties.

Options differs from futures in that the buyer does not enter an unconditional obligation, because he has the right to choose whether to exercise or not. For this advantage the buyer pays the option premium to the seller when the option is bought, as a compensation for the additional flexibility.

Question 23

What does the intercept represents?

Answer 23

The maximum loss that occurs if the spot price at maturity is 0. It is not a real loss but the amount that the buyer is worse off due to the future.

Question 24

How is the protective puts maximum loss calculated?

Answer 24

Two components:
1) The option premium
2) An “incomplete” hedge: The difference between the strike price of the option and the current spot price is not covered by the protective put

Question 25

What are options to minimize the gap between current stock price and the strike price?

Answer 25

The firm may consider a different option with a higher strike price but the premium of this option in this case will also be higher.