Posted On: Nov. 22, 2017
a. Suppose that over the long run, the risk-premium on stock relative to treasury bills has been 7.6 percent in the United States. Suppose also that the current Treasury bill yield is 1.5%, but the historical average return Treasury bill is 4.1%. Estimate the expected return on stocks and explain how and why you arrived at your answer. Expected return (on basis of current Treasury bill yield) = Risk premium on relative stock + current T bill yield = 7.6% + 1.5% = 9.7% Expected Return (on historical average basis) = Risk premium on relative stock + Historical average return on T bill = 7.6% + 4.1% = 11.7% On the basis of expected return estimates it is analysed that the expected return on the short run is 9.7% because this return is estimated on the basis of current yield on treasury bills and in the long run, the expected return is 11.7% as it is estimated by considering the historical averages of the t bill yields. b) Suppose that over the long run, the risk premium on stocks relative to Treasury bonds has been 6.5%. The current Treasury bond yield is 4.5% but the historical return T-bonds is 5.2%. Estimate the expected return on stocks and explain how and why you arrived at your answer. Expected return (on basis of current Tbill yield) = Risk premium on relative stock + current T bill yield = 6.5% + 4.5% = 11.0% Expected Return (on historical average basis) = Risk premium on relative stock + Historical average return on T bill = 6.5% + 5.2% = 11.7% The current expected return is 11.0% which is considered for the short run estimate while the historical average expected return is 11.7% which is considered for the long run expected return of the stock. c) Compare your answers for (a) and (b) and explain any differences By comparing both scenarios, the scenario with historical average looks more reliable as it estimated the long term expected return by taking historical average yield into consideration which is the approximate average of last few years and will be a better estimate rather than considering the current scenario.
Posted On: Oct. 31, 2017
Phase 1 Part 1 Risk is all pervasive and cannot be predicted. It can occur in innumerable situations. Risk can be defined as the probability or threat of damage, injury, liability, loss or any other negative incidence. It can be caused by external or internal sources. The risks can be avoided by taking appropriate preventive actions. In the case of insurance, risk has a different meaning where the chances of an unpredictable event are known but its frequency or time of actual occurrence is not known. It is the uncertainty of its occurrence that is more important. Consider each of the following, and discuss the type of risk that is present in each situation. Is the risk insurable? Explain your answers. • The Department of Homeland Security alerts the nation of a possible attack by terrorists. Attack by terrorist is a risk whose probability cannot be predicted. When, where it can happen cannot be said with surety. However the losses due to attack by terrorists may turn out to be huge and beyond the capacity of the insurers. Such attacks by terrorists are not insurable. • A home may be severely damaged by fire. This risk is also insurable as it can happen anytime and anywhere. However, insurance is restricted to damage incurred to home by accidental fire. • An investor purchases 100 shares of stock for a popular computer, tablet, and smartphone manufacturer. This type of risk is not insurable as it is a kind of gamble and stock price can go up or down depending on market conditions. • A river that periodically overflows may cause substantial property damage to thousands of homes in a floodplain. The overflow of river is not predictable. The probability and extent of damage can also not be quantified or predicted in advance. This risk is insurable. • Home buyers may be faced with higher mortgage payments if the Federal Reserve raises interest rates at the next meeting. The possibility of interest rates getting increased is known and certain. In insurance, the occurrence of event should not be certain and its extent should not be known in advance. So this is not insurable. • A worker on vacation plays the slot machines at the casino. The playing of slot machines is a gamble where there are chances of losing money. Such type of losses is not insurable as these are predictable. Part 2 When one says that an insurance policy is aleatory or talks about a contract of adhesion, what is that person referring to? The terms aleatory and contract of adhesion are commonly used in contracts between two parties and have a special meaning in the field of insurance. The term aleatory in an insurance policy refers to a contract that is dependent upon an event. The parties involved in this contract are asked to perform a particular action only upon occurrence of the specific event. Such events should not be controllable by either party. The examples of such events are death, natural disaster, fire resulting into loss of property. These types of contracts are commonly used in insurance policies. The liability of insurer does not arise unless and until the event occurs. In a contract of adhesion, the insurer has substantially more powers than the insured in creating the contract. For a contract of adhesion to exist, the insurer supplies the insured with standard terms and conditions that are the same to other customers. These are not negotiable. The insured is obliged to accept the entire contract with all of the terms and conditions specified. The insured does not have any power to add or delete any provisions in the said contract.