UIMS

Risk Management
Assignment
Kartik Chell

2012

ASSIGNMENT
Ans 1. Insurance and its types
In this modern era, so many technologies have been invented. On the other hand, risk of life has also been increased than earlier. For controlling the risk or safe life, a policy has been introduced which is called insurance. As the word insurance it-self describes its meaning to make sure of something or someone. Insurance is a guarantee of compensation in the case of loss; compensated to people or companies so frightened about danger that they have made prepayments to an insurance company. Insurance is a course of action planned to make sure that you are no worse off after an accident or calamity than you were previously. Insured is an individual whose interests are confined by an insurance policy. He is a person who contracts for an insurance policy that secures him in opposition to loss of property or life or health etc. Whenever you acquire an insurance policy, you reimburse a premium to the insurance company. If you never make a claim, you never get a hold any of the money back. Insurance is collected with the premiums of others who have taken out insurance with a meticulous compact.

Types of Insurance
Generally, there are two types of insurance. 1. Life Insurance 2. General Insurance 1. Life Insurance: The majority of people take life policy for the purpose to restore the financial involvement made for the security of their family. Life insurance can be antiseptic insurance, which pays only on the death of the insured. Three types of expenses can be covered by the earnings from life insurance: substitution of the policyholder's income, property taxes, and burial costs. Types of Life Insurance Term Insurance Policy

A term insurance policy is a pure risk cover policy that protects the person insured for a specific period of time. In such type of a life insurance policy, a fixed sum of money called the Sum Assured is paid to the beneficiaries (family) if the policyholder expires

within the policy term. For instance, if a person buys a Rs 2 lakh policy for 15 years, his family is entitled to the sum of Rs 2 Lakh if he dies within that 15-year period. If the policy holder survives the 15-year period, the premiums paid are not returned back. The advantage, apart from the financial security for an individual’s family is that the premiums paid are exempt from tax. These insurance policies are designed to provide 100 per cent risk cover and hence they do not have any additional charges other than the basic ones. This makes premiums paid under such life insurance policies the lowest in the life insurance category.

Whole Life Policy

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A whole life policy covers a policyholder against death, throughout his life term. The advantage that an individual gets when he / she opts for a whole life policy is that the validity of this life insurance policy is not defined and hence the individual enjoys the life cover throughout his or her life. Under this life insurance policy, the policyholder pays regular premiums until his death, upon which the corpus is paid to the family. The policy does not expire till the time any unfortunate event occurs with the individual. Increasingly, whole life policies are being combined with other insurance products to address a variety of needs such as retirement planning, etc. Premiums paid under the whole life policies are tax exempt.

Endowment Policy
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Combining risk cover with financial savings, endowment policies are among the popular life insurance policies. Policy holders benefit in two ways from a pure endowment insurance policy. In case of death during the tenure, the beneficiary gets the sum assured. If the individual survives the policy tenure, he gets back the premiums paid with other investment returns and benefits like bonuses. In addition to the basic policy, insurers offer various benefits such as double endowment and marriage/ education endowment plans. In recent times, the concept of providing the customers with better returns has been gaining importance. Hence, insurance companies have been coming out with new and better ULIP versions of endowment policies. Under such life insurance policies the customers are also provided with an option of investing their premiums into the markets, depending on their risk appetite, using various fund options provided by the insurer, these life insurance policies help the customer profit from rising markets. The premiums paid and the returns accumulated through pure endowment policies and their ULIP variants are tax exempt.

Money Back Policy

This life insurance policy is favored by many people because it gives periodic payments

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during the term of policy. In other words, a portion of the sum assured is paid out at regular intervals. If the policy holder survives the term, he gets the balance sum assured. In case of death during the policy term, the beneficiary gets the full sum assured. New ULIP versions of money back policies are also being offered by various life insurers. The premiums paid and the returns accumulated though a money back policy or its ULIP variants are tax exempt.

ULIPS
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ULIPs are market-linked life insurance products that provide a combination of life cover and wealth creation options. A part of the amount that people invest in a ULIP goes toward providing life cover, while the rest is invested in the equity & debt instruments for maximizing returns. They provide the flexibility of choosing from a variety of fund options depending on the customers risk appetite. One can opt from aggressive funds (invested largely in the equity market with the objective of high capital appreciation) to conservative funds (invested in debt markets, cash, bank deposits and other instruments, with the aim of preserving capital while providing steady returns). ULIPs can be usefull for achieving various long term financial goals such as planning for retirement, child’s education, marriage etc.

Annuities and Pension

In these types of life insurance policies, the insurer agrees to pay the insured a stipulated sum of money periodically. The purpose of an annuity is to protect against financial risks as well as provide money in the form of pension at regular intervals

2. General Insurance: It is an insurance which is bought for the purpose to secure your general things like, Cars, Animals, Properties etc. In general insurance, you can claim for the stolen car, burned house and the death of your pet. In short, insurance saves you and your expenses and gives guarantee for your future.

Ans 2. Pricing of Forwards and Futures. Forward and Futures Prices Simple asset (no income, no costs, etc.)
• Basic formula

F0 = S0erT where T : Time until delivery date S0 : price of the underlying asset F0 : forward or futures price today r : risk-free rate of interest per annum (continuous compounding) • Equivalently S0 = F0e−rT . Market dynamics – If F0 > S0erT : 1. Buy the asset now (go long in the asset) at S0. 2. Short forward contracts on the asset (promise to sell the asset in the future at F0). 3. Profit at delivery date = F0 − S0erT . – If F0 < S0erT : 1. Short the asset now (borrow the asset and sell it now for S0). 2. Go long on forward contracts on the asset (promise to buy the asset in the future for F0). 3. Profit = S0erT − F0. Known income Let I0 be the present value of the future income stream, then F0 = (S0 − I0)erT ⇒ S0 = F0e−rT + I0. Intuition: • Let T = 0, then F is the spot price less income. • At time T, I will receive the asset minus the income stream. Known yield • Income is not fixed. Instead it is a variable percentage of the asset’s price at the time the income is paid (e.g., a stock index). r = interest rate (assumed constant)

qt = asset’s yield pt = wealth at time t • There are two investment strategies: 1. Put p into the risk-free asset and earn r. At any time t, the rate of earning is rpt. 2. Put p into the other asset and earn q plus any capital gain, so income at any time t is qtpt + dpt dt Value of a forward contract f = value of an existing forward contract today K = delivery price in that contract • Basic formulae – Long contract: f = (F0 − K)e−rT – Short contract: f = (K − F0)e−rT Elaborations: – Simple asset: F0 = S0erT ⇒ f = S0 − Ke−rT (long contract) – Known income: F0 = (S0 − I0)erT (I0 ≡ present value of income stream) ⇒ f = S0 − I0 − Ke−rT (long contract) – Known constant yield: F0 = S0e(r−q)T ⇒ f = S0e−qT − Ke−rT (long contract) Forward contract on foreign currency F0 = S0e(r−rF )T where rF = foreign country’s risk-free rate. We can think of the foreign currency as an asset paying a known yield of rF . Forward on commodities • Formula: F0 = (S0 + U)erT where U ≡ present value of all the storage costs (intuition: let T = 0, then S = F − U). • Alternative possibility: storage costs proportional to the price of the commodity:

F0 = S0e(r+u)T where u ≡ storage cost rate. Nota that u is, in effect, a negative income and enters that way in the formula. Concumption commodities and convinience yield: 1. Suppose F0 > (S0 + U)erT To take advantage of this situation: (a) Borrow S0 + U at rate r (b) Buy one unit of the commodity and pay storage cost (c) Short a forward contract on one unit of the commidity. (d) Realize a profit of F0 − (S0 + U)erT at time T. There is no problem implementing this strategy. Doing so will tend to make F0 fall and S0 rise, eliminating the arbitrage opportunity. 2. Suppose F0 < (S0 + U)erT For an investment asset (for which stocks exist), use the following strategy: (a) Sell the commodity now; avoid paying the storage costs. (b) Invest proceeds at risk free rate r. (c) Go long in a forward contract (d) Receive a (riskless) profit of (S0 + U)erT − F0. As before, this kind of arbitrage causes S0 and F0 to change to restore the equality F0 = (S0 + U)erT . A problem with consumption goods: there may be no stocks available for borrowing. – Stocks may exist; they just are not available for borrowing because their owners are holding them to consume them, not to make an investment profit from them. – For such consumption goods, the inequality F0 < (S0 + U)erT may persist. – Users of the consumption good feel that ownership of a commodity provides benefits that are not available from holding a forward or futures contract instead. – These extra benefits give a flow of services accruing at a rate called the convenience yield, defined as the rate y that makes the following equation hold: F0eyT = (S0 + U)erT [or S0e(r+u)T if appropriate]

Ans 3. Types of Rates Treasury Rates:The Treasury rate refers to the current interest rate that investors earn on debt securities issued by the U.S. Treasury. The federal government borrows money by issuing U.S. Treasury bills, notes and bonds. The current Treasury rate is an important benchmark and indicator for investors and economists. These are the interest rates applicable to borrowing by a Government in its own currency. U.S. treasury rates are rates at which the U.S. Government can borrow in U.S. dollars; Japanese treasury rates are rates at which the Japanese Government can borrow in yen. Since Government does not default on their own currency, treasury rates are also called risk free rates.In India Treasury Bill is a negotiable debt obligation issued by a government. Treasury bills are considered to be short-term, as the period of maturity is one year or less. They are exempt from local and state taxes. They are the safest form of marketable investment. These are Indian variant of Treasury rates. LIBOR Rates: LIBOR is the interest rate that banks charge each other for onemonth, three-month, six-month and one-year loans. LIBOR is an acronym for London Inter Bank Offered Rate. This rate is that which is charged by London banks, and is then published and used as the benchmark for bank rates all over the world. LIBOR is compiled by the British Bankers Association (BBA), and is published 11 am each day in conjunction with Reuters. It is comprised from a panel of banks representing countries in each of the quoted currencies. LIBOR is generally higher than the corresponding treasury rates, since they are not risk free rate. Repo Rate In derivatives market repo or repurchase agreement is contract where an investment dealer who owns securities agrees to sell them to another company now and buy back them at a later time at a slightly higher price. In return the company provides loan to the dealer. The difference between the price at which the securities are sold and the price at which the securities are repurchased is the interest earned on securities like bonds, debentures etc. This interest rate is called

repo rate. The repo which are settled daily are called overnight repo and longer term repo are called term repo. In macro economics discount rate at which a central bank repurchases government securities from the commercial banks, depending on the level of money supply in the economy, which it decides to maintain in the country's monetary system. It is called repurchase agreement. To temporarily expand the money supply, the central banks decreases repo rates (so that banks can swap their holdings of government securities for cash), to reduce the money supply it increases the repo rates. Alternatively, the central bank decides on a desired level of money supply and lets the market determine the appropriate repo rate. The Reserve Bank of India (RBI) raised repo and reverse repo rates by 25 bps to 8.5% on in October 2011 to arrest rising inflation in Asia's third largest economy. Zero rates Zero rate or n-year zero rate or zero coupon rate is rate of interest earned on an investment that starts today and lasts for n years. The interest and principal are realized at the end of n years. There are no intermediate payments within the period of n years up till the maturity period. This is also sometimes known as nspot rate. Since no coupons or interest is paid during the period zero (today) to nperiod, it is called zero coupon rate. Zero-Coupon Bond It is a debt security that doesn't pay interest (a coupon) but is traded at a deep discount, rendering profit at maturity when the bond is redeemed for its full face value. Some zero-coupon bonds are issued as such, while others are bonds that have been stripped of their coupons by a financial institution and then repackaged as zero-coupon bonds. Because they offer the entire payment at maturity, zerocoupon bonds tend to fluctuate in price much more than coupon bonds. Bond Pricing Bonds can be priced at a premium, discount or at par. If the bond's price is higher than its par value, it will sell at a premium because its interest rate is higher than current prevailing rates. If the bond's price is lower than its par value, the bond will

sell at a discount because its interest rate is lower than current prevailing interest rates. When you calculate the price of a bond, you are calculating the maximum price you would want to pay for the bond, given the bond's coupon rate in comparison to the average rate most investors are currently receiving in the bond market. Required yield or required rate of return is the interest rate that a security needs to offer in order to encourage investors to purchase it. Usually the required yield on a bond is equal to or greater than the current prevailing interest rates. Most bonds provide coupons periodically. The owner also receives the principal or face value of bond at the time of maturity. The theoretical price of a bond can be calculated as the present value of all the cash flows that will be received by the owner of the bond using the appropriate zero rates or discount rates.

The treasury zero rates are given by the following table:

Maturity (years) 0.5 1.0 1.5 2.0

Zero Rate (% cont comp) 5.0 5.8 6.4 6.8

Example: Calculate the theoretical price of a2 year bond whose principal is Rs.100, and provide a coupon rate of 6% per annum compounded semi-annually for a coupon of Rs.3. Solution: The first coupon will compounded at 5%, second at 5.8%, third at 6.4%, fourth and principal at 6.8(see table above the average zero rate is 5+5.8+6.4+6.8 = 24/4 = 6%)

Thus we have

Bond Yield The bond yield is the discount rate that makes the present value of the cash flows on the bond equal to the market price of the bond Example: Suppose that the market price of the bond in our example equals its theoretical price of 98.39.The bond yield (continuously compounded) is given by solving to get y=0.0676 or 6.76%., with help of trial and error method, given as follows:

Par Yield The par yield for a certain maturity is the coupon rate that causes the bond price to equal its face value. In our above example suppose the coupon on a two year bond is C per annum or C/2 per six months or semi-annually. Using zero rates from above table we have;

On solving with help of trial and error method we have C = 6.87% Forward Rate It is the amount that it will cost to deliver a currency, commodity, or some other asset at a time in the future. The forward rate is the price used to determine the price of a futures contract. The forward rate is the future zero rate.

Suppose a sum of Rs.100 is compounded annually at 10% per annum, the sum received at the end of a year is Rs.110.5 the sum received at the end of the second year will be Rs.122. Thus for a zero rate of 10% forward rate will be 11% a rate received in second year of investment. This is illustrated by the following table for calculation of forward rates:

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