Homework 3
This is a large homework, counting 3 times as much as a small homework.
Due ????
Instructions
Read the article on (CN.1) Histograms and VaR at http://seedsppp.blogspot.com/2012/05/qm-histograms-and-var.html. to answer the following questions. Answers must be typed (except for crossword puzzle) and written in complete, thoughtful sentences. This follows the same directions as Homework 1, so you may want to revisit the instructions on that homework. You grade will be determined by the accuracy of your answers and my impression of how well you studied and thought about the article.
(A) Definitions—define the following words or terms and how they are discussed in the article, and do so using thoughtful sentences.
(A.1) Great Recession
(A.2) histogram
(A.3) Value-at-Risk (VaR)
(A.4 - A.14) Crossword Puzzle—Complete the following crossword-puzzle. At least one word is hyphenated.
Across
3. A type of loan given to someone with a bad credit history, making the loan more risky than standard loans.
6. A payment made by an insurance company to the holder of an insurance policy, if the adverse relevant to the policy occurs. Like, if you buy car insurance and get into a wreck, the company pays you a certain amount of money to compensate you for the damage done to your car.
7. Liquid assets offered to secure a loan, where if the loan is not paid back the lender takes ownership of the assets.
10. Someone who buys and sells financial instruments, usually to speculate on short-term movements in prices
Down
1. A(n) ___________ bank is like a bank for rich people, where they park their money and let the bank invest it and earn a return.
2. A(n) _____ fund is like an investment bank, but are often smaller, more aggressive, and specialize in a unique form of trading or investment.
4. Financial instruments are often purchased by borrowing some of the money and paying the rest out of one's own cash. A leverage— _________ equals the amount of money one borrows to buy an investment divided by the amount of one's own cash used to buy that investment.
5. Another word for borrowing. Often used to denote the amount of money one borrows.
7. Someone who loans money. These are the people who were bailed-out in the 2008 Financial Crisis.
8. A(n) _______ asset is an asset that can be easily bought and sold. Like, if you have Treasury Bonds, you can easily sell those bonds at any point in time. A house is not a(n) ____ asset because it takes a long time to sell a house, and the quicker one wishes to sell it the lower price one must accept.
9. The amount of money you regularly pay to an insurance company, regardless of whether the adverse event relevant to the insurance policy occurs. Like, if you buy car insurance, you pay this money regardless of whether you get into a wreck.
(A.15) Suppose you purchase a collection of stocks that costs $5,500,000. Regulators tell you the maximum leverage-ratio you may apply to the purchase is 30:1. What is the maximum amount of money you can borrow to help pay for this investment, and what is the minimum amount of your own money you can pay? Hint: make X the amount of cash you pay. If the leverage-ratio is 30:1, the amount you borrow is 30X. Set up an algebraic equation that allows you to solve for X.
(B) People, Stories, and Concepts
(B.1) What was the book The Number That Killed Us about? [very short answer]
(B.2) [Come back to this question after you have read all of the article] In the Margin Call scene, although it will be a little difficult for you, try and describe what the computer models were telling them. That is, what about the computer models frighten them so, and what does it mean for the company? When they were talking about “projecting” and “testing” historical patterns of volatility, what do you think they meant? When they said “projected losses were greater than the value of the company”, where did those projected loses come from? [long answer]
(B.3) Explain the type of insurance AIG sold (short answer). [short answer]
(B.4) When AIG created histograms of their projected profits and losses, what error did they commit when calculating the probabilities regarding sub-prime loans (using Reason 1 only)? [short answer]
(B.5) Describe what Bailey and Allen Greenspan were wrong about in regards to the financial industry. [short answer]
(B.6) Much of the article is dedicated to the premise that faulty histograms produced bad VaRs, helping to produce the 2008 Financial Crisis. Suppose you are helping someone understand the financial crisis but they know little or nothing about histograms. First explain to them what a VaR is, using non-technical terms. Then explain to them the three ways histograms and VaR were misused, without having to explain to them what a histogram is. Naturally, not everything you say will be technically correct. The question is whether you can relay the most essential facts in an understandable fashion. [long answer]
(B.7) You work for a crop insurance company and are in charge of creating histograms of crop yields and recommending a minimum premium price. These two outputs are used by your company to help them set crop insurance premiums. Your boss wants you to “massage” the data such that she can justify low premiums. Remember that—in general terms—the minimum premium a company can charge equals the probability of a low yield multiplied by the indemnity paid in that event. How would you go about creating a histogram that justifies low premiums, if in fact the probability of a low yield is substantial? That is, what would you differently to comply with your bosses’ request, compared to the case where you are perfectly honest and ethical? To answer this question, consult section A.4 about how VaR was misused. [long answer]
(C) Crop Insurance for Cotton in S.C.
(C.1) Download cotton yields for S.C. between 1953 and 2006 at http://asp.okstate.edu/baileynorwood/SeedsPPP/data/SCCottonYields.xlsx. Ignore the variable Time Trend. Create a clear and attractive histogram for these yields, following the directions given in Video 3—How To Construct a Histogram. Note that you must decide the appropriate bins to use. This histogram will be graded in considerable detail.
(C.2) Suppose you work for an insurance company that sells policies which pay farmers $1,000 whenever yields are 400 lbs per acre or less. The yield is per acre, and the indemnity of $1,000 means the farmer will get $1,000 for every acre enrolled in the insurance policy. Based on your histogram, what is the minimum per acre premium your company should charge for this policy?
(C.3) If your company charges a price equal to the minimum price in (C.2) plus 20%, what is the policy price?
(C.4) If you sell this policy at the price in (C.3) and next year’s yield is 478, what are the per acre profits of this policy?
(C.5) If you sell this policy at the price in (C.3) and next year’s yield is 325, what are the per acre profits of this policy?
(C.6) If you sell this policy at the price in (C.3), what is the expected profits of the policy when the policy is sold? That is, if this policy were sold thousands of times, what would the average profit per acre be?
(D) VaR Without Histograms
(D.1) Download data on the simulated profits / losses for a company at: http://asp.okstate.edu/baileynorwood/SeedsPPP/data/(fall2012)Hw3data.xlsx. There are 100 total simulated profits / losses, representing the possible profits the firm may experience and the probability of each possibility. I want you to calculate the VaR for this firm using a 7% threshold without using a histogram. Do this by first sorting the data in Excel (look under Data top at top then the Sort command underneath). Sort the profits / losses from the smallest to the largest number. Then, find the specific loss at which 7% of the simulations are less than or equal to this loss and 93% are greater. Whatever that specific loss is, that is the VaR.
(D.2) Repeat (C.1), but now identify the VaR using a threshold of 12%.
