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3、Which of the catastrophe bonds are event based? Which are subject to the moral hazard problem?

A) Parametric; Indemnified.
 
B) Indemnified; Indemnified, Parametric.
 
C) Indemnified, Parametric; Indemnified.
 
D) Indemnified; Indemnified.

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 The correct answer is C

Indemnified notes are based on internal events and are subject to a moral hazard problem. Parametric notes are based on external events.

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AIM 5: Describe the characteristics of catastrophe options and catastrophe bonds.

 

1、The payoff for CBOT catastrophe options is most like:

A) a long put option.
 
B) a covered call option. 
 
C) an insurance policy with a deductible and co-insurance feature. 
 
D) a short futures contract. 

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The correct answer is C

The CBOT catastrophe option is designed as a spread option based on an index of underwriting property losses experienced by a large pool of insurers. Its spread feature combines a long call position with a low exercise price with a short call position at a higher exercise price. As a result, losses less than the lower exercise price and greater than the higher exercise prices are uninsured, creating a net payoff similar to an insurance policy with a deductible and co-insurance feature. Long puts and covered calls do not have spread-like payoffs.

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2、The cash flows of catastrophe bonds might be linked to:

 
      I. the firm’s dividend payments.
     II. internal loss events.
    III. industrywide underwriting losses.
    IV. an operational index.

A) II, III, and IV.
 
B) I only.
 
C) III and IV only.
 
D) II and III only.

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 The correct answer is A

Cat bonds, as they are known, can include cash flows from internal risk events (as in the case of indemnified notes), external risk events (as with parametric notes), or the value of an index (as with indexed notes). The firm’s dividend payment, however, is not a risk event and can be easily manipulated by the firm.

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AIM 6: Discuss limitations to operational risk hedging.

 

1、In general, operational risk management:

A) is objective.
 
B) can accurately incorporate correlations among risk events. 
 
C) is challenged by the need to identify operational risks. 
 
D) benefits from many databases with strong predictive value. 
 

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 The correct answer is C

Operational risk management is challenged by its generally subjective nature. Even identifying the potential risk events and the correlations among these risks requires subjective analysis, thereby compromising the accuracy of the analysis. Part of the reason for the high degree of subjectivity is the lack of generally available data that can be used to confidently project future risks.

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2、Which of the following are limitations to operational risk hedging?

Identifying operational risks is a highly subjective process.
Distributions of loss frequency and loss severity are unavailable.
Risk correlations are difficult to forecast around extreme events.
A) I only.
 
B) I and II only.
 
C) II and III only.
 
D) I and III only.

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 The correct answer is D

Identifying and measuring operational risk is highly subjective. Correlations are not necessarily stationary, especially during extreme events.