Christina S. & Raiyana K. imports goods from the U.S. The owners (C&R) worried that Canada-USA trade negotiations could break down next year, leading to a suspension on imports. In the event of a suspension, C&R firm expects its operating profit to drop substantially and its marginal tax rate to from its current level of 35% to 10%. An insurance company, owned by two old friends Khawaja Q. & Doris Z. (KD) has agreed to write a trade insurance policy that will pay $500,000 in the event of an import suspension. The chance of a suspension is estimated to be 10%, with a beta equal to -2.0. Let assume that the risk-free rate is 7% and the expected return of the market is 17%. (Show Calculations).
a. What is the actuarially fair insurance premium for this insurance?
b. What is the NPV of purchasing this insurance for your firm? What is the source of this gain?