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Institute of Actuaries
EXAMINATION
12 April 2005 (pm)
Subject ST5
Finance and Investment
Specialist Technical A
Time allowed: Three hours
INSTRUCTIONS TO THE CANDIDATE
1.
Enter all the candidate and examination details as requested on the front of your answer
booklet.
2.
You have 15 minutes at the start of the examination in which to read the questions.
You are strongly encouraged to use this time for reading only, but notes may be made.
You then have three hours to complete the paper.
3.
You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
4.
5.
Attempt all 7 questions, beginning your answer to each question on a separate sheet.
6.
ST5 A2005
Faculty of Actuaries
Institute of Actuaries
(i)
(ii)
State the taxation factors and influences on these factors that need to be
considered when selecting investments which maximise after tax returns.
Outline the three main systems of corporation tax.
[6]
[3]
[Total 9]
Fund Return
Market Return
US
Japan
+5.5%
+9.4%
+5.1%
+8.3%
Market returns are stated with reference to the S&P 500 for the US and Topix for
Japan.
A trustee points out that the Dow Jones Index rose by 6% over the period and the
Nikkei rose by over 10% and therefore the fund has actually underperformed in these
regions.
Outline the points you would make in your response.
[8]
An insurance company has a line of shares held within its shareholders funds. The
shares are in a quoted investment management organisation to whom the insurance
company has outsourced the management of its policyholders funds and, due to good
recent performance, these funds are experiencing significant positive cashflows. The
rest of the shareholders funds are invested in bonds and property. The insurance
company wishes to transfer half the line of stock to the policyholders global equity
fund at a discount to the prevailing bid price and has been required by the regulator to
commission an independent valuation of the discounted share price at which the
transfer should take place.
(i)
[3]
(ii)
Explain why the company might wish to transfer the shares to the
policyholders funds.
[3]
(iii)
(iv)
ST5 A2005
(a)
(b)
List the additional information you would consider in setting the price.
[3]
Set out the other business issues that should be considered by the committee
responsible for agreeing the discount on behalf of the policyholders.
[11]
[Total 20]
(i)
[5]
(ii)
[2]
(iii)
The table below contains information about a pension fund and index returns. The
benchmark for the fund is an investment that is 50% equities and 50% bonds.
31/12/03
31/12/04
Contributions
Values (m) Values (m)
(m)
Equities
Bonds
Cash
Equity Total Return Index
Equity Index Yield
Bond Total Return Index
Bond Index
Base Rate
600.0
350.0
50.0
1,000.0
3.00%
1,220.0
275.0
3.50
700.0
450.0
50.0
1,115.0
3.12%
1,299.3
280.5
4.00
12.0
63.0
1.0
Investment
Income
(m)
15.0
25.0
1.0
(i)
Defining all formulae used and stating any assumptions made, analyse the
performance of the fund.
[11]
(ii)
Comment on the results of your analysis and any investment features that the
data may suggest.
[9]
[Total 20]
In Nestl v. National Westminster Bank plc [1994] the judge considered that
decisions of trustees should be judged by modern portfolio theory and that the risk
level of the whole portfolio is considered rather than just individual investments.
(i)
(ii)
ST5 A2005
Give examples of how trustees could make poor manager selection decisions
based on these behaviours.
[4]
[Total 14]
Spenser & Michael (S&M) is a UK-based food retailer which is well known
throughout Europe and the Far East but largely unknown in the United States of
America. S&M have tried to borrow US$500m at a fixed rate of interest in US
dollars but the interest rates S&M can secure are prohibitively expensive.
S&M have been quoted a five-year fixed rate of 6% per annum for a sterling
denominated loan.
BIM is a US-based food retailer and would like to borrow the sterling equivalent of
US$500m over five years at a fixed rate of interest in sterling. Like S&M, BIM has
been quoted prohibitively expensive rates for a sterling loan.
BIM has been quoted a five-year fixed rate of 5.25% per annum for a US$
denominated loan.
At the time of the transaction, the yield on five-year government bonds is 5.25% in
the UK and 4.75% in the US.
You are the head of the currency swap desk of a global investment bank.
(i)
Describe, using the above information, the factors that will influence the
design of a five-year currency swap.
[8]
(ii)
Design a five-year currency swap for S&M and BIM that will net the global
investment bank 0.45% per annum over the life of the swap while ensuring
that S&M and BIM have no exchange rate risk on their exchange of interest
payments.
[4]
(iii)
Describe the risks that the global investment bank takes on in structuring this
swap for BIM and S&M and how the global investment bank can hedge these
risks.
[5]
[Total 17]
END OF PAPER
ST5 A2005
Faculty of Actuaries
Institute of Actuaries
EXAMINATION
April 2005
Subject ST5
Finance and Investment
Specialist Technical A
EXAMINERS REPORT
Introduction
The attached subject report has been written by the Principal Examiner with
the aim of helping candidates. The questions and comments are based around
Core Reading as the interpretation of the syllabus to which the examiners are
working. They have however given credit for any alternative approach or
interpretation which they consider to be reasonable.
M Flaherty
Chairman of the Board of Examiners
28 June 2005
Faculty of Actuaries
Institute of Actuaries
April 2005
Examiners Report
Page 2
April 2005
Examiners Report
(ii)
Classical: A company s profits are taxed twice: once in the hands of the
company and once in the hands of the shareholder. The shareholder may be
subject to tax on dividends and/or capital gains arising from increases in the
share price.
Split-rate: Similar to the classical system excepting that different tax rates
may be levied on retained profits and distributed profits. The system might be
used in conjunction with a system that taxes investor s income and capital
gains at different rates.
Imputation: A system designed to enable a company s profit to be taxed once
rather than twice. Dividends paid from taxed profits are paid to shareholders
together with a tax credit. The rules vary greatly and can be quite complex but
it is often the case that the tax credit received is sufficient to offset the tax due
on the net dividend. Also, lower taxed investors can often reclaim the tax
credit.
Page 3
April 2005
Examiners Report
While the Dow Jones and Nikkei are indices that are often quoted they are not
particularly representative of their markets. The Dow Jones Index is based on 30
shares and the Nikkei is based on 225 shares.
The S&P 500 and Topix are more broadly based being based on 500 and 1,100 shares
respectively. They are therefore more representative.
Both the DJ and N are unweighted indices, that means that every company has the
same impact on the index.
Both the T and S&P are weighted indices, the weights being the market capitalisations
of the companies, this means that larger companies have more influence on the index
than small companies.
The constituents of the N have changed little since inception whereas the Japanese
stock market has changed significantly.
The DJ is made up of 30 industrial stocks and therefore ignores the impact of other
areas e.g. financials.
The constituents of both the S&P & T are revised regularly and encompass the full
range of companies operating in their respective markets.
Therefore the S&P & T are better indices to use when looking at fund performance as
they better represent the universe from which fund managers can select stocks.
(i)
to correct market inefficiencies and to promote efficient and orderly
markets
to protect consumers of financial products
to maintain confidence in the financial system
(ii)
to remove volatility in the insurance companies solvency margin
to reduce the inherent investment risk of the shareholders investments
get a better price than a public sale
to avoid negative publicity/speculation arising from a public sale
(iii)
(iv)
Page 4
Being seen to avoid conflicts of interest (who instigated transaction and why).
April 2005
Examiners Report
(i)
Starting point is to take the market prices of conventional bonds (e.g. gilts) for
a range of possible maturities.
Starting at the shortest maturity, T1 say, use the observed market price and
solve for the yield. This yield is an approximation for the zero coupon rate for
maturity T1, called R1, say.
Using the next shortest maturity conventional bond maturing at T2, again take
the observed price and using R1 solve for the forward rate starting at T1 for
the period T2 T1. Now solve for the spot rate R2.
Repeat using the next maturity conventional bond until the longest maturity
bond has been used. This fixes the longest spot rate at the maturity of the
longest bond.
Plot the spot rates R(T) against T
(ii)
This is the coupon rate that the bond would be required to make the theoretical
value of the bond equal to its nominal value under the prevailing pattern of
zero coupon interest rates.
(iii)
S1 = 4.65%
P2 = 108.56
April 2005
Examiners Report
S3 = 3.94%
If continuous rates used the answers are S1=4.54%, S2=4.80% and S3=3.86%.
P2=108.32(using continuous rates) is not correct but we do not penalise in other calculations.
(i)
12/2] = 18.86%
1 = 6.50%
1 = 11.50%
1 = 9.0%
Page 6
0.50) * (11.50
9.0)
April 2005
Examiners Report
Cash Asset Contribution = 0.34 (as it is not part of the index assume return =
actual, although 3.5 to 4.0 could be used and then a stock contribution would
have to be calculated)
Equity Stock Contribution = 594/1,025 * (18.86
11.50) = 4.27%
6.50) = 1.19%
The sum of the parts = 5.64% compared with actual 5.63% due to rounding
error.
(ii)
Asset allocation positive in both bond and equity decisions but holding cash a
negative.
Stock selection very positive for both bonds and equities.
Yield on equity investments was 15/594 = 2.53% compared with 3.12% for
index so investment strategy in equities is capital growth orientated or the
timing of purchases and sales was such that a full year of dividend income has
not been received.
Yield on bonds was 25/381.5 = 6.55% compared with 4.5% [ difference
between bond index and total return index] for index. This suggests a
portfolio away from the index possibly in lower quality corporate bonds or
emerging market debt.
Cash return very poor given base rates.
Fund manager should be asked to comment on the strategy.
Strategy should be compared with mandate.
(i)
Page 7
April 2005
Examiners Report
(ii)
(i)
S&M (quoted + 0.75% over sterling government bonds) has a poorer credit
rating than BIM (quoted +0.50% over US$ government bonds) as evidenced
by the spread over corresponding five-year government rates.
To avoid any exchange rate risk on the exchange of interest rate payments,
S&M will need to borrow at the five-year fixed rate of 6% per annum in
sterling and receive payments at a rate of 6% per annum fixed for five years
from the global investment bank as part of the swap design.
To avoid any exchange rate risk on the exchange of interest rate payments,
BIM will need to borrow at the five-year fixed rate of 5.25% per annum in
US$ and receive payments at a rate of 5.25% per annum fixed for five years
from the global investment bank as part of the swap design.
The difference between the US$ payments by S&M to the global investment
bank and the sterling payments by BIM to the global investment bank provides
the margin for the global investment bank.
However, the global investment bank will probably want to charge a higher
rate of interest to S&M than to BIM to reflect the poorer credit rating of the
former.
(ii)
Page 8
In arriving at its fee the global investment bank would probably wish to tilt the
charges to BIM and S&M to reflect their relative credit ratings. Thus the
April 2005
Examiners Report
global investment bank may wish to charge S&M a somewhat wider margin
than BIM.
One possibility would be to charge S&M a US$ five-year fixed rate of 5.80%
(1.05% over five-year US$ government bonds) and BIM a sterling five-year
fixed rate of 5.90% (0.95% over five-year sterling government bonds).
(iii)
The global investment bank is left with a residual foreign exchange risk on
each exchange of interest payments between the two parties.
This risk could be hedged by forward foreign exchange contracts.
The global investment bank is also left with credit risk.
Credit risk could be hedged using credit derivatives.
Page 9
Faculty of Actuaries
Institute of Actuaries
EXAMINATION
13 September 2005 (pm)
Subject ST5
Finance and Investment
Specialist Technical A
Time allowed: Three hours
INSTRUCTIONS TO THE CANDIDATE
1.
Enter all the candidate and examination details as requested on the front of your answer
booklet.
2.
You have 15 minutes at the start of the examination in which to read the questions.
You are strongly encouraged to use this time for reading only, but notes may be made.
You then have three hours to complete the paper.
3.
You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
4.
5.
Attempt all 9 questions, beginning your answer to each question on a separate sheet.
6.
ST5 S2005
Faculty of Actuaries
Institute of Actuaries
Define the role of a custodian, and list the services that they might offer in addition to
document safe keeping.
[4]
[Total 4]
(i)
Explain which of the two types of bond portfolio switches are more likely to
be carried out by the following type of investor:
(a)
(b)
(ii)
(iii)
Set out the processes involved in assessing whether or not there is a potential
yield difference between a 10 year AA rated corporate bond and a 10 year
government bond that can be exploited.
[4]
[Total 8]
(i)
(ii)
ST5 S2005
(a)
State, with reasons, which class of investor bears the most pre-payment
risk.
(b)
(c)
Describe, using a simple example, how the par value of the three
classes influences the pre-payment risk of class Y investors.
[5]
[Total 8]
(i)
[4]
(ii)
(iii)
(i)
Describe, with reasons, the types of merger that a UK based retail bank might
consider with a similar sized organisation operating in the UK.
[8]
(ii)
Describe the other factors that would need to be considered if the proposed
merger was to be with an organisation domiciled in another EU country. [6]
[Total 14]
Explain why the investment manager might actively deviate from the
benchmark asset allocation on a short-term basis.
[4]
(ii)
List the factors that should be considered by the trustees in setting the limits.
[3]
(iii)
ST5 S2005
[5]
[Total 12]
You are the investment manager of a life assurance company that has substantial
assets under management and invests a significant proportion of these assets in
alternative investments and derivative-type structures.
A sales person from an investment bank approaches you regarding the purchase of a
complex derivative product.
(i)
List the key questions regarding the derivative product that you would ask the
sales person.
[5]
(ii)
Describe the factors which you would consider in assessing the characteristics
of the derivative in terms of its fit with the life assurance company s
investment portfolios.
[5]
[Total 10]
(i)
Explain why equities are usually analysed in sector or industry groupings. [5]
(ii)
(a)
(b)
(iii)
State the features that characterise each of the following economic groups:
General Industries
Consumer Goods
Utilities
[6]
[Total 16]
You are an investment consultant to the trustees of a pension scheme. You are given
the following total return data for the fund and the indices included in the benchmark.
UK Equities
Overseas Equities
UK Bonds
Overseas Bonds
Fund Returns
Year 1 Year 2
Year 3
Index Returns
Year 1 Year 2
Year 3
10.1%
14.2%
6.4%
3.2%
17.6%
13.2%
4.1%
1.5%
8.5%
13.5%
7.2%
8.1%
16.0%
1.0%
5.4%
3.1%
2.5%
3.2%
3.1%
1.8%
5.4%
2.1%
4.5%
2.8%
The asset mix of the fund and of the benchmark at the start of year 1 was as follows:
UK Equities
Overseas Equities
UK Bonds
Overseas Bonds
ST5 S2005
Fund
Benchmark
45%
30%
15%
10%
60%
20%
10%
10%
You may assume that there is no rebalancing at any time. No contributions were paid
in and no benefits were paid out during the period.
(i)
Describe the principal sources of deviation between a fund and its benchmark.
[2]
(ii)
Calculate:
(a)
(b)
(c)
(iii)
END OF PAPER
ST5 S2005
[4]
[Total 16]
Faculty of Actuaries
Institute of Actuaries
EXAMINATION
September 2005
Faculty of Actuaries
Institute of Actuaries
Sept 2005
Examiners Report
A custodian ensures that financial instruments are housed under a proper system that
permits investment for proper purposes with proper authority.
The following services may also be provided: income collection, tax recovery, cash
management, securities settlement, foreign exchange, stock lending.
(i)
(a)
Anomaly switches, as these are less likely to alter the duration match
of the liabilities.
(b)
(ii)
The investor may take the view that despite the 0.5% pa higher yield on the 20
year bond, the need for a greater level of reinvestment during the bond s term
means that the additional return is insufficient compensation for the risk that
reinvestment terms might worsen. This is particularly likely if yields are
currently considered to be high relative to historical levels.
(iii)
First an estimate of the risk premium for the AA rated bond will be needed,
with a view to how this might change over the length of the anomaly switch.
This view will take into account default risk and other factors affecting the
yield such as lack of liquidity, coupon and any tax differences.
This will be used to estimate the additional yield that could be obtained
through changes in the risk premium relative to benchmark government bond
yields.
An allowance should be made for transaction costs at both ends of the switch.
Based on the additional yield, a decision as to whether to proceed with the
switch can be made.
(i)
Page 2
(ii)
(a)
Sept 2005
Examiners Report
(i)
(b)
(c)
Class Y investors bear very little pre-payment risk if the ratio of the
par value of the securities is 5:2:1 but class Y investors bear significant
pre-payment risk if the ratio of the par values is reversed to read 1:2:5.
BF is based on the idea that a variety of mental biases and decision making
errors affect financial decisions.
Central to BF is the psychology of how and why financial decisions are made.
Analysis within this field is believed to have some predictive qualities and the
findings used to help the proponents in their own decision making.
(ii)
(iii)
Page 3
Sept 2005
Examiners Report
Needs to cover:
(i)
Description of all the types of merger and the reasons why they are instigated
(and why not) as per Unit 8 section 4.
(ii)
(i)
(ii)
Performance target
Style of management
Correlations between assets
Cash flows and income
Costs of rebalancing
Rebalancing frequency
Scope to use derivatives
Risk Tolerance
(iii)
Not all factors will have limits placed on them as they are not manageable e.g.
cash flows and income but they will be taken into account when considering
other limits i.e. rebalancing to ensure efficient management.
Performance target limit the under performance by more than a set
percentage over a defined period, out performance also needs to be reviewed
(too high risk?).
Style of management
Page 4
Costs of rebalancing
Sept 2005
Examiners Report
Risk tolerance the funding level, corporate sponsor s financial status and
asset class risk/return expectations will all have different influences at
different times depending on how the risk of each is viewed. e.g. a well
funded scheme with a large surplus may be prepared to consider wider
parameters than one which is less well funded when the company sponsor is
financially sound.
(i)
(ii)
(i)
Grouping by industry
To reduce the number of factors that have to be taken into account when
analysing the share.
Quite a lot of industry statistics are available and are usually grouped by
industry.
Page 5
Sept 2005
Examiners Report
Disadvantages
Tend not to look at companies between sectors, only companies within
sectors.
Some shares don t move with their industry.
Advantages
Can become expert in one sector and understand it very well.
We can decide which factors affect a share price within an industry, then
analyse companies with this in mind.
Could group by:
Large cap/small cap
valuations tend to reflect growth/maturity/financial
strengths differently for large and small cap stocks.
Growth/Value
reflects the different universes and economic/market drivers
operating on these companies.
Exporters/Importers
reflects earnings from domestic or overseas influences
and impact of different regions economic growths and currencies.
Any two sensible suggestions should earn marks.
(iii)
Page 6
(i)
Sept 2005
Examiners Report
(ii)
45%
30%
15%
10%
100%
60%
20%
10%
10%
100%
26.24%
25.14%
14.20%
6.63%
22.14%
19.06%
17.04%
18.07%
14.57%
18.11%
Asset Class
Selection
0.14%
0.11%
0.00%
0.00%
0.25%
Stock
Selection
3.23%
2.43%
0.58%
0.79%
4.29%
Total
3.09%
2.32%
0.58%
0.79%
4.04%
The fund has out performed by 4.03%. Asset allocation was poor due to under
weighting UK equities and over weighting overseas equities. Equity stock
selection in both markets was very good whilst bond selection was poor in
both markets. Bond performance was consistently poor for both classes in
each year. UK equity performance was consistently good but overseas equity
performance was volatile with the third year accounting for more than the
stock selection added value in total.
Page 7
Faculty of Actuaries
Institute of Actuaries
EXAMINATION
30 March 2006 (pm)
Enter all the candidate and examination details as requested on the front of your answer
booklet.
2.
You have 15 minutes at the start of the examination in which to read the questions.
You are strongly encouraged to use this time for reading only, but notes may be made.
You then have three hours to complete the paper.
3.
You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
4.
5.
Attempt all 7 questions, beginning your answer to each question on a separate sheet.
6.
ST5 A2006
Faculty of Actuaries
Institute of Actuaries
You are a trustee to a mature but underfunded retirement benefit scheme which has
investments in a wide range of properties. Discuss the appropriateness of passive
management of the property assets within the fund.
[8]
(b)
(c)
You are advising the government of a country on how to set up a tax system. The
chief minister wants to tax investment income at a higher rate than earned income,
and to exempt capital gains from tax. His aims are to encourage entrepreneurial
activity and investment and to redistribute wealth from the rich to the poor. Explain
the flaws and unintended consequences of his proposed approach.
[8]
(i)
(ii)
[7]
250
300
5
-10
100
120
1.90
1.75
2.5
Japan
100
140
2
-5
325
400
190
200
1.0
Asset
Europe Asia
100
96
3
10
200
185
1.40
1.50
2.0
50
70
4
0
210
296
1.90
1.75
3.0
Cash
Total
0
5
0
5
100
100
1.00
1.00
4.0
500
611
14
0
The benchmark index is weighted 50% U.S., 30% Europe, 15% Japan and 5% Asia.
ST5 A2006 2
(i)
(ii)
(a)
(b)
The pairing of two shares in the same industry or sector and identifying
one as expected to rise in value while the other as expected to fall in
value.
[6]
(b)
Borrowing shares and selling them in the market hoping to buy them
back at a lower price.
[5]
(c)
(d)
[4]
(ii)
Describe how the manager might implement his pairing strategy to eliminate
some of the risks in (i) (a).
[2]
(iii)
How would the manager reduce the risk to the investors who do not redeem
their holdings in (i) (d).
[1]
[Total 22]
ST5 A2006 3
A mobile phone company requires additional financing and its treasury team has
noticed that it has an asset in the form of future payments by subscribers who are
required to make payments under their monthly contracts prior to the minimum period
ending. The team has approached your bank in order to set up an asset backed
security (ABS) issue via a special purpose vehicle (SPV). The company will transfer
the asset to the SPV in return for a payment of 500m, and the SPV will then issue an
ABS in 3 tranches as shown below, backed by these assets. The company will
purchase the equity tranche from the SPV.
Tranche
Senior
Mezzanine
Equity
Credit rating
Tranche size
AA
BB
n/a
400m
50m
50m
(i)
Explain why the company might wish to use its asset in such a way.
(ii)
Describe the tranched structure, including why there is an equity tranche, and
why the company might wish to purchase it.
[6]
(iii)
Explain the key risks to a purchaser of the mezzanine tranche, and describe
situations when these risks might result in losses.
[5]
(iv)
Comment on how your answer to (iii) would change if the asset value was
based on expected contract receipts for all existing contracts over the next 5
years, including payments after the minimum contract period expires.
[5]
[Total 22]
END OF PAPER
ST5 A2006 4
[6]
Faculty of Actuaries
Institute of Actuaries
EXAMINATION
April 2006
Subject ST5
Finance and Investment
Specialist Technical A
EXAMINERS REPORT
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.
M Flaherty
Chairman of the Board of Examiners
June 2006
Faculty of Actuaries
Institute of Actuaries
April 2006
Examiners Report
Comments
The solutions should not be taken as comprehensive. There are a number of additional points
that can be made in certain questions and these were awarded appropriate marks. There are
also a number of different solutions that can be derived for question 5 and these were also
awarded appropriate marks despite the fact that it would be unusual to see them in practice.
However alternative solutions tended not to give the same degree of information as those
shown here and consequently marks in subsequent sections of the question were lost.
In general candidates did bookwork well but failed to carry this through in the application
parts of questions and only the better candidates scored anything like reasonable marks in
higher skills parts. Roughly half the paper relates to application and candidates often gave
us bookwork rather than applying their knowledge to the problem in hand. Questions 2, 3, 6
and 7 were good examples of this with candidates on average scoring under 50% of the
marks available. Question 4 was well done by most candidates being bookwork. Question 1,
despite being bookwork, was not as well done as other bookwork sections possibly because of
the context in which it was framed. As has been the case in the past we were disappointed
with answers to question 5 despite the fact that arithmetical errors are not penalised because
we are more concerned that candidates understand the methods and assumptions that they
are using. In particular candidates show too little working, fail to use all the information
that is provided and do not think widely enough. Consequently they did not score well in the
second part of the question.
Page 2
April 2006
Examiners Report
Solution not split into (a) (c) as answers unlikely to conform to split of question.
Prospective tracking error is an estimation of the scale of volatility of prospective
relative performance given the current portfolio and benchmark.
It is usually expressed in a number of basis points per year.
It provides an estimate of the aggregate amount of investment risk within a portfolio
at the time it is calculated.
It is calculated using a quantitative model and depends on assumptions including: the
likely future volatility of individual stocks and markets relative to the benchmark and
correlations between different stocks and markets.
Tracking errors make no distinction between upside risk and downside risk.
In this regard it may not fit well with the trustees attitude to risk which will likely be
skewed to seek positive performance with a high probability whilst minimising the
probability of a significant negative performance.
Page 3
April 2006
Examiners Report
By exempting capital gains from tax and taxing investment income at a higher rate
than earned income, capital gains will become the most tax efficient method of wealth
creation and investment income will become the least tax efficient method of gaining
wealth.
Potentially this will encourage companies to retain profits rather than distribute them,
leading to higher levels of corporate investment
but it may also reduce the average rate of return for new investment opportunities
as opportunities that would previously have been ignored will now be developed.
The higher level of corporate investment will not necessarily increase the overall
growth rate of the economy as there will be less distributed income reinvested by
companies and individuals.
Individuals will be encouraged to pay themselves in the form of capital gains rather
than income, if they are able to do so, to minimise their tax liability.
This may lead to the creation of schemes that convert income into capital gains, which
across the economy as a whole are unlikely to result in any net wealth creation.
It is worth noting that wealthier individuals will typically be least dependent on earned
income, and will therefore be most able to structure their affairs to minimise their tax
liabilities.
Conversely poorer individuals are unlikely to have such flexibility and will therefore
pay more tax than if they were remunerated through capital gains.
Overseas investors are similarly likely to be able to structure their affairs in a way that
minimises tax.
Page 4
April 2006
Examiners Report
Attempts to prevent this (e.g. withholding taxes) may inadvertently result in the
country s assets commanding a lower purchase price, impacting on the wealth of the
nation as and when domestic assets are sold to overseas investors.
(i)
Financial resources
risks.
Internal organisation
keeping.
Relations with regulator
(ii)
Page 5
(i)
US
Japan
Europe
Asia
Cash
Total
(ii)
April 2006
Examiners Report
Curr Rtn
8.57%
-5.00%
-6.67%
8.57%
0.00%
1.96%
Alloc
0.00
0.03
2.99
1.84
0.00
4.86
Stock
-3.14
5.62
-0.07
-1.30
0.00
1.10
(b)
(i)
(a)
Page 6
April 2006
Examiners Report
(c)
The strategy will not be profitable unless the difference between the
rise in value of PharmaUP and the fall in value of PharmaDOWN is
sufficient to cover all the following costs:
Bid-Offer spreads
any impact on market depth
stamp duty and other levies
commission/brokerage fees
The manager will have to fund the cost of any dividends arising on the
shares borrowed and this adds to the minimum return necessary to
make the strategy profitable.
These costs will be offset to some extent on the interest income arising
on the cash generated by shorting the shares.
(d)
(ii)
To reduce stock specific risk, the manager might buy in a sector of the market
he forecasts will outperform over the next year and go short in a sector of the
market that will under perform in the same period.
This could be achieved using exchange traded funds.
(iii)
Page 7
(i)
April 2006
Examiners Report
(ii)
The equity tranche has been created to protect purchasers of higher tranches
against the value of the asset being lower than calculated in the prospectus.
Defaults in the customer contracts would first be set against the equity tranche,
then the mezzanine tranche and finally the senior tranche.
The default risks are reflected in the credit ratings, and the equity tranche is
unrated.
The ABS has been structured in this way to reduce the cost of borrowing.
The spread (additional yield) increases steeply as the credit rating declines.
The company may wish to purchase the equity tranche if it is confident that
the asset has been conservatively valued,
and therefore does not want to give up excess returns to other parties.
The nominal return on the equity tranche is likely to be well over 10%, and
therefore higher than the company s average (and possibly marginal) cost of
capital.
In practice it may be difficult to market the equity tranche as contract and
customer retention is to some extent under the control of the company, and
Page 8
April 2006
Examiners Report
There is some switching risk, although this should be low as subscribers will
have a penalty if they terminate contracts prior to the minimum period ending.
If the nature of the marketplace changes then this may result in losses.
There is some default risk if subscribers are unable to meet their remaining
contract payments. This risk would be higher if the contract automatically
terminates in certain situations (e.g. redundancy) and losses are likely to
increase in an economic downturn.
Most of the risk is likely to be restricted to the equity tranche.
(iv)
The key factor determining whether a loss will occur is how actual switches
and defaults compare to what has been assumed in the asset valuation.
The switching risk would increase materially as there will be a high expected
number of switches once the minimum contract period ends and the number of
switches is likely to remain at a moderate level for the duration of the 5 year
period
The default risk will also be higher although this is likely to remain broadly
stable over the 5 year period.
A possible exception to this pattern might be if subscribers with lower default
risk were cherry picked by a competitor.
In contrast to the previous scenario, it is likely that the mezzanine tranche will
have significant exposure to these risks, in addition to purchasers of the equity
tranche.
These additional risks would, all other things being equal, result in a higher
spread on the ABS particularly on the mezzanine tranche.
Page 9
Faculty of Actuaries
Institute of Actuaries
EXAMINATION
7 September 2006 (pm)
Subject ST5
Finance and Investment
Specialist Technical A
Time allowed: Three hours
INSTRUCTIONS TO THE CANDIDATE
1.
Enter all the candidate and examination details as requested on the front of your answer
booklet.
2.
You have 15 minutes at the start of the examination in which to read the questions.
You are strongly encouraged to use this time for reading only, but notes may be made.
You then have three hours to complete the paper.
3.
You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
4.
5.
Attempt all 7 questions, beginning your answer to each question on a separate sheet.
6.
ST5 S2006
Faculty of Actuaries
Institute of Actuaries
You are employed by a national government to oversee all aspects of the national debt
management policy.
Discuss how you might use an asset liability model, outlining the inputs, in this task.
[8]
An equity portfolio has a target beta of 1.2 relative to the market index.
(i)
[2]
(ii)
Describe the investigations you would make to determine the value added by
the fund manager to the portfolio, assuming full data is available.
[3]
(iii)
List reasons why the performance of the portfolio might differ from that of the
index.
[3]
(iv)
The beta of the portfolio has moved away from the target of 1.2. Explain how
individual stocks can be used to correct the beta.
[2]
[Total 10]
Outline the attributes of the relevant indices that you would consider in
deciding which index to use, and name two potentially suitable indices.
[6]
Two years after launch of the new contract, it consistently ranks in the top five
contracts on the exchange. The exchange is however concerned that take-up in
the asset management community has been lower than initially anticipated.
It believes that this reflects the widespread usage of restrictions in mandates for
European equity managers.
(ii)
The exchange decides to expand its range of contracts by splitting the European
equity contract into constituents that can be combined to re-create the existing
contract.
(iii)
ST5 S2006
List four classifications by which the contract may be sub-divided, and two
other variations on the original contract that might expand its appeal.
[3]
[Total 13]
ABC plc has a share price of 57 pence and paid a dividend of 2 pence per share in the
previous twelve months. It is considering issuing:
a convertible debenture, with a zero coupon, which is convertible into ordinary
shares on the basis of 150 shares per 100 nominal at any time over the next five
years; or
a zero dividend preference share at 100 that will be redeemed in five years time
at 138
(i)
Evaluate the returns that might be achieved from each of these investments
stating any assumptions.
[5]
(ii)
[7]
[Total 12]
Investments
Cash
Total
130
10
140
Income Statement
Dividends
Interest Income
5.0
0.5
Total
5.5
m
Shareholder Funds
Debenture 2016 (nominal value)
Total
110
30
140
m
Interest Expense
Management Expenses
Other Expenses
Dividends Paid
Total
2.4
0.9
0.3
1.9
5.5
The current share price is 170 pence per share and there are 55 million shares in issue.
(i)
Calculate appropriate accounting ratios for the above trust and comment
briefly on them.
[7]
In the recent past many trusts have been paying off their long-term debt.
(ii)
ST5 S2006
Calculate the effect that paying off this trust s debt might have on the results
in (i). You may assume that there are no restrictions to paying off the
investment trust s debt.
[7]
[Total 14]
You are the broker to a UK charitable foundation with assets of 1bn invested in a
diversified portfolio of assets. The foundation is considering making large changes to
its asset allocation and the trustees are particularly concerned about the possibility of
moving market prices (both on sales and purchases of lines of stock).
(i)
List four approaches that might help mitigate this problem, explaining how
these will help.
[4]
(ii)
Describe the assets for which the problem might be particularly acute, and for
which the solutions listed above are unlikely to be effective.
[2]
At a meeting with the trustees, they explained that they would like to implement the
switch in stages, and that their rules currently prohibit them from using derivatives.
For the first stage of the switch they will be investing 100m in Japanese equities and
financing this by selling 50m of UK and 50m of US equities. They wish the switch
to proceed as soon as possible.
(iii)
(iv)
Explain how the switching process would operate if derivatives were used, and
list the advantages of doing this rather than a physical asset switch.
[5]
[Total 21]
You are an investment manager specialising in equities. You want to set up a fund
that will track the FTSE All-Share index. The fund will match the index weight in
each industry sector, but will not necessarily include every index stock to achieve the
sector weight.
(i)
List the eight economic groups in the FTSE Actuaries Classification and
briefly explain their key characteristics.
[10]
(ii)
Explain in detail why the fund manager will not include every index stock to
achieve the sector weight.
[7]
(iii)
Outline the quantitative investigations that could be made to ensure that the
fund effectively tracks the index after the fund has been set up.
[5]
[Total 22]
END OF PAPER
ST5 S2006
Faculty of Actuaries
Institute of Actuaries
EXAMINATION
September 2006
Faculty of Actuaries
Institute of Actuaries
Subject ST5 (Finance and Investment Specialist Technical A) September 2006 Examiners Report
General comments
Overall candidates scored well on the bookwork sections of the paper. However, as in
previous sittings, many fared less well where answers required application (perhaps
reflecting a lack of experience of practical investment problems), especially when numerical
answers were required; as a result questions 4 and 5 proved difficult generally with even
better candidates seeming unable to work their way through demonstrating that they
understood the investments and their key features. This explains why the pass rate was higher
than it has been in some previous sittings but more importantly why there were so many
FA fails.
It is concerning that many candidates appear to have little understanding of the outside
world. An example of this is that hardly any realised that the debenture in Q5 would have to
be repaid at todays price and not par if it was redeemed.
Better candidates were able to apply the bookwork to the situation outlined in the question.
The solutions should not be taken as comprehensive. There were a number of additional
points that could have been made for various questions and these have been rewarded
appropriately.
Comments on individual questions
Q1
In general this question was answered poorly. Many candidates failed to discuss how
asset liability models could be used to oversee national debt management policy,
instead describing the steps involved when carrying out an asset liability study.
Consequently many candidates only picked up the bookwork marks.
Q2
Q3
Overall candidates scored well on this question. In particular Part (ii) was well
answered. Better candidates scored highly on Part (iii).
Q4
This question was answered very poorly with many candidates scoring low marks. It
was clear that candidates struggled to understand the various investment options and
therefore, were unable to calculate the expected returns required in Part (i). The
answers to Part ii were slightly better.
Q5
Another numerical question that was answered poorly. Many candidates failed to
apply the ratios relevant for an Investment Trust. For Part (ii) candidates assumed
that debt could immediately be paid off at face value rather than using a discounted
cashflow approach.
Q6
Q7
Most candidates scored full marks on Part (i). In general Parts (ii) and (iii) were also
well answered.
Page 2
Subject ST5 (Finance and Investment Specialist Technical A) September 2006 Examiners Report
(i)
(ii)
Page 3
Subject ST5 (Finance and Investment Specialist Technical A) September 2006 Examiners Report
Quarterly returns for the portfolio could be compared to the quarterly returns
on the target over, say, a five year period.
The excess return would indicate the level of value added by the manager.
Other relevant points.
(iii)
The performance will differ because the portfolio will be unlikely to hold
stocks and sectors in weights that are wholly representative of the index/may
have taken an active position.
The portfolios beta over the period may have varied to levels above or below
1.2 affecting returns.
The portfolio may have other objectives/constraints which affect performance.
The beta is different.
The diversification (or lack of it ) may affect volatility of portfolio returns.
The volume and dealing cost impact of trades in the portfolio.
The effects of cash flow.
The impact of tax.
The effects of expenses.
(iv)
(i)
Page 4
Subject ST5 (Finance and Investment Specialist Technical A) September 2006 Examiners Report
Some funds may have restrictions on the use of derivatives. This would mean
that a particular fund could not invest in the futures contract.
Some stocks may be excluded for ethical or social reasons (or possibly other
reasons in some cases). For example a fund may choose not to invest in
alcohol or tobacco stocks.
A subset of the European equity universe may be excluded in some mandates
as it is reflected elsewhere in an investors portfolio, or the investor has
decided for strategic reasons to exclude this subset. For example a UK
investor may have separate UK equity and European ex-UK mandates.
A fund may have restrictions on self-investment and for very large companies
pension funds this may create operational issues with using the contract.
Examples BP, Novartis.
Funds may have maximum holdings in individual securities or countries
within Europe. For example a 5% maximum investment in any single stock is
a common restriction.
Page 5
Subject ST5 (Finance and Investment Specialist Technical A) September 2006 Examiners Report
(iii)
Split by country.
Split by sector.
Split into large, mid and small cap stocks.
Split by high/medium/low dividend yield.
Split into growth and income stocks.
Variations change from stock returns on an unhedged basis to hedged into a
range of different currencies (or vice versa).
Changing the base currency.
Changing the weighting approach.
(i)
The convertible has a minimum return of 100 per 100 invested assuming
company remains solvent. ZDP has maximum of 138, convertible depends on
share price.
Convertible is ZDP plus call option.
Option price = 100 - 100/138 = 27.5.
Convertible return better than ZDP if share price above 92 pence.
ZDP compounds annually at 6.65% p.a.
Share has dividend yield of 3.5% p.a. assuming no change in rate.
Capital growth of 3.15% required to match ZDP over 5 years.
(ii)
Page 6
Subject ST5 (Finance and Investment Specialist Technical A) September 2006 Examiners Report
(a)
(b)
(i)
Page 7
Subject ST5 (Finance and Investment Specialist Technical A) September 2006 Examiners Report
(ii)
(iii)
Page 8
Subject ST5 (Finance and Investment Specialist Technical A) September 2006 Examiners Report
Page 9
Subject ST5 (Finance and Investment Specialist Technical A) September 2006 Examiners Report
(i)
Resources
These companies are involved in the extraction and supply of primary
products used throughout the economy. Oil is the most important. Key
characteristics are:
large companies
commodity price dependent
risky
global
Basic industries
This group includes the chemical industry and companies in the building
materials and construction industries, as well as companies producing steel
and other metals, and those engaged in forestry and paper. As such, these
companies are mainly producing intermediate goods.
General industries
General industrial companies are involved in the various stages in the supply
and production of goods. Many of the goods tend to be capital items, i.e.
aircraft, ships, machinery, electronic and electrical equipment. The distinctive
features of both industry groups are:
Consumer goods
Companies in the consumer goods groups manufacture consumer durables and
non-durables. Durables include cars, furniture, televisions and white goods
such as washing machines. Non-durables include food and drink,
pharmaceuticals, tobacco, health and household products, beverages and
packaging. Generally the impact of an economic cycle is less severe on nondurable consumer goods companies than on general manufacturers. This is
especially true for companies producing basic necessities. Thus, the consumer
goods group is further divided into cyclical (durable) and non-cyclical (nondurable) sectors. Other key features are:
Page 10
Subject ST5 (Finance and Investment Specialist Technical A) September 2006 Examiners Report
Services
These are also now divided into cyclical and non-cyclical sectors. Cyclical
service companies include general retailers, transport, hotel and media
companies, distributors, restaurants and pubs and support services. Noncyclicals include food and drug retailers and telecommunication services.
Once again, the impact of the economic cycle will be greater on the cyclical
group. Other key features are:
labour intensive
the more defensive companies in the group may have high gearing
the domestic market is the most important
Utilities
Utilities are involved in the supply of continuously demanded services to
households and business premises. Examples include electricity, water and gas
distribution. Most UK utilities were formerly owned by the government,
having been privatised during the 1980s. They are vulnerable to some political
risk and to changes in the regulations under which they operate. Demand is
very stable because the services that they provide are essential, or nearly
essential, and because their market share will be stable (often at 100%). Thus,
they are less affected by economic cycles than other groups. Other points are:
Financials
The financial group companies are the various industries making up the
financial services industry, e.g. clearing banks, investment banks, general
insurance companies and life assurance companies, investment trusts, real
estate (property) companies. The key distinctive feature of financial group
companies is that they tend to be capital intensive. Otherwise, the features of
companies in this group are quite varied between the different sectors:
Page 11
Subject ST5 (Finance and Investment Specialist Technical A) September 2006 Examiners Report
Information Technology
These are the companies involved in the new industries of information
technology hardware, software and the provision of computer services. While
investor demand for such shares has caused share prices to increase
dramatically in the past, many of the companies have yet to make profits or
pay dividends. Dividend yields on these companies are therefore low, and
their assets can be largely intangible.
(ii)
The fund manager only has to track the performance of the index.
So replicating the index is not essential.
Investing in many stocks and so having relatively small individual holdings in
each stock will result in high dealing costs (necessary each time the relative
sector weightings change).
This would reduce the performance of the fund and so cause
underperformance relative to the index.
Research has shown that, after overall market movements have been taken into
consideration, the share price movements of companies within industrial
groupings tends to correlate more closely with each other than with companies
in other industries, so holding a subset may well replicate the performance of
the sector.
The share price movements reflect the changes that have occurred in the
operating environment, and such changes affect companies in the same
industries in similar ways.
A specific sector may only represent a small percentage of the index and
within that sector the small number of stocks the manager proposes to use may
represent a substantial proportion of the total market capitalisation of the
sector.
Stratified sampling of the performance of each sector may have shown that the
performance of the chosen stocks is a very accurate measure of the
performance of the sector as a whole.
Sampling may enable the fund to choose its timing in addressing whether or
when to replicate changes to the underlying index.
(iii)
Page 12
Compare dividend yields, earnings growth and price earnings ratios with the
Index.
Subject ST5 (Finance and Investment Specialist Technical A) September 2006 Examiners Report
For example, within each sector for the fund and the index:
Historic comparison of the fund performance with the index quarterly over a
period of around three years to determine how well the fund has tracked the
index.
Comparison of risk adjusted performance measures e.g. Sharp or pre-specified
standard deviation.
Page 13
Faculty of Actuaries
Institute of Actuaries
EXAMINATION
13 April 2007 (pm)
Enter all the candidate and examination details as requested on the front of your answer
booklet.
2.
You have 15 minutes at the start of the examination in which to read the questions.
You are strongly encouraged to use this time for reading only, but notes may be made.
You then have three hours to complete the paper.
3.
You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
4.
5.
Attempt all 9 questions, beginning your answer to each question on a separate sheet.
6.
ST5 A2007
Faculty of Actuaries
Institute of Actuaries
(i)
(a)
(b)
(ii)
(iii)
Explain why it is necessary to estimate the equity risk premium from historical
data.
[2]
(iv)
(i)
[1]
(a)
(b)
[6]
[Total 11]
Describe how the economic cycle can impact companies price/earnings ratios.
[5]
Stock A
Stock B
Stock C
$100m
$10m
$20
3%
$24
3.2%
$500m
$25m
$20
2.8%
$25
2.5%
$200m
$25m
$20
4%
$16
4.5%
[2]
Explain why the two investors may have constructed their portfolios as they
did.
[3]
(iv)
Calculate the portfolio returns over the period for each of the two investors. [3]
(v)
Describe three other equity styles that other investors may be using.
ST5 A20072
[3]
[Total 16]
(i)
(a)
(b)
(ii)
(a)
Explain why conflicts of interest may arise between equity and bond
holders in a company.
(b)
A professional fund manager invests in the constituent shares of the FTSE 100 index
and weights the investments of the fund on an arithmetic average basis using the
market capitalisation of the constituents of the FTSE 100 index. The fund manager
adjusts the constituent shares and their weights in line with changes in the weights
used in the construction of the index. To all intents and purposes, the fund attempts to
track the price and yield performance of the FTSE 100 index.
The investors in the fund asked an independent investment consultant to evaluate the
total return performance of the professional fund manager relative to the total return
performance of the FTSE 100 index over the last ten years. The independent
investment consultants report examined the fund managers total return and
concluded that the professional fund manager had under performed the FTSE 100
Total Return Index over the ten year period in question.
(i)
Describe the most likely reasons for the fund managers under performance
relative to the FTSE 100 index over the past 10 years.
[12]
(ii)
Outline two ways of reducing the under performance of the fund manager
relative to the FTSE 100 index.
[2]
[Total 14]
(i)
Sketch, on the same diagram, the payoff at maturity of the following options
on a quoted share assuming that they have the same strike price, same maturity
date and that the ratio of premiums is 2:1 with the call option being the more
expensive option:
(a)
(b)
a put option
a call option
[3]
(ii)
Using the same diagram as in part (i) of this question, sketch the payoff profile
of an equally weighted portfolio consisting of options (i)(a) and (i)(b).
[3]
(iii)
Suggest an investment scenario in which the payoff profile in part (ii) might
be of interest to an investor.
[2]
[Total 8]
ST5 A20073
(i)
(ii)
(i)
(ii)
[6]
[Total 9]
[5]
[3]
[Total 8]
You are the finance director for a regional Japanese bank and are considering the
issue of a bond. You have the option of issuing the bond in sterling or in local
currency and have available the following information:
Sterling issue
Domestic issue
+125bps
+175bps
4.50%
2.00%
You should assume the yield curve is flat across all maturities in both the sterling and
the domestic market.
(i)
(ii)
Discuss why the spread over government bonds may differ between the UK
and Japanese markets for the same issuer.
[6]
(iii)
Calculate the return an investor would achieve, in yen terms, by investing and
holding each bond to maturity. State any assumptions made.
[6]
(iv)
Outline the steps you would take to lock into the lowest funding cost.
[2]
[Total 18]
ST5 A20074
[4]
You are a portfolio manager for a high alpha actively managed bond fund. Your
annual performance target is 1.5% p.a. above the return on the all stocks
government treasury bond index. This target is after deduction of your 0.4% annual
management fee.
One of your bond dealer contacts has invited you to subscribe to a new innovative 20
year amortising bond whose return is linked to the mortality experience on a pool of
insured annuitants. Under this bond, the coupon and principal payments are reduced
(or increased) if more (or fewer) annuitants survive than expected, within minimum
and maximum amounts.
The dealer has made a compelling pitch to you that this is the first of a number of
such bond issues and that the spreads on these bonds will narrow considerably over
time as the market gains familiarity with these issues. The Chief Investment Officer
of your investment house requires you to submit a formal analysis of the bond issue
for consideration at the next Investment Committee meeting.
(i)
Outline the issues you would consider in your analysis of the opportunity to
generate outperformance for the bond fund by participating in the offer.
[6]
(ii)
Describe what further investigations and information you would require before
you could make a recommendation on whether to participate and how much to
invest.
[2]
[Total 8]
END OF PAPER
ST5 A20075
Faculty of Actuaries
Institute of Actuaries
EXAMINATION
April 2007
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.
M A Stocker
Chairman of the Board of Examiners
June 2007
Faculty of Actuaries
Institute of Actuaries
Subject ST5 (Finance and Investment Specialist Technical A) April 2007 Examiners Report
Comments
Most candidates scored well on questions 5 and 6 with many achieving full marks. Although
some candidates scored well on questions 2 and 3 also, most candidates attained closer to
half the available marks. Questions 4 and 7 were the worst answered with candidates
achieving typically scores of less than a third of the available marks. For example, few
candidates were able to identify multiple likely reasons for underperformance and most were
unable to describe a debenture trust deed and the advantages thereof. Although it was
pleasing to see the scores achieved by better candidates, it continues to be a source of
frustration and disappointment that candidates appear to ignore valuable information
contained within the question and lose easily achievable marks as a consequence.
In every diet there will be candidates who are very close to the pass mark and yet receive an
FA indeed I suspect candidates would be very surprised to see just how tightly distributed
the marks are; deciding where the pass mark falls will have a material impact on the
numbers of candidates who are successful and the examiners take great care to ensure a
consistency of standard across candidates, subjects and diets. The pass rate for this diet was
very similar to the last session although the pass mark was higher, reflecting the overall
higher scores achieved by candidates on bookwork parts of questions.
All extenuating and mitigating circumstances were considered in awarding grades
coincidentally those candidates who had submitted the most severe mitigating arguments had
in fact achieved sufficiently high marks to justify a Pass grade.
Notwithstanding the high scoring on bookwork elements, candidates should note the bias in
the paper towards recognising higher level skills and practical application this is
intentional and will continue. Likewise the examination system does properly allow for prior
subject knowledge to be assumed. It is not appropriate to repeat all relevant material within
the Core Reading and in the exam creation process, the profession takes great care to ensure
that the paper can be answered by a candidate who has taken a normal route through the
exams - indeed questions have been removed from previous draft papers as a result.
Candidates looking to progress should be aware that the SA series of exams, particularly
investment related, are even less bookwork focussed and require the candidate to
demonstrate a breadth and depth of competency as would be expected from a practising
actuary in a constantly changing discipline. Hence simple regurgitation of bookwork will not
be sufficient to ensure a Pass grade. Candidates should ensure they familiarise themselves
with the current investment issues facing institutional investors in the 18 months preceding a
diet and the solutions being debated by the various stakeholders.
Page 2
Subject ST5 (Finance and Investment Specialist Technical A) April 2007 Examiners Report
(i)
The risk-free rate of return is the rate of return on a security which has no
credit risk. Assets providing such a return include fixed interest government
bonds, inflation-linked government bonds and short-term government bills.
(ii)
Required return = Required risk free real rate of return + expected inflation +
risk premium
(iii)
For an asset with certain cashflows (e.g. a bond) the risk premium can be
estimated from the price since an IRR calculation can be carried out, although
an adjustment needs to be made for default risk.
Conversely, the risk premium from the price of an asset with uncertain future
cashflows (e.g. an equity) cannot be estimated using an IRR calculation.
This leads to a need to analyse historical data, although this may not
necessarily be a good guide as the risk premium is based on expected return,
rather than achieved return.
(iv)
Page 3
Subject ST5 (Finance and Investment Specialist Technical A) April 2007 Examiners Report
(i)
If the economy is moderately buoyant and profits are fairly stable, both
defensive and cyclical companies might be similarly rated in terms of the P/E
ratios.
As the economy starts to move into recession P/E ratios for cyclical companies
are likely to fall while those of defensive companies will remain stable or may
even rise slightly.
At the bottom of the cycle P/E ratios of cyclical companies will probably have
risen from their low point as earnings have fallen, but defensive stocks will
still be more highly rated.
As the economy starts to recover, the P/E ratios of cyclical companies will rise
in anticipation of future earnings growth. P/E ratios of defensive companies
may now be lower than those of cyclical stocks.
As growth continues, the earnings of cyclical companies will catch up with the
share price and P/E ratios will fall back towards their long-term average level.
(ii)
Value stocks typically have low P/E ratios (12 or lower) and higher dividend
yields (4% or more). They tend to be stocks with low expectations of future
earnings growth or are out of favour with investors (reflected in the P/E ratio).
Conversely, growth stocks typically have high P/E ratios (20 or higher) and
lower dividend yields (2.5% or less). These tend to be stocks with higher
expectations of future earnings growth (reflected in the P/E ratio).
(iii)
The neutral weights for the three stocks are 12.5% stock A, 62.5% stock B and
25% stock C. The PE ratios are 10, 20 and 8 respectively, with stock A
yielding close to the average, B having a slightly lower than average yield and
C a high yield. These two measures suggest that stock A has a small value
bias, B has a growth bias and C has a value bias, hence the weightings in the
two investors portfolios.
(iv)
(v)
Page 4
Subject ST5 (Finance and Investment Specialist Technical A) April 2007 Examiners Report
(i)
Agency costs can arise in an organisation where the owners have delegated
operational decisions.
They become increasingly likely as an organisation grows, although they can
also occur in a smaller organisation where the owners and managers are
separate.
This separation of ownership and management can lead to a divergence of
interests, and such conflicts of interest are called principal-agency conflicts.
Agency costs are defined as the costs of monitoring the agents (managers) and
influencing/incentivising them to act in the interests of the principals
(owners)
and thereby reduce conflicts/create alignment.
Without such monitoring or influencing, management may act in a way that
diverges from the interests of the owners, and this is arguably a consequence
of rational behaviour by the management seeking to exploit their position.
(ii)
Conflicts of interest arise between equity and bond holders since bond holders
have no upside potential beyond return of their capital and interest payments
but are exposed to downside risks.
Conversely equity holders have significant upside potential and typically
exercise day to day control over the company, leading to conflicts.
Possible conflicts can include:
Page 5
Subject ST5 (Finance and Investment Specialist Technical A) April 2007 Examiners Report
(i)
(ii)
Futures
The manager may be able to reduce the drag on investment performance
arising from cash holdings by using FTSE 100 futures contracts.
Stock Lending
The manager may be able to reduce the size of her under performance by
engaging in stock lending whereby she will receive a fee for lending stocks to
other institutions (such as the prime brokers of hedge funds) on a collateralised
basis.
Page 6
Subject ST5 (Finance and Investment Specialist Technical A) April 2007 Examiners Report
(i)
(ii)
(iii)
The portfolio of options pays off at maturity when there is a large move either
way in the price of the underlying stock over the life of the option.
Conversely investors in the portfolio of options will lose out if there is little or
no movement in the price of the underlying stock by the maturity date of the
option.
(i)
(ii)
Competition is reduced.
Page 7
Subject ST5 (Finance and Investment Specialist Technical A) April 2007 Examiners Report
(i)
Trusts constitute a relationship between persons in which one person has the
power to manage property and the other person has the privilege of receiving
the benefits from that same property.
The legal owner of the property of a trust is called the trustee and she has the
right to possession of the property.
The beneficiary of the trust is the person who receives all the benefit from the
property.
The divisions between legal and beneficial ownership are normally created by
an express instrument of trust known, usually, as the deed of trust.
The trust deed will also specify the beneficiaries by name or as being persons
who are members of a particular group.
Trustees are required to act in the best interests of the beneficiaries of the trust.
The standard of care required of trustees varies with their level of expertise in
that a higher standard of care is required of those who hold themselves out to
be professional trustees compared with an ordinary man.
(ii)
(i)
(ii)
Spread over government yields reflects the extra premium that the bank must
pay to compensate the investors for extra risks of reduced liquidity and
default. These risks should be similar regardless of the currency of the bond
issue. It is likely that the bank earns its cashflows in local currency so has no
exposure to sterling so one may argue that the sterling denominated issue
has additional currency risks and should have a higher spread to governments
to compensate. The spread is also affected by supply and demand dynamics
the lower spread in reflecting a higher level of demand.
(iii)
Page 8
Subject ST5 (Finance and Investment Specialist Technical A) April 2007 Examiners Report
(iv)
(i)
The dealer is probably correct that initially spreads over gilts will be high due
to investors unfamiliarity with such an issue.
Also investors typically (but not always) prefer vanilla bonds without
embedded exposures or options, leading to higher spreads on more complex
issues due to difficulty in assessing if pricing is favourable or not.
However, it is also possible that there is considerable demand in the investor
community for such issues, in which case initial spreads may be lower.
If the market does become more confident about these bonds then subscribing
would offer the prospect of say a 50bps reduction in spreads, which would
amount to 6% increase in value if the duration was 12 years (for example).
Alternatively, if the market did not develop strongly, this could result in the
fund being stuck with a long-term illiquid issue albeit providing a modest
spread over vanilla bonds of a similar term and credit. If the bond had a
shorter term e.g. 5 years, this would be less of a concern.
Such a negative scenario could also occur if the market for mortality-linked
bonds does develop, but with different design features.
Assess impact on duration of the new bond from sensitivity analysis of
expected annuitants survivors. Also important to assess the resultant duration
of the fund from the desired allocation to the new bond, and relative to the
duration of the reference index.
(ii)
Further investigations:
Page 9
Subject ST5 (Finance and Investment Specialist Technical A) April 2007 Examiners Report
Feedback from internal analysts and external market participants, e.g. asset
managers, bond dealers, analysts.
The proposed offer price of the bond is a key bit of information that would
be required.
Page 10
Faculty of Actuaries
Institute of Actuaries
EXAMINATION
26 September 2007 (pm)
Enter all the candidate and examination details as requested on the front of your answer
booklet.
2.
You have 15 minutes at the start of the examination in which to read the questions.
You are strongly encouraged to use this time for reading only, but notes may be made.
You then have three hours to complete the paper.
3.
You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
4.
5.
Attempt all 8 questions, beginning your answer to each question on a separate sheet.
6.
ST5 S2007
Faculty of Actuaries
Institute of Actuaries
(i)
(ii)
[1]
(a)
(b)
How do these costs impact the overall objectives of the regulator. [5]
[Total 6]
You are the financial director of a small private software company. Due to a contract
being recently cancelled there is likely to be a short-term liquidity issue where the
company cannot meet its creditors for the next three months, after which the financial
picture looks healthy. The Chairman of the company is opposed to long-term debt.
You have been asked to provide the Chairman with alternative sources of short-term
finance to resolve the impending liquidity issue.
(i)
[5]
(ii)
Outline the main contract terms that differentiate between the types of
borrowing available.
[4]
[Total 9]
Three companies are intending to raise finance via the debt market.
Company B A public listed company that is well established but has suffered
from decreasing sales and has posted losses for the last two years.
(i)
Explain with reasons the credit rating that is likely to be assigned to each of
the three bond issues.
[2]
(ii)
(a)
(b)
Explain how this would vary for each of the three companies.
[3]
ST5 S20072
(a)
(b)
Calculate the expected default loss for the first year of each bond,
stating any assumptions that you make.
[8]
The Government of the country is concerned that the local currency is appreciating
too fast and decides to introduce immediate controls on transactions by overseas
investors. As a consequence the domestic equity market index has fallen by 15% and
treasury bonds are now yielding 5.25% p.a.
(iv)
Explain how the yields on the bonds issued by the three companies might
change as a consequence of the change in market levels.
[6]
[Total 19]
A friend has decided that they would like to try to increase their wealth by investing
in derivatives. After reading some articles they realise that they do not fully
understand some of the terminology and have approached you for help.
(i)
[8]
(ii)
(b)
(c)
(iii)
(a)
(b)
The current share price of XYZ is 60p. Your friend has been offered the following
options in XYZ.
(iv)
ST5 S20073
Strike Price
3 Month
6 Month
Call 75p
Put 85p
5p
10p
10p
5p
Given this information, draw the pay-off charts associated with each of these
options clearly identifying the price when the option is in the money.
[6]
[Total 19]
(i)
[2]
(ii)
Outline the main economic indicators which show whether the policies applied
by the government have been successful.
[2]
To promote growth after a prolonged recession the government has decided to reduce
interest rates from 5% to 3%.
(iii)
individuals
businesses
the economy as a whole
[6]
[Total 10]
You are the investment consultant to a 400m pension fund that has a 15% shortfall in
assets compared with the national common funding standard introduced by the newly
created regulator of pension funds. In addition, the new regulator has insisted that all
defined benefit funds have a national common funding level above 105% in seven
years time. One of the trustees has read a newspaper article claiming that more
pension funds are investing in hedge funds as a way of meeting their liabilities and the
requirements of the new regulator.
(i)
(a)
(b)
Outline the main types of hedge fund that the pension fund could
invest in.
[2]
[3]
One of the criticisms of hedge funds is the lack of reliable performance data.
(ii)
[4]
(iii)
Explain how the fund could invest in hedge funds alongside other assets and
derivatives in order to achieve the national common funding target objectives.
[6]
[Total 15]
(ii)
ST5 S20074
[3]
[9]
[Total 12]
You have recently been appointed as the financial adviser to a private company. The
company wants to provide an initial offering of shares and to be listed on the stock
exchange. You have been asked to provide a valuation of the company.
(i)
[5]
(ii)
State the information you would wish to see in order to provide a valuation.
[5]
[Total 10]
END OF PAPER
ST5 S20075
Faculty of Actuaries
Institute of Actuaries
EXAMINATION
September 2007
M A Stocker
Chairman of the Board of Examiners
December 2007
Faculty of Actuaries
Institute of Actuaries
Subject ST5 (Finance and Investment Specialist Technical A) September 2007 Examiners Report
Comments
Most candidates scored well on questions 1, 3 and 4 with many achieving full marks.
Although some candidates scored well on questions 2 and 5 also, many candidates attained
closer to half the available marks. Questions 6, 7 and 8 were the worst answered (7 in
particular).
In every diet there will be candidates who are very close to the pass mark and yet receive an
FA indeed I suspect candidates would be very surprised to see just how tightly distributed
the marks are; deciding where the pass mark falls will have a material impact on the
numbers of candidates who are successful and the examiners take great care to ensure a
consistency of standard across candidates, subjects and diets. That said, it was fairly clear
where the hurdle should have been set. The examiners were pleased to see that the pass rate
for this diet was slightly higher than last time even though the pass mark was somewhat
higher. Where candidates scored lower it was typically because although they were able to
reproduce the required bookwork for one or other question, they were unable to apply the
bookwork knowledge appropriately.
Candidates should note the bias in the paper towards recognising higher level skills and
practical application this is intentional and will continue. Likewise the examination system
does properly allow for prior subject knowledge to be assumed. Investment is a necessarily
practical subject and at this level, the examiners expect candidates to demonstrate a breadth
and depth of competency as would be expected from a practising actuary in what is a
frequently evolving discipline. Hence simple regurgitation of bookwork will not be sufficient
to ensure a Pass grade.
Candidates looking to progress should be aware that the SA series of exams, particularly
investment related, are even less bookwork focussed and require the candidate to
demonstrate a breadth and depth of competency as would be expected from a practising
actuary in a constantly changing discipline.
In order to succeed, candidates should ensure they familiarise themselves with the current
investment issues and general market background facing institutional investors in the 18
months preceding a diet and the solutions (and sources of) being debated by the various
stakeholders. A recurring theme in recent years has been a move towards capital market
rather than purely insurance and asset management solutions hence a question regarding
banking and derivative approaches to asset and liability risk management or modern
financial theory and commercial applications should be considered likely scope for
examination.
All extenuating and mitigating circumstances were considered in awarding grades.
Page 2
Subject ST5 (Finance and Investment Specialist Technical A) September 2007 Examiners Report
(i)
(ii)
Direct cost
Economic cost
Term loans
Evergreen credit
Revolving credit
Bridging loans
International bank loans
Trade credit
(ii)
Commitment
Maturity
Rate of interest
Security
Page 3
Subject ST5 (Finance and Investment Specialist Technical A) September 2007 Examiners Report
(ii)
(iii)
(a)
(b)
Yield
4.75%
6.00%
8.00%
4.25%
(iv)
All else being equal, all bond yields will increase by 100bps to reflect the
change in government bond yields.
However, the equity market has fallen which would imply that there is
concern about the corporate sectors future economic prospects or that
earnings have fallen.
This would suggest a widening of spreads on corporate borrowings relative to
government debt.
The impact on each of the three companies will vary depending on the
sensitivity of their existing and future revenue streams to the factors causing
the economic downturn.
In practice, it is likely that there would be a flight to quality reflecting
reduced liquidity in poorer credits and greater concerns about defaults.
This would mean that demand for higher quality bonds increases and the
demand for lower quality bonds reduces.
Page 4
Subject ST5 (Finance and Investment Specialist Technical A) September 2007 Examiners Report
This would imply that the spreads for companies A/B/C might increase from
50/175/375 bps to 5075/200250/425500bps, before allowing for company
specific factors.
Derivatives (Unit 7)
(i)
Speculation
Exchange-traded derivatives could be used for speculation; effectively
betting on a strong view of a particular market movement. The difference
between speculation using options and speculation using the underlying
asset is that buying the underlying asset requires an initial cash outlay
equal to the total value of what is bought whereas entering into a future
contract or an option contract requires only a fraction of the initial cash
outlay. Thus a much higher level of leverage (gearing) can be achieved.
Arbitrage
Arbitrage involves locking in a riskless profit by simultaneously entering
into two transactions in two or more markets. Using various combinations
of options and the underlying instruments, portfolios with the same return
but with different constituent parts can be created. Arbitrage opportunities
can arise when the prices of these different portfolios get out of alignment
and a riskless profit can be made.
In practice only very small arbitrage opportunities are observed in prices
that are quoted in most financial markets. Also, transaction costs would
probably eliminate the profit for all but the very large investment houses
that face very low transaction costs.
Hedging
Hedging allows a fund manager to reduce a risk that the fund already
faces. Hedging using options, for example, involves taking a long or short
position in a number of options contracts which is the opposite to the
position held in the underlying asset. Conceptually, a loss made in the
underlying asset will be offset by an approximately equal gain on the
options position.
This technique is very useful where say a fund is going to sell its holding
in two or three months and it wishes to avoid a fall in market values.
However, if the market rises there will be a loss on the futures position
approximately equal in value to gain on the underlying equities so the
strategy does close off the opportunity for the fund to participate in any
upward movements in the underlying assets while the hedge is in place.
Page 5
Subject ST5 (Finance and Investment Specialist Technical A) September 2007 Examiners Report
Portfolio management
Options can be used to manage the reallocation of assets from one market
to another. For example, call options on equity indices can be used to gain
exposure to upside movements in the markets; put options can be used to
remove exposure to downside movements in markets. Calls and puts can
be used to change a funds exposure to an asset category or to change a
funds exposure within an asset category.
(ii)
(a)
(b)
Initial Margin the initial payment put down to cover the risk of the
contract.
Variation Margin the margin which is payable or received on a
daily basis to mark to market.
(iii)
(c)
The clearing house is removing the credit risk and they need some
form of compensation to cover themselves for this risk.
(a)
(b)
(iv)
Call the loss on the 3 month is 5p to 80p when break even then in the money.
6 month is 10p loss until 85p.
Put 3 month is in profit to 75p then loss of option, for 6 month is in loss at
80p.
Page 6
Subject ST5 (Finance and Investment Specialist Technical A) September 2007 Examiners Report
(ii)
(iii)
(a)
(b)
(c)
Page 7
Subject ST5 (Finance and Investment Specialist Technical A) September 2007 Examiners Report
(a)
Global Funds
Event-driven Funds
Market Neutral Funds
(b)
(ii)
(iii)
Deficit reduction
Regulatory, financial and peer group pressures
Finite repair term imposed by regulators scope for absolute return
structures
Surplus control
Short term fix may prove over cautious
Page 8
Cash flow hedging coupled with Regulator proposals for Deficit Repair
terms change pension funds from Relative (to yields, inflation) to
Absolute/Targeted Return investors
Alternative assets, including hedge funds, have obvious role in Deficit
Repair
Subject ST5 (Finance and Investment Specialist Technical A) September 2007 Examiners Report
Market neutral hedge funds plus swaps/bonds equal Liabilities Plus fund
Hedge funds have a role as the alpha generator in new products, but could lose
their separate identity
(i)
Operational risk is the risk of loss resulting from inadequate or failed internal
processes, people, and systems or from external events.
Operational risk includes IT, legal and compliance risk.
Operational risk differs from market or credit risk as it is typically not directly
taken in return for an expected reward
Operational risk exists in the natural course of corporate activity
Operational risk is more difficult to quantify and measure compare with
market or credit risk.
Operational risk is very important as it seems to have been responsible for
more spectacular corporate losses than the other financial risks.
(ii)
Page 9
Subject ST5 (Finance and Investment Specialist Technical A) September 2007 Examiners Report
(i)
A listings authority is responsible for ensuring that any new issue of shares is
conducted in an orderly and fair way, and that the conduct of the company
remains consistent with the listing of the shares after the issue.
A listing authority will ensure that a reasonable amount of financial
information is in the public domain.
Listing authorities are normally concerned with:
(ii)
The process by which shares are offered to potential shareholders and the
price is set for the issue of shares.
Rules to ensure that companies with listed securities and connected parties
continue to behave in a manner that does conflict with other objectives of
the listing authority.
The value of the company will be driven by the level and likelihood of future
profits.
General factors
Page 10
Subject ST5 (Finance and Investment Specialist Technical A) September 2007 Examiners Report
Financial measures
Page 11
Faculty of Actuaries
Institute of Actuaries
EXAMINATION
16 April 2008 (pm)
Enter all the candidate and examination details as requested on the front of your answer
booklet.
2.
You have 15 minutes at the start of the examination in which to read the questions.
You are strongly encouraged to use this time for reading only, but notes may be made.
You then have three hours to complete the paper.
3.
You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
4.
5.
Attempt all 7 questions, beginning your answer to each question on a separate sheet.
6.
ST5 A2008
Faculty of Actuaries
Institute of Actuaries
(i)
[3]
(ii)
[2]
(iii)
Explain why it might be desirable for a central bank to act as a lender of last
resort to private sector banks, commenting on the nature of banking assets and
liabilities.
[4]
(iv)
Outline the disadvantages of there being a lender of last resort system in place.
[3]
(v)
[2]
[Total 14]
The trustees of a UK pension fund with 800 million in actively managed assets are
looking to restructure the assets in order to more closely match the liabilities. The
current and target structures of the assets are given in the table below. Assets are
managed by three managers currently. All three managers are to be replaced with two
new managers.
Current
Assets
US equities
UK equities
Emerging market equities
Private equity
UK gilts
Total
Current Value
(m)
400
100
100
150
50
800
Target
Assets
Target
Value (m)
UK equities
UK gilts
Overseas bonds
300
400
100
Total
800
The trustees want to move to the target structure immediately but have not yet chosen
the managers for the target structure.
(i)
Describe the biggest mismatches between the current and target portfolios. [2]
(ii)
Outline how the trustees can move the assets towards the target structure
before the new managers for the target portfolio have been appointed.
[4]
[4]
(iii)
The trustees finally decide on the target managers and want to go ahead with the
move to the new structure, however market conditions have changed and liquidity has
decreased and volatility has increased.
(iv)
List the various costs that are incurred when transferring assets.
(v)
Describe how the costs identified in (iv) will be affected by the current market
conditions.
[3]
[Total 15]
ST5 A20082
[2]
You are working for a life office in their investment team and have been presented
with the opportunity to buy for 150m a freehold on an office block that is currently
occupied by a bank. Two years ago, the bank had arranged a 32 year lease with the
current freeholder, as follows:
Term of lease
32 years
Annual rent
Ground rent
Inflation lag
3 months
(i)
Write down an equation for the present value of the remaining rental
payments, expressed in terms of zero coupon interest rates (zt) and inflation
rates (zinf,t)
[3]
When the bank hears that the freehold is in the process of being sold, it offers to set
up an inflation swap to exchange the inflation-linked rental payments for fixed
payments. This would be a separate contract to the lease, and would be subject to
daily collateralisation.
(ii)
Describe the cashflows that would be paid and received under the inflation
swap with the bank.
[4]
(iii)
Explain why the life office might feel the inflation swap makes this transaction
more attractive, despite paying a margin to the bank arranging the swap. [2]
(iv)
Describe the various risks that apply to the life office under the freehold, the
lease and the swap, and explain how they might vary over time and according
to economic factors.
[9]
[Total 18]
(i)
(ii)
List five ways in which a large institutional investor can achieve the returns
(gross of costs and tax) of a global equity index.
[3]
(iii)
Explain why this type of index would be more useful for performance
measurement for an overseas investor than the most widely quoted local
equity index.
(iv)
[2]
[2]
Explain why this type of index would be less suitable than the most widely
quoted local equity index as a base for exchange-traded derivative contracts.
[5]
[Total 12]
ST5 A20083
(i)
[2]
(ii)
(a)
(b)
Outline how the change in management has affected the risk and return profile
of the individuals investment portfolio.
[2]
The individual had the opportunity to sell the stock 6 months ago, but decided to hold
onto the stock. Since then, the share price has fallen further.
(ii)
Outline the various reasons why the stock might not have been sold.
[5]
(iii)
The investor believes the share price has reached its lowest point and expects it to rise
in the near future. The investor wants to try to make back some of their losses.
(iv)
Describe a technique, using the current share price, that the investor could use
to make a profit on their holding without selling any shares.
[2]
Describe the effect on the investors exposure to the bank if the banks share
price rose by 30%.
[2]
(vi)
Describe the effect on the investors exposure to the bank if the banks share
price fell by 30%.
[2]
[Total 15]
ST5 A20084
(i)
(ii)
(iii)
List six factors that are important to take into account when valuing a
company.
[3]
List six sources of information that an analyst may use when valuing a
company.
[3]
Describe how the P/E ratios of the following types of company may change
through an economic cycle:
(a)
(b)
(c)
a house builder
a tobacco company
a retail bank
[9]
Rather than look at P/E ratios an analyst has decided to value the companies within
his sector on a discounted cash flow basis.
(iv)
END OF PAPER
ST5 A20085
Faculty of Actuaries
Institute of Actuaries
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.
M A Stocker
Chairman of the Board of Examiners
June 2008
Faculty of Actuaries
Institute of Actuaries
Subject ST5 (Finance & Investment Specialist Technical A) April 2008 Examiners Report
Comments
Most candidates scored well on questions 5, 7 and to a lesser extent 2, with many achieving
close to full marks. Questions 4, 6 and 3 were the worst answered (3 in particular, with the
average candidate achieving less than a third of the marks available).
In every diet there will be candidates who are very close to the pass mark and yet receive an
FA indeed candidates would be very surprised to see just how tightly distributed the marks
are; deciding where the pass mark falls will have a material impact on the numbers of
candidates who are successful and the examiners take great care to ensure a consistency of
standard across candidates, subjects and diets. That said, it was fairly clear where the
hurdle should have been set with a clear distinction between candidates graded as a Pass
and not. The examiners were disappointed to see that the pass rate for this diet was slightly
lower than last time given the pass mark was lower too. Where candidates scored lower it
was typically because although they were able to reproduce the required bookwork for one or
other question, they were unable to apply the bookwork knowledge appropriately. Few
candidates provided satisfactory answers to calculation questions.
Given the intent of the profession to push out in to wider fields involving the practical
application of actuarial skills in financial risk management and the increasing numbers of
candidates sitting this exam, it continues to be a disappointment that many candidates
achieve such low scores. Indeed, it is most astonishing the numbers who achieve grades of
FC and FD since this would imply very little knowledge and understanding even after a
course of study.
Candidates should note the bias in the paper towards recognising higher level skills and
practical application this is intentional and will continue. Likewise the examination system
does properly allow for prior subject knowledge to be assumed. Investment is a necessarily
practical subject and at this level, the examiners expect candidates to demonstrate a breadth
and depth of competency as would be expected from a practising actuary or senior student in
a frequently evolving discipline, particularly for those looking to progress to SA6. Hence
simple regurgitation of bookwork will never be sufficient to ensure a Pass grade.
As noted before, in order to succeed, candidates must ensure they familiarise themselves with
the prevailing investment issues and the general market background facing institutional
investors in the 18 months preceding a diet, more so the solutions (and sources of) being
debated by the various stakeholders. A recurring theme in recent years has been a move
towards capital market rather than purely insurance and asset management solutions hence
questions regarding corporate finance, banking and derivative approaches to asset and
liability risk management or modern financial theory and commercial applications should be
considered likely scope for examination. Likewise regulation and globalisation are common
issues in many areas.
All extenuating and mitigating circumstances were considered in awarding grades.
Page 2
Subject ST5 (Finance & Investment Specialist Technical A) April 2008 Examiners Report
(i)
(ii)
Liquidity risk is the risk that asset owner is unable to recover full value of
asset when sale is desired (or for a borrower, the risk of credit being
unavailable when an maturing loan needs to be refinanced/rolled over)
(iii)
Banks typically hold significant amounts of medium to long dated loan assets
on their balance sheets, which are highly illiquid. In contrast, their liabilities
will typically be shorter-term in nature, including deposits and shorter-term
inter-bank loans.
Without a lender of last resort (LOLR), a bank is exposed to the risk that it
will not be able to maintain payments to its creditors if sufficiently many
deposits are withdrawn or if it is unable to refinance maturing loan payments.
The perception that a bank is nearing such a position can lead to a run on the
bank as deposits are easily withdrawn which can have wider social and
economic impacts.
With a LOLR, a bank is much less likely to end up in such a position. Hence
most developed economies have a LOLR system in place, explicitly or
implicitly.
(iv)
The key disadvantage is moral hazard. The management of banks would have
a weaker incentive to manage liquidity (by term of cashflows under assets and
liabilities) as carefully as if a LOLR was not present. This reflects that in the
latter scenario a bank would become insolvent and either require bailing out
by an acquirer, or creditors to the bank would incur losses (and shareholders
would almost certainly see their capital extinguished, and management would
lose their jobs).
Moral hazard can also be argued to extend to depositors: with a LOLR system
a depositor would not need to assess the credit standing of the bank accepting
the deposit.
Most countries have taken the view that this latter aspect of moral hazard is
acceptable, whereas the former is less acceptable (except where necessary to
prevent contagion to other financial institutions).
Page 3
Subject ST5 (Finance & Investment Specialist Technical A) April 2008 Examiners Report
The other key disadvantage is whether the losses that might accrue to the
central bank under the LOLR system would ultimately be borne by taxpayers.
However in the long run it is not good for the economy for an inefficient
business to receive such support.
(v)
Moral hazard and central bank losses can be reduced by ensuring that banks
borrowing from the LOLR pay a penal rate of interest on loans. In reality this
is unlikely to compensate for the credit risks associated with this type of
lending.
Other measures may include requiring additional collateral for LOLR loans,
nationalisation of a failing bank and ensuring that all other sources of
financing have been explored including acquisitions or other marriage
broking.
Regulation of liquidity management, asset quality, approved persons for
management may also mitigate the disadvantages.
(i)
(ii)
(iii)
Page 4
Subject ST5 (Finance & Investment Specialist Technical A) April 2008 Examiners Report
(iv)
(v)
(i)
z inf 0.25 29
PV = 9m 1 + 1
1 + ztinf 0.25
Inf
1 0.25 5 t =1
) (1 + z )
t
29
t
+
100
(1 + zt )
t =0
where Inft is the realised inflation index at time t, zt is the zero coupon bond
rate at time t and ztinf 0.25 is the inflation rate at time t (with 3 month lag)
credit also available for assuming that the inflation rate is a series of forwards, in
which case the formula would be as follows:
z inf 0.25 29 t
PV = 9m 1 + 1
1 + ztinf 0.25
Inf
1 0.25 5 t =1 i =1
(ii)
)(1 + z )
29
t
+
100
(1 + zt )
t =0
The first 1 payment (at time t=0) would be excluded from the inflation swap
as there is no inflation linkage. The remaining 29 payments are inflation
linked.
Under these latter payments, the life office would pay out 9m pa plus 5
years known historic inflation (from 5y 3m ago to 3m ago, assuming a 3
month lag in obtaining inflation data) plus actual future inflation (from 3m ago
to the payment date less 3 months) at the time of each annual payment. In
return the life office would receive 9m pa plus 5 years known historic
inflation (from 5y 3m ago to 3m ago, assuming a 3 month lag in obtaining
inflation data) plus expected future inflation under the inflation swap curve
(from 3m ago to the payment date less 3 months).
(iii)
From a regulatory capital perspective the life office may find a fixed nominal
payment more attractive than an inflation-linked payment if its liabilities are
fixed in nature.
From a valuation perspective, the life office may feel that inflation is an asset
that is worth selling if it expects inflation in the future to be lower than the
current breakeven rate of inflation in the swap markets.
Page 5
Subject ST5 (Finance & Investment Specialist Technical A) April 2008 Examiners Report
(iv)
Location falls out of favour. Reversion value will therefore fall (relative to
similar properties in other locations), and lower rent likely to be realised
on a fresh lease. Long lease provides some protection.
Lease
Tenant cancels lease. This becomes increasingly likely towards the end of
the lease as the tenant will be looking at its needs in the future, and there
may be fewer penalties for cancelling late in the term (assuming a market
rent is being charged, otherwise there would be an incentive to stay or sublet the building).
Earlier in the lease this is a possibility due to restructuring or M&A
activity (or possibly the default of the bank) a new tenant would need to
be found and potentially the inflation swap may no longer match the new
lease.
Tenant renegotiates lease. This could happen at any time during the lease,
and becomes more likely if economic factors are such that rental yields are
falling generally (depending on the terms of the lease). Mismatching issue
if the renegotiated lease breaks the direct inflation link assumed under the
inflation swap (eg move to fixed % increases each year, or rent review
based on rents on comparable properties).
Inflation swap
Page 6
Subject ST5 (Finance & Investment Specialist Technical A) April 2008 Examiners Report
the rental payments would no longer be valid. This would create further
costs and possible liquidity issues.
(i)
(ii)
(iii)
Stocks not available to foreign investors are not included in these indices. This
is not the case for most local indices, so these are often more suitable for
performance measurement purposes than local indices.
Some local indices are weighted averages or total return based
They have a consistent methodology between countries.
They are easier to obtain than some local indices (single data source).
Also, some local indices do not restrict constituent weightings to the free float,
which means they are unsuitable for performance measurement purposes.
Finally, there are index values shown net of withholding taxes and in various
currencies which may be helpful for an overseas investor.
(iv)
Page 7
Subject ST5 (Finance & Investment Specialist Technical A) April 2008 Examiners Report
(i)
(ii)
Page 8
(i)
The bank has become a riskier investment there may be an additional sector
risk if this banks performance impacts or infers a wider contagion.
As the bank increases its risk the expected return investors seek from the
investment should also increase
However, the investment only makes 1% of portfolio so although bank has
increased in risk the impact at the total portfolio level should be minimal.
(ii)
Subject ST5 (Finance & Investment Specialist Technical A) April 2008 Examiners Report
(iii)
(iv)
Write options eg put options for a lower price than the current share price for
which the investor will receive a premium.
The closer to the current price the higher the premium they will receive.
(v)
(vi)
(i)
(ii)
Sources of information:
The financial press and other commercial information providers
The trade press
Published accounts
Public statements by the company
The exchange where the securities are listed
Government sources of statutory information that a company has to provide
Visits to the company
Discussions with the companys management
Discussions with competitors
Stockbrokers publications.
Page 9
Subject ST5 (Finance & Investment Specialist Technical A) April 2008 Examiners Report
(iii)
(a)
(iv)
(b)
(c)
Page 10
Faculty of Actuaries
Institute of Actuaries
EXAMINATION
24 September 2008 (pm)
Enter all the candidate and examination details as requested on the front of your answer
booklet.
2.
You have 15 minutes at the start of the examination in which to read the questions.
You are strongly encouraged to use this time for reading only, but notes may be made.
You then have three hours to complete the paper.
3.
You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
4.
5.
Attempt all 7 questions, beginning your answer to each question on a separate sheet.
6.
In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.
ST5 S2008
Faculty of Actuaries
Institute of Actuaries
(i)
Set out a formula for calculating the information ratio for a portfolio that
contains two asset classes, defining all terms used.
Asset
Class
1
2
3
Risk Free
(ii)
Tracking
Error (%)
10.0
7.0
5.0
4.0
10.0
5.0
5.0
Asset Class
Correlations
1
2
3
1.00
-0.25
0.25
1.00
0.50
1.00
Using the above data, for each pair of asset classes calculate:
(a)
(b)
Annual
Return (%)
(iii)
(iv)
Explain the effects that gearing and being able to sell short might have on
portfolio returns and the information ratio.
[3]
[Total 16]
[2]
You are the property fund manager at a large life insurance company and have been
approached by a small retail chain that wishes to sell and leaseback the six stores in its
chain.
Discuss the factors that you would consider in determining the sale price.
[3]
[10]
A passive investment manager is planning to launch a high alpha fund with the aim of
outperforming a global index by 3% p.a. The investment manager believes the
outperformance can be generated from three sources:
(i)
(a)
(b)
(c)
(ii)
ST5 S20082
Discuss the implications the fund launch might have on the structure and
management of the investment management department.
[7]
[Total 18]
A developing country has recently established a stock exchange. There are currently
7 stocks listed, but only one pays a dividend. Dividends are currently paid to
investors free of tax. The company that operates the exchange wishes to create an
index to measure the performance of the listed companies.
(i)
Give the formula that could be used to calculate the index value.
[2]
It has been decided that the initial value of the index will be 10,000 and details of the
7 companies are:
Initial Market
Cap
Initial Price
Company
(EDUm)
(C)
A
B
C
D
E
F
G
500
300
200
700
800
900
1,000
200
150
50
350
400
100
500
Price at end
of first day
(C)
Price at end
of second day
(C)
205
151
50
345
402
102
505
205
155
52
348
380
103
503
(ii)
Calculate the value of the index at the end of day 1 and day 2.
[4]
(iii)
Calculate the total return produced by the index over the two days.
[2]
(iv)
You are an investment manager working for the investment arm of a small life
insurance company that has used exchange-traded options as part of its equity
portfolio management.
(i)
(ii)
List the main features and characteristics of the main equity indices of UK,
USA, Japan, Germany and France.
[5]
(iii)
(iv)
ST5 S20083
[4]
[2]
Outline the investigations that the investor should carry out prior to deciding
whether to invest in the new company.
[5]
(ii)
Outline the difficulties the investor might encounter when trying to research,
analyse and place a valuation on the company.
[2]
The investor expects the global economy to slow in the next 12 months and enter into
a recession.
(iii)
Discuss how the company and the quoted shares might be affected if the
investors predictions are correct.
[3]
The investor decides not to invest in the stock directly, but takes out a 3 month call
option on the stock at a price which is 5% below the expected flotation price of 50p.
The company floats later in the month. On the first day the stock increases by 3%
over the actual flotation price of 45p.
(iv)
Define the term out of the money for both a put option and a call option
giving a brief example of each.
[2]
(v)
Outline how the price of the call option is likely to have changed in the six
weeks since purchase.
[3]
[Total 15]
(ii)
Outline the principles you would recommend adopting under legislation for
institutional investment.
[6]
[Total 9]
END OF PAPER
ST5 S20084
Faculty of Actuaries
Institute of Actuaries
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.
R D Muckart
Chairman of the Board of Examiners
December 2008
Faculty of Actuaries
Institute of Actuaries
30/12/2008
Subject ST5 (Finance and Investment Specialist Technical A) September 2008 Examiners Report
General comments
Generally a poorly answered paper than previous diets; although the pass rate was
consistent with recent diets, this equated to a disappointingly lower pass mark. Candidates
typically answered Questions 5 and 6 better than the others, with Questions 1 and 3
attracting the worst responses.
Many candidates seemed to understand the key issues being examined and so appreciated the
general content of solutions that the examiners were looking for however those that were
unsuccessful will find their solutions lacked sufficient (and often the most basic) detail and
scored lower accordingly. Worse, some candidates deviated from the topic and included
irrelevant material although candidates will not be explicitly penalised for this, it gives an
impression of a lack of understanding and, more importantly, wastes valuable time. Where
candidates made relevant points in other parts of their solutions, the examiners have used
their discretion as to whether to recognise these answers or not.
Again there were many candidates close to the pass mark whom were awarded an FA most
candidates would be very surprised to see just how tightly distributed the marks are; deciding
where the pass mark falls will have a material impact on the numbers of candidates who are
successful and the examiners take great care to ensure a consistency of standard across
candidates, subjects and diets. It was fairly clear where the hurdle should have been set; as
a result, the pass rate for this diet was similar to last time. However the pass mark remains
much lower than the examiners feel ought to achievable by candidates, many of whom are
likely to be working as advisers or asset managers in this most practical of fields. Several
candidates were awarded an FD in this diet and the examiners remain concerned by the
numbers of candidates still achieving only an FC grade, since this too would imply little
preparation or, worse, knowledge and understanding.
Candidates are reminded of a bias in the paper towards recognising higher level skills and
practical application this is intentional and will continue. Likewise the examination system
does properly allow for prior subject knowledge to be assumed. Investment is a necessarily
practical subject and, at this level, the examiners expect candidates to demonstrate a breadth
and depth of competency as would be expected from a senior student in a frequently evolving
discipline. Hence simple regurgitation of bookwork will never be sufficient to ensure a Pass
grade and this was evident from the dispersion of candidates responses in the more
differentiating questions.
As noted before, in order to succeed, candidates must ensure they familiarise themselves with
the prevailing investment issues and the general market background facing institutional
investors in the 18 months preceding a diet, more so the solutions (and sources of) being
debated by the various stakeholders. A recurring theme in recent years has been a move
towards capital market rather than purely insurance and asset management solutions hence
questions regarding banking and derivative approaches to asset and liability risk
management or modern financial theory and commercial applications should be considered
likely scope for examination. New asset classes and ways of investment will themselves
generate new types of risk and so the need for new regulation and ways of monitoring and
management.
All extenuating and mitigating circumstances were considered in awarding grades.
Page 2
30/12/2008
Subject ST5 (Finance and Investment Specialist Technical A) September 2008 Examiners Report
(i)
(ii)
r (%)
(%)
IR
1,2
1,3
2,3
0.25
0.125
0.5
3.75
1.625
2.00
3.95
4.84
4.33
0.95
0.34
0.46
(iii)
Only the combination of assets 1 and 2 gives a better IR than asset1 or asset 2
on their own. The minimum variance portfolio does not give the best IR for
each combination. This outlines the problem of using minimum variance
portfolios in building a portfolio.
(iv)
Gearing will give additional returns provided the cost of gearing is less than
the assets return. The debt is usually at a fixed rate of interest and so has no
variance. Thus although higher returns are achieved they will be at the cost of
higher risk (tracking error) unless the cost of debt is less than the risk free rate
(unlikely). Thus the information ratio will fall.
Selling short an asset that has a lower expected return and re-investing in a
higher returning asset will increase the return but will significantly increase
the risk. However if the assets are moderately to highly correlated and the
asset being bought has a sufficiently high risk adjusted return over the asset
being sold it will be possible to have an improved IR. However such
situations tend to be arbitraged away very quickly.
The most important consideration is the retailers quality and financial strength as the
rental income from all the properties in the portfolio are dependent on these factors.
It is therefore important to assess the financial position of the company both pre and
post the sale and leaseback.
Why is the company looking to sell the properties?
What will it be doing with the money it raises?
How long has the company been trading?
Page 3
30/12/2008
Subject ST5 (Finance and Investment Specialist Technical A) September 2008 Examiners Report
How long has the current management team been running the chain, do they have any
plans for retirement/succession?
What future plans do the management have for the chain?
Has it been through more than one economic cycle? If so how did it perform during a
recession? If not does it sell necessities or luxury items?
The properties themselves are also important.
Their location both in terms of which towns and the location within the town.
Age and the state of repair.
Could other retailers easily move into the space?
The lease details would need to be determined.
How long are the leases?
Are there any break clauses?
Are the leases on upward only rent reviews?
How often are rents reviewed?
What rent will be paid initially?
Finally details of the yields on similar properties would need to be ascertained.
(i)
(a)+(b) Alpha is the difference between a funds expected returns based on its
beta and its actual returns. Alpha is sometimes called the value that a
portfolio manager adds to the performance. If a fund returns more than
what you'd expect given its beta, it has a positive alpha. If a fund
returns less than its beta predicts, it has a negative alpha.
Looking at the three strands separately:
Page 4
30/12/2008
Subject ST5 (Finance and Investment Specialist Technical A) September 2008 Examiners Report
This is an area that has received a lot of attention in the recent past
with the advent of quantitative models.
These models may allow investors to better identity anomalies and
thereby make better decisions.
Given the large amount of data available a system that processes this
information better may well lead to improved or more rapid decision
making.
Given the wide variety of information available any processing system
will have to be very flexible.
Better models of companies and sectors can also be developed to better
predict the future profitability and cash flows of a company or sector.
Again given the diversity of companies and sectors it is difficult to
devise a financial model that will be applicable to all companies.
Subject ST5 (Finance and Investment Specialist Technical A) September 2008 Examiners Report
(c)
(ii)
A large number of analysts unless the aim was only to cover a limited part
of the market.
A quantitative team.
All these functions would need co-ordination and there would need a person or
people to reconcile the different recommendations and actually construct a
portfolio.
It is possible that an investment process with all these inputs may become
unwieldly.
There is also the possibility that the various input streams may produce
conflicting recommendations.
There is a danger that a portfolio constructed using these ideas could exhibit
abnormally high or low tracking errors. This would need careful explanation
to potential clients.
The attribution and explanation of performance would also be very complex.
The cost of such an operation may mean that this approach is only open to
fund managers with significant funds under management.
(i)
Where
i W ( Pit / Pi 0 )
i Wi
Page 6
30/12/2008
Subject ST5 (Finance and Investment Specialist Technical A) September 2008 Examiners Report
(iii)
(iv)
The investors in the fund must pay investment management fees, custody fees,
audit fees, governance fees and administration fees whereas such fees are not
taken into account in the calculation of returns on the Index.
The Index includes the reinvestment of gross dividends paid by its constituent
companies whereas the investment manager will only receive such dividends
net of withholding tax.
The Index does not take into account the costs of rebalancing the index for
such activities as new entrants, exits, mergers and takeovers and changes in
the market capitalisation of constituents.
Such costs include stockbrokers commissions, stamp duty and other levies.
When the fund manager receives small amounts of dividend income, it may
not be cost effective for her to invest such small amounts across the
constituents in the correct proportions.
The manager will therefore have part of the portfolio invested in the
constituents of the index and part invested in cash.
The cash holding will cause the manager to under perform the index in a rising
market and out perform the index in a falling market.
Page 7
30/12/2008
Subject ST5 (Finance and Investment Specialist Technical A) September 2008 Examiners Report
Problem with definition of emerging market. This will vary between investors
and index providers.
Lack of homogeneity means alternatives for stock/sector exposures may not be
closely correlated.
At individual market level and relevant weights, there may be foreign
ownership restrictions, different share classes and different definitions of
capitalisation according to free float.
Some markets may be very concentrated with associated liquidity issues. This
could have implications for investors with caps on exposures to particular
companies.
Marketability and availability of stock will vary and political instability can
cause capital control issues and so grounds for inclusion/exclusion within
index with limited notice of change.
For total return, income adjustment should reflect investor circumstances in
terms of reinvestment (actual receipt may be long after dividend declaration)
and taxation e.g. unrecoverable taxes.
Pricing and valuation information may be poor and untimely which will affect
dealing and monitoring of tracking.
Costs of dealing may be higher and may need to be reflected in judging
tracking success.
Restrictions on investment in certain countries imposed either by trustees or
regulation may render index less appropriate.
May have undue sector or stock biases versus total portfolio.
Research, administration, custody and dealing costs may be disproportionate
or difficult to facilitate.
Taxation will be a particular problem especially capital gains tax.
If making direct investment, unlikely to have portfolio similar to index.
Other practical management and monitoring issues.
Page 8
30/12/2008
Subject ST5 (Finance and Investment Specialist Technical A) September 2008 Examiners Report
(i)
UK -FTSE 100- largest 100 companies by market cap. Account for 80% of
total market. Weighted arithmetic average basis. Free float.
USA Dow, 30 shares. Unweighted arithmetic average.
S&P 500, weighted arithmetic index
Japan Nikkei 225 companies, unweighted arithmetic average
Topix 1100 shares, market cap weighted arithmetic
Germany DAX 30 shares, total return index
France CAC, 250 shares free float, market cap
(ii)
(iii)
(iv)
Options are financial instruments that convey the right, but not the
obligation, to engage in a future transaction on some underlying security,
or in a futures contract.
Exchange traded options have standardized contracts, and are settled
through a clearing house with fulfillment guaranteed by the credit of the
exchange. Since the contracts are standardized, accurate pricing models
are often available.
Trading options entails the risk of the option's value changing over time.
However, unlike traditional securities, the return from holding an option
varies non-linearly with the value of the underlier and other factors.
A further, often ignored, risk in derivatives such as options is counterparty
risk. In an option contract this risk is that the seller won't sell or buy the
underlying asset as agreed. However exchange trading enables
independent parties to engage in price discovery and execute transactions.
As an intermediary to both sides of the transaction, the exchange provides:
- fulfillment of the contract is backed by the credit of the exchange,
which typically has the highest rating (AAA),
- counterparties remain anonymous,
Page 9
30/12/2008
Subject ST5 (Finance and Investment Specialist Technical A) September 2008 Examiners Report
(i)
What investigations
Management ability
Quality of the cars/products
Prospects for market growth, market research and outlook for future
economy
Competition, who else makes the same type of cars. What is their business
model like
Input costs
R&D costs
Likely Profit
Marketing and sales strategy
The accounting ratios
Predicted level of borrowing
(ii)
(iii)
Describe how the company and the quoted shares might be affected.
Car company would be defined as consumer good, durable, cyclical.
As enter into recession PER will fall, share price likely to be depressed
Sales of new cars likely to fall to less demand.
Profits likely to decrease due to reduced demand and potential reduction in
price. Input costs likely to remain unchanged.
Page 10
30/12/2008
Subject ST5 (Finance and Investment Specialist Technical A) September 2008 Examiners Report
(iv)
Define the term out of the money for both a call option and a put option
giving a brief example for each option.
Out of money for a call option means the current share price is less than
the strike price attached to the option. Example if strike price is 250 and
current price is 200, out of the money.
Out of money on put means that the current price of share is higher than
the strike price attached to the option. Example current share price is 300
and the strike price attached to put option is 250.
(v)
Marks were given for reasoned arguments reflecting points such as:
There is a price to pay for the option which once added to current price
means out of the money initially.
The actual floatation price was lower than expected.
Price reflects volatility and time values.
(i)
(ii)
Faculty of Actuaries
Institute of Actuaries
EXAMINATION
22 April 2009 (pm)
Enter all the candidate and examination details as requested on the front of your answer
booklet.
2.
You have 15 minutes before the start of the examination in which to read the
questions. You are strongly encouraged to use this time for reading only, but notes
may be made. You then have three hours to complete the paper.
3.
You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
4.
5.
Attempt all six questions, beginning your answer to each question on a separate sheet.
6.
In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.
ST5 A2009
Faculty of Actuaries
Institute of Actuaries
(i)
(ii)
[8]
(iii)
Describe the key reasons why hedge fund index returns are likely to overstate
actual returns and understate volatility for a typical hedge fund investor. [4]
(iv)
State the formula for the Sharpe ratio, defining any terms you use.
[2]
(v)
Explain why hedge funds highlight the Sharpe ratio in their promotional
material, rather than the Treynor or Jensen ratios.
[2]
(vi)
Describe the key limitations of the Sharpe ratio as a measure of the skill of a
hedge funds managers.
[5]
[Total 27]
You are the portfolio manager for a global equity pooled fund and have received a
quarterly analysis of companies in the European telecoms sector.
(i)
(ii)
(a)
(b)
List the factors that you might expect to see included in the numerical
analysis.
[6]
Outline the additional commentary that you would expect to see for a
company in the sector that is more highly leveraged than average, with a
significant amount of debt due to be repaid in the next two years.
[3]
Your company is considering launching two new global equity pooled funds, the
Global Equity (Higher Leverage) Fund and the Global Equity (Lower Leverage)
Fund. The intention is for a combined investment in the two new funds to broadly
correspond to an investment in the existing fund. The two funds will invest in the
same universe of underlying companies and can make the same buy/sell decisions as
the existing global equity fund. However, companies that are highly geared can only
be invested in by the Higher Leverage Fund.
(iii)
Discuss why a potential investor might find the choice of two new funds more
attractive than the existing global equity fund.
[7]
(iv)
Explain why an investor should not expect investments of $1m in each of the
two new funds to perform precisely in line with a single $2m investment in the
existing global equity fund.
[4]
[Total 20]
ST5 A20092
The trustees of a pension fund decide to purchase a three year swap contract under
which the pension fund will receive a fixed rate payment stream. The pension fund is
required to pay a floating rate payment stream in return. The pension fund receives
the following information about the swap and the likely payments:
Term 3 years
Notional value of swap 50m
Payments are made in arrears semi-annually
The swap year calculations assume there are 360 days in a year
Period
1
2
3
4
5
6
183
181
182
182
181
183
4.00%
4.25%
4.5%
4.75%
5.0%
5.25%
(i)
[1]
(ii)
[2]
(iii)
[1]
(iv)
[4]
The pension fund trustees proceed with the proposed contract for the payments
described above and the fixed rate of the swap is set at 4.75% pa.
(v)
Calculate the profit or loss to the pension fund at the end of the swap contract.
[4]
(vi)
Explain what difference there would have been to the profit/loss on the swap if
interest rates had risen during the duration of the swap contract.
[2]
[Total 14]
ST5 A20093
(i)
(a)
(b)
(ii)
(a)
(b)
(iii)
Draw a diagram for each of the following strategies and explain why an
investor may wish to undertake such strategies.
(a)
(b)
Buying one call and one put with the same expiry and strike price
(c)
Buying call options of a certain strike price and selling the same
number of call options at a lower strike price (in the money) with the
same expiry date.
[6]
As part of an investors portfolio there are 100 call options that have been written
with an exercise price of 1.50 and an expiry date of November. The option premium
received was 0.50 per option.
(iv)
[1]
(v)
[2]
(vi)
Calculate the profit or loss to the investor if the price of the share at expiry is:
(a)
(b)
(c)
0.75
1.50
2.15
[2]
The derivatives exchange where the call options are traded requires an initial margin
of 20% of the premium received. In addition a variation margin has to be paid equal to
100% of the option price movement. The value of the premium at the end of
September was 0.55.
(vii)
Calculate the total margin the investor has had to post to the exchange at the
end of September.
[2]
[Total 17]
ST5 A20094
(i)
[1]
(ii)
Write down the equation of value that needs to be satisfied by the par yield,
C2, of a two year bond (interest paid annually in arrears), in terms of the zero
coupon yield, ZCt, at time t.
[2]
(iii)
Calculate the zero coupon yields at times 1, 2 and 3 from the following par
yield curve, assuming coupons are paid annually in arrears:
Term
Par Yield
1
2
3
4
5.50%
5.40%
5.35%
5.30%
[6]
(iv)
Describe three techniques that can be used to identify bond anomaly switching
opportunities.
[6]
[Total 15]
(i)
(a)
(b)
(ii)
END OF PAPER
ST5 A20095
Faculty of Actuaries
Institute of Actuaries
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.
R D Muckart
Chairman of the Board of Examiners
July 2009
Faculty of Actuaries
Institute of Actuaries
Subject ST5 (Finance and Investment Specialist Technical A) April 2009 Examiners Report
Comments
Pleasingly, a better answered paper than previous diets leading to a higher pass rate even with a
higher pass mark. Candidates typically answered Questions 1, 4 and 5 much better than the others,
with Questions 2 and 3 attracting the worst responses, considerably so. This is not surprising given
that Questions 2 and 3 represented the opportunity to demonstrate higher level skills in terms of nonstandard/practical application of theory to current issues in investment hence candidates who wish
to progress to SA6 will need to improve their understanding of and approach to this type of question.
That said, most candidates seemed to identify and understand the key issues being examined and so
appreciated the general content of solutions that the examiners were looking for however those that
were unsuccessful will find their solutions lacked sufficient (and often the most basic) detail and
scored lower accordingly (this was most evident in Question 6). Many candidates still deviate from
the topic and include irrelevant material or over emphasise minor points although candidates will
not be explicitly penalised for this, it gives an impression of a lack of understanding and, more
importantly, wastes limited time. Time and priority management are key skills actuaries need to have.
Where candidates made relevant points in other parts of their solutions, the examiners have used their
discretion as to whether to recognise these answers or not. Likewise the examiners share and agree
alternative possible solutions to questions during the marking process.
Again there were many candidates close to the pass mark whom were awarded an FA most
candidates would be very surprised to see just how tightly distributed the marks are; deciding where
the pass mark falls will have a material impact on the numbers of candidates who are successful and
the examiners take great care to ensure a consistency of standard across candidates, subjects and
diets. Several candidates were awarded an FD in this diet and the examiners remain concerned by
the numbers of candidates still achieving only an FC grade, since this too would imply little
preparation or, worse, knowledge and understanding.
Candidates are reminded of a bias in the paper towards recognising higher level skills and practical
application this is intentional and will continue. Likewise the examination system does properly
allow for prior subject knowledge to be assumed. Investment is a necessarily practical subject and, at
this level, the examiners expect candidates to demonstrate a breadth and depth of competency as
would be expected from a senior student in a frequently evolving discipline. Hence simple
regurgitation of bookwork will never be sufficient to ensure a Pass grade and this was evident from
the dispersion of candidates responses in the more differentiating questions.
As noted before, in order to succeed, candidates must ensure they familiarise themselves with the
prevailing investment issues and the general market background facing institutional investors in the
18 months preceding a diet, more so the solutions (and sources of) being debated by the various
stakeholders. A recurring theme in recent years has been a move towards capital market rather than
purely insurance and asset management solutions hence questions regarding banking and
derivative approaches to asset and liability risk management or modern financial theory and
commercial applications should be considered likely scope for examination. New asset classes and
ways of structuring investment will themselves generate new types of risk (such as operations,
liquidity, credit and counterparty), so the need for new ways of monitoring and management.
All extenuating and mitigating circumstances were considered in awarding grades and, where there
was a genuine cause, credit given.
Page 2
Subject ST5 (Finance and Investment Specialist Technical A) April 2009 Examiners Report
(i)
There are various reasons why the performance of an investment portfolio will
be measured:
1. To improve future performance. First, data collected during performance
monitoring can form the inputs for planning future strategy. Secondly, if
fund managers know that their performance is being measured, it might
give them an extra incentive to maximise the returns of the funds they
manage.
2. Comparison of the rate achieved against a target rate. Many funds will
have one or more target rates of return. For example, the trustees of a
pension fund will want to know the rate of return achieved on the
investments compared with the rate of return assumed in the actuarial
valuation.
3. Comparison against the performance of other portfolios, an index and/or a
benchmark portfolio. Those responsible for the funds will want to know
how the performance of the portfolio compares with other portfolios. On
the basis of this information, they are able to make decisions regarding the
future investment of the assets, e.g. should a new fund manager be hired?
Also, by analysing the performance against a notional portfolio, it may be
possible to identify some relative strengths and/or weaknesses of
individual fund managers (e.g. in sector or stock selection).
Other reasons could include the assessment of performance related fees or
more generic assessments of success/failure of the portfolio.
(ii)
Page 3
Subject ST5 (Finance and Investment Specialist Technical A) April 2009 Examiners Report
Impact on fund manager behaviour: knowledge of how, and how often he will
be assessed is likely to influence the investment strategy of a manager. This
may not be in the funds best interests. For example, frequent monitoring can
encourage a short term approach to investment.
Cost: users of performance measurement services must balance the value of
the service against the cost. Also, for a number of assets (e.g. property),
valuation is difficult, time-consuming and very subjective. Detailed, frequent
calculations based on subjective valuations are inappropriate.
(iii)
(iv)
Selection bias funds with a good history are more likely to apply for
inclusion at the time of reviewing index constituents. Similarly, it is not
always possible to obtain accurate performance information from a failing
hedge fund so the provider may only be able to exclude the fund rather
than report its full losses. Both of these factors will create an upward bias.
S=
Rp r
p
Page 4
Subject ST5 (Finance and Investment Specialist Technical A) April 2009 Examiners Report
(vi)
The key limitations of the Sharpe ratio with regard to hedge fund returns are as
follows:
(i)
(a)
The analysis should identify and analyse the key factors affecting the
future profitability of companies within the sector...
...and offer an outlook for the sector as a whole.
The analysis should enable the portfolio manager to form a view on the
attractiveness of the sector relative to other sectors...
...and also form a view on the relative attractiveness of individual
companies within the sector.
The analysis should also comment on the timescale over which
differences between perceived value and market prices might converge
(or if not, why they might persist)...
...and the recommendations should be justified by a combination of
numerical analysis and qualitative research...
(b)
Revenues
Operating profit
Pre-tax profit
Earnings per share
Price/earnings ratio
Price/book value
Dividend yield
Outstanding debt
Page 5
Subject ST5 (Finance and Investment Specialist Technical A) April 2009 Examiners Report
(iii)
A new investor will not necessarily gravitate to the established global equity
fund, depending on his/her requirements.
Particular reasons why the new funds might offer a better fit for the investors
requirements could include one or more of the following factors:
Alpha based view
The investor believes that the fund manager has greater potential to deliver
alpha in the Lower Leverage or Higher Leverage niches than in the main fund
that invests in both categories of company.
This may reflect that the investor believes that a global approach to equity
investment is better suited to, for example, the Lower Leverage category,
where there are fewer country-specific factors that need to be accounted for in
selecting stocks.
Beta-based views
Page 6
Long term: the investor wishes to have a long-term bias towards Lower
Leverage or Higher Leverage companies.
Short-term: the investor believes that at the current point in the economic
cycle, Lower Leverage or Higher Leverage companies have better
prospects.
The above may reflect a risk-based view (e.g. more highly leveraged
companies have higher volatility) or a return-based view (e.g. more highly
leveraged companies will underperform at times of high interest rates /
high credit spreads).
Subject ST5 (Finance and Investment Specialist Technical A) April 2009 Examiners Report
(iv)
At the launch date of the two niche funds it would appear that equal
investments in the two funds would in aggregate equal the existing fund.
However, the two approaches would begin to diverge almost immediately,
although not greatly as they are based on broadly the same stock/sector
selection decisions.
Differences would arise due to inflows and outflows from investors into the
different pooled funds, resulting in varying cash weightings and transaction
costs which would impact on the relevant fund.
Further differences will arise if a stock was reclassified as moving from the
Lower Leverage category to the Higher Leverage category (or vice versa).
This reflects that for the existing fund this would not lead to a buy/sell
decision (in the absence of other factors), whereas for the two niche funds one
would need to sell the stock and one would need to buy the stock (in the
absence of other factors). Crossing trades will mitigate against market impact
and transaction costs to the extent that the Lower Leverage and Higher
Leverage funds are making equivalent but opposite changes in a particular
stock.
(i)
A swap agreement in which the fixed rate receiver has the right to terminate
the swap on one or more dates prior to its scheduled maturity. This early
termination provision is designed to protect a party from adverse effects of
large changes in fixed rates.
(ii)
The pension fund wants to enter into swaps to reduce risk but the actual
liabilities are subject to refinement which might mean swaps adjustment.
Page 7
Subject ST5 (Finance and Investment Specialist Technical A) April 2009 Examiners Report
There is a yield pick up on the swap and therefore, is being held for tactical
reasons and not as a long term investment.
(iii)
(iv)
Period
Number of days
in period
1
2
3
4
5
6
183
181
182
182
181
183
Annual
Forward
Interest
4.00%
4.25%
4.50%
4.75%
5.00%
5.25%
1/2 year
interest rate
2.03%
2.14%
2.28%
2.40%
2.51%
2.67%
value
term
payment
days
50000000
3
semi-annual arrears
360
(a)
PV
1
1/[1+(days/360*Interest)]
2 1/[1+(days/360*Interest) 2 periods]
3
etc.
4
etc.
5
etc.
6
etc.
Total
Discount
0.9801
0.9596
0.9382
0.9162
0.8938
0.8705
5.5584
PV of payments
996406
1025205
1067229
1100102
1123398
1161602
6473942
Notional
24910160
24122468
23716197
23160035
22467962
22125746
140502569
Candidates were given credit for rounded solutions rather than the
level of detail shown. Full marks were not available if candidates
assumed a half year rather than a specific day count.
(b)
PV of notional
PV of floating rate
Theoretical swap rate
(v)
140502569
6473942
4.61%
Page 8
Subject ST5 (Finance and Investment Specialist Technical A) April 2009 Examiners Report
(vi)
The higher interest rates would mean the pension fund would be paying out
more than assumed and therefore, the profit assumed would be reduced or
turned into a loss (out of the money)
(i)
(a)
(b)
(ii)
(a)
(b)
(iii)
The charts illustrate the basic shape of the payoff and credit was given for
similar, suitably annotated graphs
(a)
Butterfly spread
Investor does not believe a stock will rise or fall much before expiry
thinks volatility will be low. Wants limited risk strategy but also
limits profit.
Page 9
Subject ST5 (Finance and Investment Specialist Technical A) April 2009 Examiners Report
(b)
Straddle
Investor believes the underlying price will change significantly but
does not know which way it will go. Profit if volatility is high.
(c)
Bear spreads
A bear call spread is a limited profit, limited risk options trading
strategy that can be used when the options trader is moderately bearish
on the underlying security. Thinks the share price will fall.
(iv)
(v)
Chart would show 50 profit when share price starts at 0 until exercise price
1.50. The investor would then start to decrease the profit. At 2.00 exercise
the investor profit would be 0. At 2.50 the loss would be 50
Page 10
Subject ST5 (Finance and Investment Specialist Technical A) April 2009 Examiners Report
(vi)
0.75 = 50 profit,
1.50 = 50 profit assuming can buy stocks in market at zero cost
2.15 = 15 loss assuming can buy stocks at zero cost. Loss on purchase of
shares is 65 and profit from premium 50
(vii)
Initial margin is 0.2 50p 100 shares = 10. Then have to post 100% of the
movement which is 5p. The additional margin is then 5 for the 100 shares so
the total margin = 15.
(i)
The par yield is the coupon rate that would be required for a coupon-paying
bond to be valued at par under the current interest rate curve.
(ii)
1 = C2 (1 + zc1 )
+ (1 + C2 )(1 + zc2 )
(iii)
Term
1
2
3
4
(iv)
Par Yield
5.50%
5.40%
5.35%
5.30%
V(Bond)
100.000%
100.000%
100.000%
100.000%
ZC Yield
5.500%
5.397%
5.346%
5.290%
Subject ST5 (Finance and Investment Specialist Technical A) April 2009 Examiners Report
Yield models: rather than compare a bonds yield with a redemption yield
curve it can be compared with one of the alternatives such as a yield surface or
par yield curve.
(i)
(a)
(b)
(ii)
Page 12
Faculty of Actuaries
Institute of Actuaries
EXAMINATION
1 October 2009 (pm)
Enter all the candidate and examination details as requested on the front of your answer
booklet.
2.
You have 15 minutes before the start of the examination in which to read the
questions. You are strongly encouraged to use this time for reading only, but notes
may be made. You then have three hours to complete the paper.
3.
You must not start writing your answers in the booklet until instructed to do so by the
supervisor.
4.
5.
Attempt all seven questions, beginning your answer to each question on a separate
sheet.
6.
In addition to this paper you should have available the 2002 edition of the Formulae
and Tables and your own electronic calculator from the approved list.
ST5 S2009
Faculty of Actuaries
Institute of Actuaries
(i)
[5]
(ii)
(a)
(b)
Explain the reasons why basis risk may arise when a futures contract is
used to hedge a position in the cash market.
[3]
(iii)
State the formula for the optimal hedge ratio, defining the terms used.
(iv)
Outline why fixed income derivatives are more difficult to value than equity
derivatives.
[4]
(v)
Determine the price of a 10-month European call option on a 9.75 year bond
with a face value of 1,000. Assume that:
[2]
ST5 S20092
An investment consultant advises two pension funds that are both long-term investors
in separate global equity portfolios managed by Makeoff Global Investment
Company. Over the 12 months to 31 December 2008 the returns for the two clients
have been materially different. On further investigation, the investment consultant
obtains the following information:
Beta of portfolio
Holding in Banks
Investment Style
(i)
(ii)
Pension Fund A
Pension Fund B
0.8
4% underweight to benchmark
Value
1.2
10% overweight to benchmark
Growth
(a)
(b)
Describe how the Betas quoted above will have impacted performance
over the period under review.
[3]
Explain what is meant by the terms Value and Growth.
(a)
(b)
Give an example of the type of shares that Value and Growth style
investors would invest in.
[4]
(iii)
Explain, using the information in the table above, which pension fund would
have been expected to have performed better during the period under review.
[3]
Another long-term investor follows the same investment strategy as Pension Fund B.
However, during the 12 months to 31 December 2008 they have experienced different
performance to Pension Fund B.
(iv)
(i)
(ii)
List the principal questions that a credit rating agency will ask in assessing and
ascribing an issuer rating for a company that issues debt.
[4]
(iii)
Explain why a bond issued by a company might have a higher or lower credit
rating than the company itself.
[2]
[Total 10]
ST5 S20093
[2]
[Total 12]
(i)
Describe the problems with, and the possible solutions to, the investment
technique known as liability hedging.
[8]
The trustees of a pension scheme with two sections (Section A and Section B) wish to
reduce the impact of interest rate changes on the amount of the difference between the
present value of the assets and the present value of the liabilities.
The table below shows the payments that are due to be paid out from each scheme
section and also those from a bond the trustees are thinking of purchasing to achieve
their investment objective.
Bond
Year (t) Cashflows
1
2
3
4
5
10
10
10
10
100
Section A
Liabilities
11
0
5
32
93
Section B
Liabilities
5
10
13
27
85
Assumptions
(ii)
ST5 S20094
Assuming no other investments, state with reasons for which Section the bond
is better suited to achieve the trustees objectives. Show all your calculations.
[5]
[Total 13]
(i)
[3]
REITs are relatively high-yield investments and a REIT must pay out at least 90% of
its taxable profit as a dividend to shareholders.
(ii)
Explain how you would expect the share price of a REIT to change with a rise
in interest rates.
[3]
You have been asked to assess the value of a possible REIT investment, Equity in
Property, which has a current market capitalisation of $8bn. You have been given the
following accounting information:
Rental income
Fee and asset management
Total Revenues
2008
2007
1,808,925 1,799,581
14,373
9,582
1,823,298 1,809,163
Property maintenance
498,608
464,981
Taxes and insurance
196,987
181,890
Property management
68,058
72,416
Fee and asset management
7,819
7,885
Depreciation
444,339
419,039
General and administration
38,810
46,492
Other costs
1,162
18,284
Total Expenses
1,255,783 1,210,987
(iii)
Operating Income
Net earnings
567,515
543,847
598,176
421,313
Capital Expenditures
181,948
156,776
You have proposed basing your valuation on a measure of Funds from Operations
(FFO), which excludes depreciation and the gains on sales of depreciable property.
(iv)
Calculate and reconcile FFO for each of the two years with net earnings.
[2]
(vi)
Explain how you would use FFO and AFFO to value the proposed investment
in Equity in Property in order to recommend a purchase or not.
[6]
[Total 17]
ST5 S20095
Two investors have the same time horizon to complete the following trades.
(i)
(a)
(b)
Another investor with 500m invested in equities believes equity markets will fall by
35% over the next 12 months. The general market consensus is markets will rise by
5% over the next 12 months.
(ii)
Set out three strategies that the investor could adopt to protect themselves
from a fall in equity markets.
[6]
(iii)
(iv)
Describe the effect adopting each strategy would have on the investors
investment performance if the equity markets increased by 5% over the next
12 months.
[6]
[Total 20]
END OF PAPER
ST5 S20096
[4]
Faculty of Actuaries
Institute of Actuaries
EXAMINERS REPORT
Introduction
The attached subject report has been written by the Principal Examiner with the aim of
helping candidates. The questions and comments are based around Core Reading as the
interpretation of the syllabus to which the examiners are working. They have however given
credit for any alternative approach or interpretation which they consider to be reasonable.
R D Muckart
Chairman of the Board of Examiners
December 2009
Comments for individual questions are given with the solutions that follow.
Faculty of Actuaries
Institute of Actuaries
Subject ST5 (Finance and Investment Specialist Technical A) September 2009 Examiners
Report
1
a. An investment trust where the ordinary share capital consists of income
and capital shares. Holders of income get distributed income, holders of
capital little or no income but get residual value of assets after income
shares have been redeemed at fixed value.
b. Issue of further shares at a given price to existing shareholders in
proportion to their existing shareholdings. The purpose is for the issuing
company to raise more money.
c. Sometime called capitalisation or bonus issue is a further issue of new
shares (with the original nominal value) to existing shareholders in
proportion to their holdings. Reserves are capitalised to provide the
additional shareholders' equity.
d. Existing shares are split into two shares of half the original nominal
value. No new capital is raised and no reserves are capitalised.
[6]
2
(i) The main difference between (OTC) forwards and (exchange-traded) futures is
that, for a forward, there is no cash flow until the maturity. For a future, there
are daily marking-to-market and settlement of margin requirements.
If interest rates are constant then the values of the cash flows are equal and,
hence, the prices must also be equal. When interest rates vary unpredictably,
forward and futures prices are no longer the same because of the daily cash
flows from settlement and the interest earned on cash received (or paid on
borrowing). When the price of the underlying asset is strongly positively
correlated with interest rates, a long futures contract will be more attractive
than a similar long forward contract and futures prices will tend to be higher
than forward prices. The reverse holds true when the asset price is strongly
negatively correlated with interest rates.
The theoretical differences between forward and futures prices for contracts
that last only a few months are, in most circumstances, sufficiently small to be
ignored. However, for long-term futures contracts, the differences between
forward and futures rates are likely to become significant. To convert futures
to forward interest rates, a convexity adjustment is applied:
Forward rate = Futures rate
2t1t2
Page 2
Subject ST5 (Finance and Investment Specialist Technical A) September 2009 Examiners
Report
The asset whose price is to be hedged is not exactly the same as the
asset underlying the futures contract
The hedger is uncertain as to the exact date when the asset will be
bought or sold.
The hedge requires the futures contract to be closed out well before
its expiration date.
(iii) The optimal hedge ratio, h, (ratio of the size of the position taken in futures
contracts to the size of the exposure) is given by:
h=
where
F
and
(iv) Fixed income derivative payoffs will be dependent in some way on the level of
interest rates. They are therefore more difficult to value than equity
derivatives, since:
(v) Assuming that the bond prices at the maturity of the option are log-normally
distributed, the value of the call option c is given by
c = P(0,t) [F0
where
(d1) X (d2)]
d1 = (ln (F0 / X) + ( 2T / 2) /
and
d2 = (ln (F0 / X) ( 2T / 2) /
F0 (the forward bond price) = (B0 I) / P(0,T)
where B0 is the bond price at time zero and
I is the present value of the coupons that would be paid during the life of the
option.
In this case, I = 30 e
0.25
0.02
+ 30e
Page 3
0.75
0.026
0.025
= 59.293
= 1236.203
Subject ST5 (Finance and Investment Specialist Technical A) September 2009 Examiners
Report
Then d1
Hence, c = e
0.026
1236.203
= 0.97857 [(1236.203
0.57139) 1300
0.2839) (1300
0.65355)]
0.2567)]
= 16.83
3
(i)
a. Beta is a measure of a stock's volatility relative to movements in the
whole of the market and is thus a measure of systematic risk. It is usually
defined as the covariance of the return on the stock with the return on the
market, divided by the variance of the market return.
b. Pension Fund A would have been less volatile than the market, Pension
Fund B would have shown more volatility.
(ii)
a. Value investing is a style of investing based on picking shares that have
low valuations relative to their current profits, cash flows and dividend
yield. Value factors commonly analysed include:
Low
Book to Price
Earnings
Sales
Yield
to Price
Growth shares are shares with high price to book values. The expectation
is that earnings and profits will grow above average. Other factors
analysed include:
Sales
Growth
Return
on Equity
Earnings
Revisions
Page 4
Subject ST5 (Finance and Investment Specialist Technical A) September 2009 Examiners
Report
Low beta expected to perform better as less volatile than high beta (everything
being equal)
Financials underperformed market in general so being underweight would be
better
Growth stocks tend to underperform value when markets are falling
Overall we would expect Pension A to perform better
(iv) Cashflows
Tax differences
Management Fee structure
Performance calculation in different base currencies
Credit was given for other sensible reasons
4
(i) The key factors in managing credit risk are:
the
the
Page 5
Subject ST5 (Finance and Investment Specialist Technical A) September 2009 Examiners
Report
downside risk
quality of
cash
forward
looking analysis
strategy,
capital
Specifically:
Purpose
What does the company do and why do they need to borrow? Possible reasons
for seeking finance include:
organic
growth
acquisition
investment
capital
in an associated company
expenditure
dividend
/ share buy-back
Payback
What is the expected source of repayment? Is there a secondary source? Issues
to consider include:
cash
possible
refinancing
Risks
What risks (quantitative and qualitative) could jeopardise debt servicing in
future? Factors to consider include:
macro
market position)
Structure
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Subject ST5 (Finance and Investment Specialist Technical A) September 2009 Examiners
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Does the bond structure reflect the risks and protect investors interests?
(Structure, Status, Safeguards, Pricing)
(iii) A higher rating would apply where the bond has additional security relative to
an unsecured creditor of the issuer (e.g. a fixed or floating charge, or seniority
due to some other factor). [1; 1/2 if no example]
A lower rating would apply where the bond has weaker security relative to an
unsecured creditor of the issuer (e.g. the bond is subordinate to unsecured
creditors). [1; 1/2 if no example]
5
(i) Liability hedging is where the assets are chosen in such a way as to perform in
the same way as the liabilities. A specific example of this is the familiar
concept of immunisation, where assets are matched to liabilities by term in
order to hedge interest rate risk (to some degree). Other familiar forms of
hedging would include matching by currency and the consideration of the real
or nominal nature of liabilities when determining the choice of assets.
However, these examples relate only to specific characteristics of the
liabilities, whereas liability hedging aims to select assets which perform
exactly like the liabilities in all states.
The most familiar example would therefore be the choice of assets to hold in
order to hedge unit-linked liabilities.
In most cases the problem is solved by establishing a portfolio of assets,
determining a unit price by reference to the value of the asset portfolio, and
then using this price to value units held, allocated or realised.
However, even this simple approach can generate many practical problems
use of historic prices for transactions, moving between bid and offer pricing
bases, delays in notification of new money / withdrawals / units allocated or
realised.
A particular problem may arise when intermediaries are given delegated
authority to switch clients holdings between funds, which may result in
extreme volatility of movements for myriad small holdings.
A potentially greater problem arises when the assets held are not the same as
those underlying the value of the liabilities.
Thus, if units are allocated and realised by reference to some external fund,
then it is likely that the internal investment manager will not know what assets
are held by the external manager at any given point in time.
Alternatively, the requisite information may only be available after some
delay, by which time the assets actually held by the external manager are
likely to have changed.
An extreme example of this problem is where the value of liabilities is linked
to some external index (for example, guaranteed contracts where the
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Subject ST5 (Finance and Investment Specialist Technical A) September 2009 Examiners
Report
Year (t)
1
2
3
4
5
Year (t)
1
2
3
4
5
Bond
10
10
10
10
100
1st
condition
10
9
9
8
79
115
2nd
condition 3rd condition
10
10
18
36
26
78
33
133
396
1982
484
2240
Interest
rate
1.0475
1st
Liability A condition
11
11
0
0
5
4
32
27
93
74
115
2nd
condition
11
0
13
106
369
499
Interest
rate
1.0475
1st
Liability B condition
5
5
10
9
13
11
27
22
85
67
115
2nd
condition 3rd condition
5
5
18
36
34
102
90
359
337
1685
484
2187
6
(i) REITs work much like closed-end pooled funds, but instead of owning a
portfolio of securities, the REIT owns a portfolio of real estate properties
and/or mortgages.
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Subject ST5 (Finance and Investment Specialist Technical A) September 2009 Examiners
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REITs are registered securities and trade in the secondary market, like stocks.
As a result, investors get the benefit of diversification (since most REITs own
a large number of properties) and liquidity.
Unlike other pooled funds, REITs are permitted to use leverage the income
from the properties within the REIT is then used to pay the costs of any loans
involved.
There are two main types of REITs:
Equity REITs these invest mainly in actual real estate properties, such as
office buildings, residential property eg apartments, warehouses and shopping
centres. Equity REITs are usually not highly leveraged.
Mortgage REITs these invest mainly in mortgages and construction loans
for commercial properties and tend to use leverage to a greater degree than
equity REITs.
(ii) Total return from REIT is dividends plus price appreciation. Unlike other
quoted equities, most of the expected return of a REIT comes not from price
appreciation but from dividends.
On average, about two thirds of a REIT's return comes from dividends.
As a high-yield investment, a REIT can be expected to exhibit sensitivity to
interest rate changes.
Typically there is a strong inverse relationship between REIT prices and
interest rates.
On average, it would be safe to assume that interest rate increases are likely to
be met by REIT price declines although the actual change will vary by sector.
For example, some argue that in the case of residential and office REITs rising
interest rates would drive up REIT prices because increasing rates correspond
to economic growth and more demand.
However individual REITS may perform differently depending on their
underlying property exposures and degree of leverage.
(iii) From 2007 to 2008, Equity in Property's net income, or earnings grew by
almost 30% (+$122,500 to $543,847).
These net income numbers, however, include depreciation expenses, which are
significant line items.
For most businesses, depreciation is an acceptable non-cash charge that
allocates the cost of an investment made in a prior period.
But real estate is different than most fixed-plant or equipment investments in
that property rarely 'depreciates' in value (in the short term) as the result of
physical wear.
Net income, a measure reduced by depreciation, is therefore an inferior gauge
of performance and so valuation measures based on earnings are equally
flawed.
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Subject ST5 (Finance and Investment Specialist Technical A) September 2009 Examiners
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(iv) The general calculation involves adding depreciation back to net earnings
(since depreciation is not a real use of cash) and subtracting the gains on the
sales of depreciable property.
These gains are subtracted because we assume that they are not recurring and
therefore do not contribute to the sustainable dividend-paying capacity of the
REIT.
Hence the calculation and reconciliation of net income to FFO for EiP is:
Net earnings
Plus Depreciation
Gain on Depreciable Property
Sales
Other miscellaneous Depreciation
items and gains
FFO
2008
543847
444339
(300426)
2007
421313
419039
(102614)
69838
100651
757598
838389
Credit was given for appropriate description of the calculation, since the requisite
data was not provided in the question.
(v) FFO does not deduct for capital expenditures required to maintain the existing
portfolio of properties, hence the most important adjustment made to calculate
AFFO is the subtraction of capital expenditures.
FFO
Minus Capital Expenditures
AFFO
757598
(181948)
575650
838389
(156776)
681613
This number can be taken directly from the accounts as an estimate of the cash
required to maintain existing properties, although you could make a better
estimate by looking at the specific properties in the REIT.
(vi) Once we have the FFO and the AFFO, we can try to estimate the value of the
REIT.
The key assumption here is the expected growth in FFO or AFFO.
This involves analysing the underlying prospects of the REIT and its sector
exposure, considering:
Prospects
Prospects
External
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Subject ST5 (Finance and Investment Specialist Technical A) September 2009 Examiners
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distribute most of its profits and therefore does not have a lot of excess
capital to deploy. Many REITs, however, successfully prune their
portfolios: they sell underperforming properties to finance the
acquisition of undervalued properties.
The total return on a REIT investment comes from two sources: (1) dividends
paid and (2) price appreciation.
Expected price appreciation comprises two components:
1. Growth in FFO/AFFO
2. Expansion in the price-to-FFO or price-to-AFFO multiple
Given a market capitalisation of $8 billion, then:
Price/FFO = 8000/758 = 10.55x
Price/AFFO = 8000/575.7 = 13.9x
Interpreting price-to-FFO or price-to-AFFO multiples is not an exact science,
and the multiples will vary with market conditions and specific REIT subsectors (for example, apartments, offices, industrial).
Want to avoid buying into a multiple that is too high.
If you are looking at a REIT with favourable FFO/AFFO growth prospects,
then consider both sources together.
If FFO grows at 10%, for example, and the multiple of 10.55x is maintained,
then the price will grow 10%. But if the multiple expands about 5% to 11x,
then price appreciation will be approximately 15% (10% FFO growth + 5%
multiple expansion) making the current market valuation more attractive.
Debt is ignored by assuming that Equity in Property's debt burden is modest
and in line with the industry peers.
If EiPs leverage (debt-to-equity or debt-to-total capital) were above average,
we would need to consider the extra risk implied by the additional debt and
adjust the valuation accordingly.
7
(i)
a. Bid/offer spreads
Taxes
Market impact costs
Commission costs
Opportunity costs
There may be rebates payable if a Multilateral Trading Facility (MTF) is
used.
b. Trades are relatively small compared to market and you would have to
establish the names they are trading in, as larger trade might be highly
liquid where as small trade might be small cap
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Subject ST5 (Finance and Investment Specialist Technical A) September 2009 Examiners
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