ST5 Question Bank

Faculty of Actuaries Institute of Actuaries

EXAMINATIONS

April 1999

Subject 301 — Investment and Asset Management

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1. You have 15 minutes at the start of the examination in which to read thequestions. You are strongly encouraged to use this time for reading only butnotes may be made. You then have three hours to complete the paper.

2. You must not start writing your answers in the booklet until instructed todo so by the supervisor.

3. Write your surname in full, the initials of your other names and yourCandidate’s Number on the front of the answer booklet.

4. Mark allocations are shown in brackets.

5. Attempt all 12 questions, beginning your answer to each question on aseparate sheet.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet and this question paper.

In addition to this paper you should have availableActuarial Tables and an electronic calculator.

Faculty of Actuaries301—A99 Institute of Actuaries

301—2

1 Describe, giving formulae, two methods by which an index representingcapital movements can be adjusted to produce a total return index, i.e.including capital growth and divided income, for an equity market.

Discuss the principal limitations of each method. [6]

2 Define and describe the beta of an equity portfolio.

Give two examples, including formulae, of risk-adjusted return measureswhich make use of the beta of a portfolio. [6]

3 Discuss the main factors which influence the choice of risk discount rate to beused when assessing a capital project.

Describe the additional complications if the assessment were to take accountof separate borrowing and lending rates. [10]

4 A call option on a particular share is at the money and is offered to you at apremium of 10% of the exercise price. The only asset you have is a cashdeposit equal to the call option premium (interest on this cash deposit can beignored). Contract profit at expiry is defined as the excess return over cash ondeposit.

Explain, both in words and using a diagram, the relationship between contractprofit and share price. [6]

5 (i) Define the terms initial margin, settlement price and variation margin,and explain why margin is levied, in the context of exchange-tradedfutures. [4]

(ii) State the advantages and main disadvantage of dealing in derivativeson an exchange compared to dealing in the OTC market. [3]

[Total 7]

6 (i) Define volatility for a fixed interest bond, using a formula. [1]

(ii) Bond A has an annual coupon of 6% and is redeemable in 3 years. BondB also has an annual coupon of 6% but is redeemable in 30 years. Thevolatility of Bond A is 2.673 and the volatility of Bond B is 13.765.

Estimate the % change in price for each bond, if the yield curve changessuch that yields at the short end rise by ½% and yields at the long endfall by ½%. [3]

301—3 PLEASE TURN OVER

(iii) Outline a scenario of current and future inflation which is consistentwith this change in the yield curve. [3]

[Total 7]

7 (i) State a formula relating the rental yield of properties to the dividendyield on equities. Suggest an alternative formula appropriate forproperties with low rental growth, stating any assumptions. [3]

(ii) Explain the difference between portfolio-based indices and barometerindices for property investments.

Comment on the suitability of each of these types of index for assessingthe performance of a property portfolio. [3]

[Total 6]

8 List the taxation factors which an individual will consider in selectinginvestments which maximise the after tax return. [6]

9 Outline the additional difficulties which face an analyst conductingfundamental investment analysis of a company based and operating in LatinAmerica. [6]

10 A listed company has a long record of strong sales and profits growth relativeto its competitors within an industry where the market has been steadilyexpanding. The company has recently reported results which show anunexpected decline in profits. The share price, which had been performingwell in recent years, has fallen sharply.

You are an investment analyst new to the sector.

Explain in detail the investigations you would conduct and the comparativefactors you would assess in carrying out an analysis of the prospects for thecompany and its relative attractiveness within the sector at the current shareprice. [11]

11 Economic growth has been strong for a number of years in a medium sizeddeveloped country. In order to curb inflation the central bank has raised shortterm interest rates substantially over the last few months.

Describe how the economic situation may develop over the next two years andhow this is likely to affect the level of bond and equity markets. [15]

301—4

12 (i) State the relationship between the total return on equities and the riskfree rate of return, expected inflation and the equity risk premium.

[2]

(ii) Explain the effect on the components of the relationship in (i) at thepoint when a country enters into a prolonged recession. [6]

(iii) In the light of these poor domestic prospects, resident investors in therecession-troubled country in (ii) above are considering switching intoshares in a neighbouring country. Owing to inflationary problems inthis neighbouring country, it has very high interest rates and verystrong nominal dividend growth.

Discuss the implications of this investment strategy. [6][Total 14]


EXAMINATIONS

April 1999


EXAMINERS’ REPORT


Subject 301 (Investment and Asset Management) — April 1999 — Examiners’ Report

Page 2

Overall, the most disappointing feature was the number of “bookwork” questions whichwere badly answered – generally because the candidates gave insufficient informationto award marks. They also failed to use all of the information flagged in the questions.In the longer questions, few candidates provided more than the basic answers, and sowere unable to distinguish themselves. Comments on individual questions appear initalics at the end of the solution to each question.

1 A total return index can be calculated either by an XD adjustment or a yieldadjustment.

XD adjustment — assuming dividend or interest payments are reinvestedback into the index on its ex dividend date, i.e. it is added to current marketcapitalisation, the corresponding increase in the index value would be theinvestment income divided by the base value. The xd adjustment is the totalaccumulation of each constituent over the year as each constituent companydeclares a dividend. It is returned to zero at the end of each year, and a newaccumulation is started.

The total return index (TRI) at time t is derived from the index (I) using the exdividend adjustment (XD) by the formula

TRI(t) = TRI(t − 1) * I(t) / [I(t − 1) − {XD(t) − XD(t − 1)}]

Limitation: There is an assumption that reinvestment takes place on the exdividend date. It is important to ensure that tax and re-investmentassumptions are understood.

Yield adjustment − the income received over the 12 months prior to time t is

I(t) * yt where yt is the dividend yield at time t

The total return is obtained by adding the yield adjustment to the capital onlyindex.

Limitation: Over shorter time periods, the income is estimated on aproportionate basis; however, this only gives an approximation, as income isnot generally received uniformly over the year.

Bookwork and badly answered - some students mistook two methods to mean twoformulas for the same method (and lost potential marks).


Page 3

2 The beta of a portfolio is a measure of the volatility of the portfolio relative tomovements in the whole market as measured by an index. It is defined as thecovariance of the return on the portfolio with the return on the market index,divided by the market index return.

The risk adjusted measures which make use of beta are

Treynor Measure — measure of reward per unit of systematic risk definedas

T = (Rp − r) / Bp

where Rp is the return on the portfolior is the risk free rate of return over the period, andBp is the systematic risk in the portfolio

Jensen Measure — is a measure of return relative to a benchmark with thesame degree of risk

J = Rportfolio − Rbenchmark , where Rbenchmark = r + Bp (Rmarket − r)

Standard bookwork − well answered.

3 First determination is whether a “real” or “nominal” rate is required.Real rate is used in conjunction with cash flows which are determined on thebasis of present day money values which exclude the effects of future priceinflation.Nominal rate used if the cash flows (and the financing payments) take accountof the effects of inflation.In this case, the rate should be equal to the real rate, compounded with theassumed average rate of price inflation.

If risk is not wholly allowed for in the cash flows, then it should be built intothe discount rate for the project.In particular, would expect systematic risk to be allowed for by varying thediscount rate, according to the level of “riskiness” of the project.

The starting point for the risk discount rate should be based on the cost ofcapital. The current cost of raising capital should be based on an incrementalcost allowing for an average of equity and debt capital for the entity (company)involved. For debt capital, this will be (index-linked rate + a corporate risk premiumbased on company’s credit rating) * (1 − t) to allow for corporation tax.For equity capital, this is expected total real return + an allowance for equityrisk premium.


Page 4

If the project is deemed to have a higher level of systematic risk, then a higherrate would apply, considered as an additional risk premium based on otherexperience.Or, by making an arbitrary addition to the rate.

While one cannot be precise in making this adjustment for risk, grosslydistorted rates (due to arbitrary additions due to risk) are unlikely to behelpful.

On balance, it may be helpful to evaluate the project at two different ratesevaluate the project under both rates, and interpret whether the results aremeaningful.

Complications: Using different rates for net positive and net negative cashflows will add to the complexity of calculations, in particular when there are aprobability of outcomes. It will also lead to situations where there are multiple solutions to evaluationsof the internal rate of return on the project.

Straight bookwork relating to a new subject. Few students discussed whether to usenominal or real interest rates and there was insufficient explanation as to the costing ofthe capital. A number of students chose to concentrate on probabilistic and systematicrisk, a very small element of the question.

4 As the cash is not available to finance the purchase of the shares, on exercisewe must immediately sell the shares. The contract profit will be determined by the difference between the marketprice for the shares and the exercise price.The most that can be lost is the premium paid. If the market price rises by 10% then the receipt on exercise and resale(ignoring transaction expenses) will equal the premium paid i.e. no loss but noprofit. The contract profit is linearly related to the excess of the share price abovethe exercise price.

This is shown diagrammatically as follows:

−100%

Contractprofit as a% of thepremium

+100%

20%10% % Excess of shareprice in threemonths time overexercise price


Page 5

i.e. if the share price does nothing we loose everything, if it goes up 10% webreak even and if it goes up 20% we double our money.

Quite well done with students showing a good understanding of what was required.

5 (i) Margin is the collateral which each party to a futures contract mustdeposit with the clearing house.

When the contract is first struck, the parties will be required to depositinitial margin as an amount of cash or other assets (of an acceptableform) with the clearing house for the exchange.The required amount is changed on a daily basis to mirror risk(variation margin). The closing price for a contract at the end of the day’s trading is thesettlement price. Variation margin is calculated by reference to the settlement price.Margin is levied, so that in the event of a party to a contract defaultingthe clearing house will protect the other party to the contract byensuring the contract is fulfilled.The clearing house will call on the margin deposited to help it fulfil thecontract. In this way, the margin finances the guarantee of the contractprovided by the clearing house.If the price of a contract moves adversely for a party then the amountheld on the deposit with the exchange will be increased by way ofvariation margin. Similarly, profits will be remitted on a daily basis.

(ii) The advantages of exchange traded contracts compared to OTCcontracts are:

• better liquidity• better market transparency• the counter party is the clearing house who will be a good credit

whereas for an OTC contract the counter party is the issuing bankand the credit risk will depend on the strength of that bank.

The main disadvantage is that exchange traded contracts arestandardised and the particular contract needed may not be available.In the OTC market, a contract may be constructed for your particularneed.

Poorly answered - a surprising number of students failed to definethe Settlement Price correctly and in general there was some confusion in thedifferences between futures and options . Part 2 was handled better


Page 6

6 (i) If the dirty price of a bond is P and its redemption yield is y, thevolatility V is:

V =−1P

dPdy

(ii) For small changes in yield, the approximate proportionate change inprice for a bond is given by:

∇PP

= −V × ∇y

where V is the volatility of the bond and ∇y the change in the yield.

For Bond A, the approximate % change in the price is:

−2.673 × 0.005 × 100 = −1.3%

For Bond B, the approximate % change in the price is:

−13.765 × –0.005 × 100 = 6.9%

(iii) Such a change in the yield curve may occur when short terminflationary pressures are suppressed by the authorities raising shortterm interest rates. This is reflected in the increased yield on short bonds. The reduction in yields on long bonds reflects a reduction in theexpected long term rate of inflation.

The action of the authorities over short term inflation may have ledlong bond investors to feel more confident for the prospects of longterm inflation.

Broadly well-answered.

7 (i) The gap between rental yields and dividend yields can be broken downinto the following components:

(property risk premium – expected rental growth) – (equity riskpremium – expected dividend growth).

For properties with low rental growth, a comparison of rental yieldwith the gross redemption yield on conventional bonds may be moreappropriate.

In which case, the gap between rental yields and the bonds grossredemption yield on bonds should be equal to:


Page 7

(property risk premium – expected rental growth) – inflation riskpremium.

(ii) Portfolio based indices measure rental values, capital values or totalreturns of actual rental properties. An index will produce resultsparticular to the portfolio underlying its construction.

The barometer type of index aims to track movements in the generalproperty market by estimating the maximum full rental values of anumber of hypothetical rack-rented properties.

A portfolio based index may be inappropriate if the portfolio underlyingthe index differs significantly from the portfolio held. Further,typically the return on the index is a money weighted return so theindex performance will be effected by the timing of the cash flow of theunderlying portfolio. A barometer index may be unsuitable for portfolioperformance measurement since an investor could not closely match itsmovement with an actual portfolio of property holdings.

Part 1 was answered reasonably well. Candidates showed a good understanding of themain principles involved. However, marks were needlessly lost in part 2 as answerswere too short (and incomplete).

8• The individual’s personal tax circumstances• The rate of tax charged on an investment• Tax allowances, e.g. indexation allowance, tax free limits on ISAs, etc.• The components which make up the total return on the investment• How the tax is charged on these different components of the investment

return• The timing of tax charges• Whether the tax is paid at source, or has to be paid subsequently• The liability of the investor to income and capital gains tax (and other

duties)• The extent to which losses and gains can be aggregated between different

investments or over different time periods for tax purposes.

Bookwork - reasonably well done although poorer candidates rapidly ran out of ideas.

9• General factors applicable to investment analysis of any company• Management — ability to meet them and discuss issues• Quality of product — knowledge issue• Prospects for market growth — availability of good industry data• Competition — identification and familiarity issues• Input costs and retained profits — quality of accounting data• History — availability of back data and quality of that data• Financial analysis — quality of initial data


Page 8

• Sources of information — its quantity and quality, accessibility, languageissues

• Valuation — local methodology, applicability and quality of data

Near bookwork – the better candidates identified that this was more than the standardquestion on overseas investment and tailored their answer accordingly. Failure to dothis lost marks.

10 Two of the principal considerations will be whether the market reaction is“knee jerk” or based on a change in company expectations. Has the companyissued any statements along with its reported earnings decline?

The company will be valued on growth criteria, as a growing company in agrowing sector.

It is important to identify what has caused the profit decline — this meansbreaking down the results to determine components adding to the bottom linedecline, e.g.

• what has happened to turnover, for this company as an absolute andrelative to sector

• what has affected costs of the business — are there any special expenses• have there been particular exceptional items, e.g. increase in R&D

expenditure• are there particular write-offs leading to the decline• etc.

It is also important to determine what were the preceding expectations for thecompany, and for other companies operating in the same sector. Is this merely a company specific item or are there sector wide implicationswhich need consideration?

Are there any particular special features of the company — recent staffchanges at senior level, changes of accounting practice, takeover activity,which may have contributed to the decline.

The balance sheet should be examined for the changes — debt increases, costof funding debt, etc.

In terms of its relative positioning, the fall in share price may have presenteda buying opportunity relative to the sector if the fall is overdone. It is important to realise that share price moves are based on prospectivefactors.

At the same time, it is fairly often the case that bad news comes through inseveral stages so it is important to ensure that if the analysis suggests that theprice fall is overdone, nevertheless there is a risk of further bad newsemerging to take the price lower before it might recover.


Page 9

The business sector is not described. Specific sector analysis will also berequired.

This question was answered very poorly. In particular, many candidates becamebogged down in how to analyse a company. This question was about a specific event, i.e.how to analyse the unexpectedly poor results of a growth company in a growth sector,and its effect on the share price. Of those candidates who had identified a number ofthe appropriate issues, few then went on to give any substance to these issues, or tosuggest how to conduct a detailed analysis of the profit and loss account .

11 Factors to consider are pattern of GDP growth, inflation and the exchangerate.

GDP Growth: Raising of short rates will take some time (6–9 months lag) toaffect the real economy.The time lag and the degree of impact will depend on the nature of borrowingsby the private sector (i.e. short or long fixed or floating in nature).

Eventually, however, the economy will slow; domestic demand will weaken ascorporate profitability is hurt by higher debt servicing costs and consumptionslows.

Inflation will also not react immediately but eventually as domestic demandslows it will fall.

Initially the exchange rate should rise.This will help to dampen inflation and economic growth in as much as it willweaken the competitiveness of the export orientated sector and increase thelevel of cheaper imports.How rapid or prolonged this slowdown becomes depend on the reaction of thecentral bank.If short rates are not cut as inflation falls and the economic slowdown bites,then under the weight of what will become increasingly high real rates ofinterest will be a risk that the economy slips into recession.

Bond Market

The reaction of the bond market should be positive. How positive and how immediate the reaction will be depends on how quicklyinflationary expectations will start to reduce.Also in view of the strong growth being experienced prior to rates being raisedit is reasonable to assume that (all things being equal) tax receipts will bebuoyant and the supply of Government Debt will be shrinking.This favourable supply demand balance should help boost bond prices furtherand it is likely that the yield curve will invert.If high short rates persist and the slowdown gathers pace inflationaryexpectations will continue to fall and bonds will continue to perform well.


Page 10

Equity Market

Strong growth should have boosted corporate profitability and hence theequity market is likely to have responded well initially. As fears of higher interest rates and inflation grow (prior to the first rate rise)the equity market is likely to have started to discount the coming bad news.The general level of the equity market will subsequently be affected by thecombined influence of the following:

(i) How quickly and how severely investors revise down their expectationsof future corporate profitability in the face of a slowing economy and astrong currency.

(ii) How much of this is offset by the positive influence of falling bondyields.

In general lower bonds yields and lower inflation should improve the relativevaluation arguments for equities. However, if expectations of growth and inflation fall to levels associated withrecessionary conditions any further deteriorations will be negative for equitymarkets since they will lead investors to expect a severe corporateprofitability squeeze.

Reasonably well answered, although a number of candidates showed insufficientknowledge of basic economics . Again, few candidates detailed issues specific to therequirements of the question.

12 (i) Let d = dividend yieldg = assumed dividend growth rate

Then d + g = Required risk free real rate of return (RFRR) and expectedinflation (EI) + equity risk premium (ERP).

(ii) In a prolonged recession the outlook for profits growth will be negative.

This means that expected dividend growth (g) will probably be negativeas well.

Assume that the RFRR and the ERP remain constant (if anything theRFRR may fall a little and the ERP could rise).

It is also safe to assume that in a recession the EI will also have fallenand could be negative. However it is unlikely that it will have fallenanything like the extent that g will have fallen.Hence, in order to preserve the relationship in (i) d will have to rise;and the rise could be substantial.

e.g. normal conditions could be

(d) + (g) = (RFRR) + (EI) + (ERP)


Page 11

2½% + 3% = 2½% + 2% + 1%

Say g becomes −3% + EI falls to −2%.

d would need to rise to 4½%

Other points

• dividends can often be maintained by companies in spite of severeprofits falls

• the theoretical relationship is a very long term one and in practice gmay only be negative for a couple of years before returning to apositive number

(iii) The economic conditions in the two countries are very different.

The home economy is in deep recession, which would be expected to bea poor environment for equity investment. The attraction of investingin the equity market of the neighbouring country is the expected morefavourable level of investment growth. If inflation is stable (even though high), then it need not be a problemfor the equity market. The more favourable conditions would be anadvantage for investing in the neighbouring country.

However, if the inflationary conditions were unstable, or if theneighbouring country was intending to act on reducing inflation, the outlook for the market would be more uncertain, although theprospects of reducing interest rates should prove to be a marketsupport.

From the perspective of a foreign investor, a currency mismatch wouldbe introduced.In particular, it is likely that with high inflationary conditions, thecurrency would devalue. The extent of devaluation would depend on the level of inflation offsetby the level of real economic growth.

The risk for a foreign investor would depend upon the nature of theirliabilities.

The advantage and disadvantage of the move ultimately will come downto the trade-off between higher growth reduced by expected currencydevaluation.

This was poorly answered - a surprising number of candidates failed to use theiranswer to part 1 to help them with part 2 of the question. Few candidates related Part3 to the earlier parts of the question.


EXAMINATIONS

September 1999












Faculty of Actuaries301—S99 Institute of Actuaries

301—2

1 Describe how the principles underlying the actuarial control cycle can be usedin developing a model to manage an equity portfolio. [5]

2 (i) Describe the purpose of an investment trust, its pricing, its legalstructure, and the basis on which it operates. [5]

(ii) Describe how an open-ended investment company (OEIC) differs froman investment trust. [2]

[Total 7]

3 Describe the operation and role of a clearing house in futures trading. [4]

4 List the distinctive features of companies classified within the “utilities”industry sector. [5]

5 Describe the factors influencing the investment strategy of a collectiveinvestment vehicle. [7]

6 (i) Distinguish between barometer and portfolio-based property indices.[2]

(ii) Discuss the use of portfolio based property indices as a benchmarkagainst which to assess the investment performance of a directlyinvested property portfolio. [3]

[Total 5]

7 Outline six different methods an actuary might use to value individualinvestments. [6]

8 (i) Explain the relationship between the yields of corporate bonds andgovernment bonds in the same currency. [2]

(ii) Describe briefly how this relationship might be affected by an economicdownturn. [1]

(iii) In a stable economic environment, how might the expectation ofsustainable low inflation of under 2% per annum affect the relationshipin (i). [2]

[Total 5]

9 A large charitable foundation is considering the acquisition of a substantialforest in North America for its US$-denominated investment portfolio.

Describe how you would evaluate the investment potential of the forest. [8]

301—3

10 An index fund aims to track the FTSE All-Share index. The fund will matchthe index weight in each industry sector, but will not necessarily include everyindex stock to achieve the sector weight. For example, in a particular sectorwhich contains 15 stocks, the fund manager decides to hold only three of thestocks.

Explain in detail why the fund manager might structure the fund in thisparticular way. [7]

11 You are the investment manager of a large unitised pension fund. The fundhas a strict policy of not holding direct property investments. The marketingmaterial of the fund states that it aims to outperform the median of a peergroup of pension funds by stock selection alone. The peer group comprises 60managed funds, a number of which hold property assets. Median performancedata and breakdowns of the asset allocation of peer group funds are publishedevery three months.

Discuss the asset allocation issues that arise for you in attempting to meet themarketing claims of the fund. [14]

12 You are a consulting actuary specialising in the appraisal of capital projects.An international mining company has approached you to examine one of itsproposed projects. The company is considering an investment of £800 millionto develop a copper mine in a third world country not known for its politicalstability. From a technical point of view, the quality of the ore is excellent.Using the company’s technology the copper can be produced for less than 25%of the current world-market price of copper.

The company has asked you to identify the risks facing the project and tosuggest a method of risk analysis.

(i) (a) Describe the steps necessary to achieve an effectiveidentification of risks facing the company’s project.

(b) Describe briefly five major risks facing the project. [10]

(ii) Describe how the risks of the project can be analysed. [4][Total 14]

13 You are the manager of a global equity fund valued at US$1 billion. You wishto alter the asset allocation, switching some of the portfolio from the UKmarket to the US market, with the expectation that the switch will bereversed in three month’s time.

(i) Describe the problems and costs you would encounter, if the switch wasconducted by sales and purchases of individual securities. [6]

(ii) Explain how equity index futures might reduce the costs and problemsassociated with changing asset allocation on a short term and a longterm basis. [7]

[Total 13]


EXAMINATIONS

September 1999


EXAMINERS’ REPORT


Subject 301 (Investment and Asset Management) — September 1999 — Examiners’ Report

Page 2

1 The control cycle has five elements.

The initial starting point is the general commercial and economic environmentagainst which stocks are traded and valued.

In developing a solution consideration has to be given to alternativeinvestment options (for example the mix of domestic and internationalequities), consideration of the liabilities and asset liability matching.

Risks — like solvency — need to be explored and consideration given to futuresolvency levels.

The solution involves devising a model using the tools available together witha professional approach to ensure that the model is based on sound thoughtand clear communication.

Once a model has been built it then has to be tested and the results fed backinto the system to refine the problem and the solution. Close attention needsto be paid to those factors which caused the model to depart from its expectedoutcome.

2 (i) Investment trusts fall into the category of collective investmentvehicles (CIVs) which are structures for the management ofinvestments of a large number of relatively small investors deliveringthem a greater level of diversification than they could hope to achievewith their own resources.

An investment trust company is a public limited company which isnormally quoted on a stock exchange.

Investment trusts have a Board of Directors which is responsible forthe direction of the company and for ensuring the trust adheres to theinvestment mandate set out in the offer document to shareholders.

Investors participate in the investment performance of the underlyingassets by purchasing shares in the investment trust. Investment trustsare closed-end CIVs as they are closed to new money. The shares inissue change hands on a stock market without new money being raisedby the company.

An investment trust can be geared.

The price of the shares is loosely based on the net asset value of theinvestment trust’s shares and is driven by supply and demand for theshares on the stock market on which the investment trust is listed.Investment trust shares normally trade at a discount to net asset value.Shares are bought from market markers in at the offer price and sold atthe bid price; thus investors bear a bid/offer spread on purchases.


Page 3

The investment mangers are appointed by the Board of Directors,report to the Board and take the day-to-day investment decisions.The investment managers receive a fee for their services; usually apercentage of the assets under management.

The directors of the company receive directors’ remuneration for theirservices.

(ii) Open-ended investment companies (OEICs), cannot gear.

Unlike investment trusts OEICs are open ended; new shares arecreated when new money is invested and existing shares are cancelledwhen money is disinvested.

Unlike investment trusts OEICs always trade at net asset value.

Unlike investment trusts OIECs have; entry and exit charges areexplicit.OIECs can raise new tranches of capital, which attract differentmanagement fees to existing tranches.

Comment: Bookwork, but surprisingly poorly answered.

3 The clearing house is the central counterparty in futures transactions. Whentrades are agreed between participants in the pit or on-screens, the contractbetween the parties is novated (i.e. the clearing house becomes the buyer toevery seller and the seller to every buyer).

Details of the trade are registered with the clearing house.

Each party to the trade has a contractual obligation to the clearing house.

In turn the clearing house guarantees performance of each side of the originaltrade.

This guarantee removes the credit risk of individual participants.

Each party must deposit collateral or a margin with the clearing house.

There are two types of margin, the initial margin and the variation margin;both margins serve to reduce the clearing house’s credit exposure to theexchange participants.

4 Utilities are involved in the supply of continuously demanded services tohouseholds and business premises.

Demand is stable, as the services they provide are, in the main, essential.


Page 4

They usually require an extensive physical infrastructure; this tends to makethem capital intensive.

Most utility companies are natural monopolies.

They are usually tightly regulated and therefore prices are vulnerable topolitical risk.

They generally have low growth prospects; this leads to a high gross dividendyield.

Gearing is generally low.

They are largely dependent on the domestic market, although some companiesare diversifying internationally.

5 Description of investment objectives as set out in the marketing material oroffer documents. For example, if the offer documents specify activeinternational equity fund management then the manager is expected to be anactive investor in international equities.

Taxation; depending on the tax regime the fund may have to adjust itsinvestment policy to minimise the impact of taxation on the return of the fund.For example, a fund that pays no tax on capital gains but tax on investmentincome may prefer low yielding high growth stocks.

Legal restrictions e.g. maximum percentage of the fund invested in any onestock or the maximum percentage of the market capitalisation of an individualstock that the CIV can hold.

Size of CIV; large CIVs need to hold a larger number of stocks than would saya private individual so as to avoid having a large percentage of the marketcapitalisation of an individual stock.

Peer group positioning; this is particularly important if the manager has tocompete for funds in the market. The key risk for the manager and his clientsis underperformance relative to the competitors.

The need to differentiate between exposure to an underlying market and thecurrency of that market and thereby introduce currency hedge strategies.

Cash flow — whether the vehicle is open-ended, and subject to cash inflow andoutflow, or whether it is closed-ended with no cash flow.

Comment: appeared to give some candidates problems. This question was not aboutliabilities.


Page 5

6 (i) A barometer index aims to track movements in the property market atlarge by estimating the full capital or rental values of a number of hypotheticalrack-rented properties (e.g. local house prices).

Its main use is to highlight short term changes in the market level interms of prices, rents and yields.Portfolio based indices measure rental values, capital values or totalreturns of actual properties.Since current rental income of these properties is fixed until the nextrent reviews, response to movements in rental values will be sluggish.Capital value growth will be based on property valuations conductedperiodically, because estimation of property value is expensive andthere will be few transactions.

(ii) A portfolio based index is based on an actual portfolio of properties.Results from different indices will depend on size, regional spread andsector mix of the individual properties included.So, it will be important to ensure that the index used is representativeof the portfolio which you are measuring.Although, property is unique and portfolios of property areheterogeneous.Valuations will be carried out at different points of time, both for theindex and for the portfolio being measured.Sales of many types of properties are not necessarily revealed tooutside parties, so there are problems of obtaining price data.Rates of return for the indices will typically be money-weighted.This will be important if the portfolio being measured is subject toheavy cash flows.

7 Historic book value

This is the price originally paid for the asset

Written-up or written-down book value

Book value adjusted for changes since the date of purchase in accordance withsome formula

Market value

May not be uniquely be defined; it can only be known with certainty when asale takes place.


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Smoothed market value

Market values can be smoothed by taking some form of average over aspecified period to remove daily fluctuations

Discounted cash flow

Literally discounting the cash flows resulting from holding the asset andallowing for any residual value or loss on disposal.

Stochastic modelsThese are an extension of the discounted cash flow method in which futurecash flows, interest rates or both are treated as random variables; the result ofsuch a valuation is a distribution of values from which the expected value orother statistic can be determined

Expected utility

Instead of discounted cash flow, the utility of each possible outcome can becalculated in a stochastic model

Arbitrage value

This is calculated by replicating the investment with a combination of otherinvestments and applying the condition that in an efficient market the valuesmust be equal

Comment: Methods which were circular (e.g. depended on market price) were rejected.

8 (i) Corporate bonds tend to have higher yields than the equivalentgovernment bonds due to the higher risks of default and lower levels of liquidity.

(ii) The yield spread is expected to widen due to greater fears ofbankruptcies for corporates.

(iii) Government bond yields will probably be very low, and thus with astable economic background, the yield spread is likely to narrow asinvestors reduce their risk premia in the chase for higher yields

9 A forest is a hybrid between a property and an equity. It is a “real asset”.Many property features apply, but some areas (e.g. volatility of yield) are moresimilar to equities. Features are:Marketability — there will be substantial cost involved in buying and sellingso this is likely to be a long term holding.


Page 7

Unit size — the cost of a forest will be substantial, and the number of potentialforests (if buying) or of purchasers (if selling) will not be great.Location will be critically important. A forest only has investment potentialfor its income producing potential. At some stage, this means felling the treesand selling the timber. It is therefore important that the timber is accessibleand that there is sufficient demand “locally”.

Uniqueness — there is a uniqueness factor. Features which influence thisuniqueness will be the quality and type of timber, demand for the type oftimber, the age of the trees, their appropriateness for harvesting, etc.Yield and security of income — the forest’s yield potential will depend on theability to harvest the timber (depends on age of various sections of the forest),the cost of harvesting and bringing the timber to its market, the demand forthe timber, and the volatility of that demand.Demand will also depend on the range of uses — e.g. housing or otherconstruction demand, and the competing courses of supply (not necessarilytimber).Exposure to economic influence — e.g. demand, particularly construction,which is very cyclical and which is a heavy user of timber.Expense of maintenance — a forest will require looking after. Access routesneed to be maintained, the forest need to be looked after to prevent disease,harvesting will cost money, and the felled timber needs to be prepared fortransport, or brought to market.Investment characteristics can be changed by the owner, e.g. it might bepossible to do so by introducing new types of trees which can alter (over thelonger term) the quality and type of timber and the speed of harvesting.There may be risks attached, environmental, legal or political.

Comment: Rather poorly answered. Many candidates failed to appreciate that thisinvestment had many property characteristics.

10 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 ineach stock will result in high dealing costs (necessary each time the relativesector weightings change) that will reduce the performance of the fund and socause underperformance relative to the index.

Research has shown that, after overall market movements have been takeninto consideration, the share price movements of companies within industrialgroupings tends to correlate more closely with each other than withcompanies in other industries, so holding three instead of fifteen may wellreplicate the performance of the sector.


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The share price movements reflect the changes that have occurred in theoperating environment, and such changes affect companies in the sameindustries in similar ways.

The specific sector may only represent a small percentage of the index andwithin that sector the three stocks the manager proposes to use may representa substantial proportion of the total market capitalisation of the sector.

Stratified sampling of the performance of this sector may have shown that theperformance of the three stocks in question is a very accurate measure of theperformance of the sector as a whole.

Sampling may enable the fund to choose its timing in addressing whether orwhen to replicate changes to the underlying index.

Comment: Surprisingly many candidates thought that the index fund would structureits holdings sampling in order to outperform.

11 The first issue is how to match the median manager’s holding in property.

Could hold property shares or units in a property unit trust as a proxy forproperty.

Or could hold a mix of equities and bonds on the basis that the return onproperty is expected to be somewhere between the two.

Then there is the question of matching asset allocation within each asset classlisted in the question; for example one must decide if, and then how, to distribute assets by sectorwithin the UK Equity asset class.

One option is not to try, and instead seek to add value by sector selection,but this goes against the marketing statement so must be rejected.

The best method is to match a suitable index weighting by sector within eachasset class;for example, the assets in the UK Equity class can be distributed by sector inline with the FTSE-All Share Index sector weightings.

Another issue is that there may be a time lag between the end of the quarterand the date that the quarterly data is published.

Hence the information that the investment manager has available to rebalancethe portfolio at the end of each quarter may already be out of date.

The difficulty is twofold.

First, other managers, who are seeking to add value by asset class allocation,may alter their asset class allocation at some point during the quarter. Clearlythis alters the median manager asset class allocation, but the investment


Page 9

manager has no knowledge of this until seeing the published data at the end ofthe quarter.

If enough managers do this then the change could be substantial.

There is no easy way to deal with this; the investment manager could look tosee if there are any surveys done on asset allocation say, monthly, but thesemay not be reliable.

It is inevitable that part of the investment performance relative to thebenchmark will be explained by difference in asset allocationalthough these should be evenly distributed between positive and negativeeffects and over a longer period should average zero.Secondly, if the unitised fund either outperforms or underperforms relative tothat asset class because of superior/inferior stock selection, then it will berespectively overweight or underweight in that asset class.

The best way of dealing with this is to use new money coming into the fund (orwithdrawals from the fund) to rebalance.

When rebalancing, the cost of dealing needs to be considered, which could actas a drag on performance if it is too high.

Comment: The most poorly answered question. Again, this question was not aboutliabilities. Candidates’ greatest problem was failure to answer the question asked,which related to meeting the marketing claims of the fund. Instead, they largelytreated this as a question on property. The property aspects of the solution commandedfew marks.

12 (i)

(a) There are five steps:

Make a high-level preliminary risk analysis to confirm that the projectdoes not obviously have such a high risk profile that it is not worthanalysing further.

Hold a brainstorming session of project experts, senior internal staff atthe company and external mining investment experts who are used tothinking strategically about the long-term.The aim is to identify project risks that are both likely and unlikely, todiscuss these risks and their interdependency, to attempt to place abroad initial evaluation on each risk, both for frequency of occurrenceand probable consequences if it were to occur and to generate initialmitigation options and discuss them briefly.

Carry out a desktop analysis to supplement the results from thebrainstorming session, by identifying further risks and mitigationoptions using a general risk matrix, researching similar projectsundertaken by the sponsors or others in the past and obtaining the


Page 10

considered opinion of experts who are familiar with the details of theproject and the outline plans for financing it.

Carefully set out all the identified risks in a risk register with crossreference to other risks where there is interdependency.

Ensuring that upside risks as well as downside risks are covered.

(b) List of risks (not exhaustive — other risks are acceptable too) words inbold represent a broad categorisation of the risks identified:

• Perhaps the biggest risk is that the mine will be expropriated by thegovernment of the third world country after the company hasinvested in developing the mine. Political

• The government may impose/increase taxes on the output of mine orincrease its annual fee for the licence to work the mine. Thecompany is in a very weak negotiating position once it has investedin the mining operation — it may be better to pay increasedtaxes/licence fees than pull out of the country. Political/Financial

• The world market price of copper might fall from its present levelsreducing the overall payback from the project and increasing thetime to discounted break-even between initial investment and thefuture cashflows. Economic

• The mine could flood, be covered in by a mud slide or be preventedfrom operating as a result of some other natural disaster. Natural

• A part of the output from the mine may be mis-appropriated orstolen either at the mine or in transit to the world market. Crime

• The initial reports on the quality of the mine’s ore may prove to beincorrect so that the costs of exploitation are higher than originallyanticipated. Business

• It may not be as easy as was first envisaged to recruit suitable locallabour, put together the infrastructure to exploit the mine and movethe output to a port for shipment to the world market. Project

(ii) The purpose of risk analysis is to ascertain the frequency of occurrenceand the consequences if the risk event occurs.

The analysis should concentrate on independent risks.

A guide to frequency of occurrence can usually be got from experts ineach risk. The analysis should be supplemented by a study of theavailable statistics.

The financial consequences of the event should be expressed in terms ofpresent-day money values. They may consist of a range of possible


Page 11

values. A mid point or a probability distribution could be used forfurther analysis.

The expected NPV of a risk occurring in a future year can be obtainedby multiplying the probability of occurrence in that year by the NPV ofthe incremental impact on the cash flows of the project if the eventwere to occur in that year.

Risks should then be prioritised for further analysis. Risks with lowNPVs may be discarded by allowing for them in a general contingency.Risks with high NPVs and risks which would be disastrous but whichhave low probabilities of occurrence should be retained for furtheranalysis.

Comment: Well answered.

13 (i) The main problems in moving monies between markets for both longand short term switches are as follows:

• the costs (commission, bid-offer spread, purchase taxes, etc.) inswitching between markets and reversing the switch within a fewmonths can be significant

• short term switches may upset a strategic profile of stocks in amarket

• the operational aspects of carrying out a decision can be slow withthe consequent loss of some of the benefits of the decision

• the back office may be over stretched leading to a higher risk oferrors if several stocks are being bought and sold at once

• lack of liquidity and depth in the underlying markets can reduceflexibility

• the taxation impact of selling shares which have shown significantappreciation in price may be unacceptable in terms of cost

• For a short term switch, bid/offer spreads, commissions and any lackof liquidity and depth will cost the manager four-fold in a round tripbetween two markets.

(ii) Using stock index futures the manager can adjust and subsequently re-adjust the portfolio’s exposure between the two markets at asignificantly lower cost.

No tax is crystallised on equity capital gains and the long term profileof the fund remains intact.


Page 12

The investment decision can be executed immediately to catch all theanticipated movements in both markets whereas some of the benefits ofthe decision could be lost because of the time taken to process sales inthe underlying stocks in the relevant markets.

In the case of a short term switch there would be of the order of fourcontract notes to be processed for each stock in one of the markets(assuming say 25 stocks are held in each market this would run to 100contract notes to be processed); using index futures only four contractnotes need to be processed.

Futures markets are often more liquid than the market in theunderlying stocks so it is possible to deal in size without moving themarket. Stock index futures avoid the need to trade the underlyingstocks and thereby avoid the movement in the market prices of stockassociated with trading large volumes.

In a very large investment house it may be virtually impossible to makesubstantial asset allocation switches without the use of futures.

For a long term switch between markets, stock index futures can alsobe very useful.

The switch can be achieved by selling stock index futures in the marketthe manager wishes to reduce his exposure to (say the US) and buyingstock index futures in the market to which the manager wished toincrease his exposure (say the UK).

With this strategy, the manager is protected from falls in the USmarket because losses on the underlying securities are made up bygains on the short position.

Gains on the UK market accrue to the fund through the long futuresposition.

Having locked in his strategic asset profile the manager can nowcomfortably proceed with stock switching and unwind the futurespositions appropriately as he proceeds. The fact that the manager doesnot have to sell large volumes of stock quickly, should allow themanager to do individual stock deals on more advantageous terms.

This strategy allows the manager to ensure he locks in his long termview without losing the market opportunity while trying to fine tunehis stock selection and switching process.

As equity transactions are spread over a longer time period thepressure on the back office is reduced.

Comment: Reasonably well answered, although it did differentiate candidates.


EXAMINATIONS

10 April 2000 (am)

Subject 301 — Investment











Faculty of Actuaries301—A2000 Institute of Actuaries

301—2

1 (i) List the advantages of investing via an investment trust rather than aunit trust. [3]

(ii) Explain the term “discount to net asset value” in the context of aninvestment trust. Give three reasons why an investment trust mightstand at a premium, rather than a discount, to net asset value. [3]

[Total 6]

2 (i) (a) List the investment characteristics of property.

(b) State with reasons how you would expect the return on propertyto compare to the return on index linked Government bonds. [6]

(ii) State with reasons whether you would expect industrial property oroffice property to be the higher yielding investment. [4]

(iii) Explain the factors which you would expect to influence the differencein performance between individual property company shares in a lowinflation environment. [4]

[Total 14]

3 An equity market index is often broken down into separate industrial sectorcomponents.

(i) Explain the advantages of comparing shares within their industrialsectors. [3]

In analysing each of its equity portfolios, an investment management companycompares the dividend yields of its holdings with those of the index. To dothis, the company:

• ranks the holdings by increasing yield

• splits the portfolio into five equal numbers of holdings (“quintiles”)

• calculates the weighted average yield of each quintile, using the marketvalue of shareholdings as weights

The company conducts the same exercise for the index, and compares thequintile averages of each portfolio with the other portfolios it manages andalso with the quintile averages of the index.

The company carries out the same analysis using earnings growth rates andalso price to earnings ratios.

(ii) Explain what the company expects to achieve from comparing portfoliosin this way. [3]

[Total 6]


4 One of the stated objectives for the management of an equity portfolio is that itshall aim to have a beta of 1.2 relative to the market index.

(i) Explain the term beta, and the meaning of a value of 1.2. [2]

(ii) Describe the investigations you would make to determine the valueadded by the fund manager to the portfolio, assuming full data isavailable. [3]

(iii) List six reasons why the performance of the portfolio might differ fromthat of the index. [3]

[Total 8]

5 (i) Two options have identical characteristics except that one is anAmerican option and the other is a European option.

Explain which option will have the greater market price. [2]

(ii) Explain the difference between a futures contract and an optioncontract.

[4]

(iii) Explain why only a small proportion of exchange traded futurescontracts reach delivery, and describe the practical steps taken toachieve this result. [3]

(iv) Explain two types of risk faced by the counterparties in an over thecounter swap arrangement. Discuss the steps which can be taken byeither counterparty to minimise these risks. [4]

[Total 13]

6 You are the investment manager of a fixed interest unit trust. For severalyears your remit has been to invest solely in government securities with aterm to redemption of less than 7 years. In recent times, total returns fromthe unit trust have declined and competition has intensified. The chiefinvestment manager has asked you to consider ways in which the total returnof the portfolio might be improved.

Describe what could be done to improve the total return of the portfolio. [6]

7 An index manager offers a fund which tracks the local equity index using fullreplication. As a consequence of a merger of a local company which is an indexconstituent with a foreign company (which is not an index constituent), theindex weight of the local company will increase from 3.5% to 6% of the index.

Outline the steps which the index manager must conduct to maintain thetracking ability of the fund. [4]

301—4

8 (i) State the principal aims of the authorities which regulate investmentmanagement and securities industries. [3]

(ii) Define a self-regulated regime and a statutory regime. Discuss theirmain differences. [3]

[Total 6]

9 (i) List four factors concerning the liabilities which should be taken intoaccount when determining investment strategy. [3]

(ii) Explain the significance of the covariance of the return for an

individual investment with the return of the portfolio, when selectingindividual investments for a portfolio. [2]

The director of a small business has managed her company from a wheelchairfor many years. She has decided to retire, aged 65, to look after her husband,aged 70, who is suffering from Alzheimer’s disease (a progressive braindisorder). They have no dependants. Their principal source of wealth, otherthan their residence which is specially designed for wheelchair access, is tiedup in the business. She has agreed to sell the business for a cash sum of £1million, which will be used to provide for their future.

(iii) (a) Describe the information you would require in order to enableyou to assess their financial liabilities.

(b) Propose an asset mix which is appropriate to meet theseliabilities, giving reasons for the weighting and choice of eachasset. [9]

[Total 14]

10 Over the last 12 months, the dividend yield on a share has doubled so that it isnow twice that of the market.

(i) Discuss possible underlying reasons for the doubling of the yield. [3]

(ii) State three accounting ratios you would use to conduct further analysis,explaining the relevance of each ratio, in the specific circumstances ofthis share. [3]

[Total 6]

301—5

11 For several years, the equity investments of a pension fund have beenallocated between two index tracking funds. One fund tracks theperformance of the largest 100 listed global companies (ranked by marketcapitalisation). The second fund tracks the largest 100 domestic companies(ranked by market capitalisation) listed in the major developed country inwhich the pension fund’s liabilities are domiciled.

Over the years, the domestic fund has performed better than the global fund.You have been asked to advise whether the equity allocation to the two fundsshould be re-balanced.

Discuss briefly the issues which you would consider and the calculations youwould make before deciding whether it is appropriate to re-balance theholdings in the two funds. [6]

12 (i) You intend to build a risk model for the purpose of capital projectevaluation. Define risk and describe how you would incorporate riskinto your model. [3]

For many years the inhabitants of two islands have travelled between theislands in boats and car ferries. A major construction company is planning tobuild to a toll bridge as a link between the two islands. They have asked youto conduct a risk analysis of the project.

(ii) Describe the steps which you would take to identify the risks facingthis project. Include three examples specific to the toll bridge in youranswer. [4]

(iii) List four methods of mitigating risk in a capital project.

For each of the four methods listed, include an example of a risk whichis specific to the toll bridge project, and which could be mitigated inthis way (provide a different risk example for each of the fourmitigation methods). [4]

[Total 11]


EXAMINATIONS

April 2000

Subject 301 — Investment

EXAMINERS’ REPORT

� Faculty of Actuaries

� Institute of Actuaries

Subject 301 (Investment) — April 2000 — Examiners’ Report

Page 2

Overall, this might be described as a relatively “normal” examination in terms of therange and quality of candidates’ responses. Bookmark questions fell into two categories –those where candidates largely obtained near full marks, and those where manycandidates gained only half marks, due to the incompleteness of their answers. As aconsequence, the major determinant of success for many individuals was the quality oftheir answers to those questions that examined higher level skills. Detailed comments areas follows:

1 (i) Although question says list, marks should only be awarded for stating the

advantage, e.g. “gearing” is not an advantage – the advantage is that it enablesoutperformance when the market is rising. Marks attribution. Alternatives in thelast bullet only count once.

� The gearing of investment trusts should enable them to outperformunit trusts in bull markets.

� Investment trust schemes may be bought at a discount to net assetvalue and if the discount narrows this should be a source ofoutperformance relative to unit trusts.

� Investment trust can provide equivalent income stream at a discount.

� Investment trust management charges are usually lower than for unittrust.

� Investment trusts can invest in a wider range of assets than unittrusts.

� Investment trusts may have a better tax position than unit trusts.

� An investment trust is not required to hold cash for liquidity to satisfyredemptions (OR is not obliged to buy or sell at potentiallyunattractive prices just because of cash inflow or outflow).

(ii) The discount to net asset value per share is defined as:

net asset value market price

net asset value

�

expressed as a %age.

This may become a premium because:

(a) the value of assets may be historic and due for re-rating,

(b) investors in the trust may be barred from direct entry to themarkets in which the trust is invested and they may be preparedto pay premium in order to gain the exposure they desire,


Page 3

(c) investors in the trust may anticipate the trust management addingvalue on top of the current market prices of the trusts investments,

(d) the sector covered by the trust may suddenly become fashionableand the trust rise in price as a consequence.

Q1 A straight-forward question and generally well handled. Many candidatesfailed to gain full marks because they answered part (i) with a list of words ratherthan including a brief explanation of each advantage.

2 (i) The investment characteristics

� real asset expected to provide a hedge against unanticipated inflation;

� a running yield typically between that available on equities andbonds;

� rental income subject to infrequent rent reviews, which may beupwards only;

� very unmarketable;

� high dealing costs;

� security of income depends on the quality of the tenant;

� susceptible to Government controls;

� buildings suffer from obsolescence but land always likely to have somevalue;

� unit size is large;

� each property is unique;

� no central market with quoted property prices

� valuation is a matter of professional judgement

� investment characteristics can be changed by the owner/marriagevalue.

In comparison with index linked Government bonds, property is lessmarketable, less secure and more expensive to manage. Investors wouldtherefore be expected to require a higher return from property.

(ii) Relative to office properties, generally, industrial properties;

� are cheaper and quicker to build which limits rental growth;

� become obsolete more quickly because they are more vulnerable todeterioration and so have higher depreciation costs as a percentage ofthe total value;

� are harder to re-let because of specific use:

� have a higher content of land value within price;

� are more vulnerable to economic recession.

For these reasons, industrial properties would generally be expected toprovide a higher yield than offices. In a low inflation environment,


Page 4

interest rates would also be expected to be low.Rent increases will be difficult to implement, unless properties are inareas of high demand.Although broad economic conditions may be favourable, deflationaryproblems may cause difficulties for some tenants or particular sectors,leading to voids.For property companies with gearing, the cost of servicing debt is likely tobe relatively low although the differential between the interest rates paidby higher quality and lower quality borrowers may be wide.

Q2 Parts (i) and (ii) were generally well answered with several candidates gaining fullmarks. The answers to part (iii) were generally disappointing.

The question asked candidates to consider the difference in performance in a low inflationenvironment. Many candidates gave reasons which did not directly relate to thisenvironment. The correct way to approach the question was to assume that the overallperformance of the two companies would have been broadly equal in a normalinflationary environment. Hence, candidates were being asked to explain the factorswhich might be expected to produce differential performance in a low inflationaryenvironment.

3 (i) Practicality

� factors affecting one company in an industry are likely to be relevant to othercompanies in that industry

� much of the information for companies in the same industry will come from acommon source, and will be presented in the same way

� no analyst can expect to become an expert in all areas, so specialisation isappropriate

� the grouping of equities by a common factor adds structure to decision-making. It assists portfolio classification and management

Correlation of Performance

� Research shows that the share price movements of companies within thesame sector are more closely correlated with each other than with companiesin other sectors

� The price movements reflect the changes which have occurred in theoperating environment of companies in the same sector.

(ii) By comparing the portfolios with each other, these analyses identify theconsistency of the company’s management of the portfolios.


Page 5

The analyses will also identify style biases (e.g. growth or value characteristics)in the portfolios, relative to the index.

They will also identify how risky the portfolios are relative the index.

If conducted over time, they will also show how stable is the style of managementof the company.

Q3 Part (i) was straight-forward and well answered. Part (ii) was a practical questionrequiring candidates to consider the analysis being undertaken and how it might be usedby the company. The hint to the answer is contained in the earlier part of the question.The bulk of the answer to part (i) is concerned with consistency of approach. The answerto part (ii) is also concerned with consistency of approach over time and relative to theindex.

4 (i) The Beta of a portfolio is a measure of the portfolio’s volatility relative to

movements in the whole market. It is usually defined as the covariance ofthe return on the portfolio with the return on the market, divided by thevariance of the market return.

A beta of 1.2 means the change in value of the portfolio should be 20%greater than the change in value of the market.

(ii) The performance of the portfolio would be compared to the return on theindex. The portfolio’s target return should recognise the pre specifiedlevel of risk. Using an index representative of the market the portfolio isinvested in, target returns could be calculated on 1.2x the index return.Quarterly returns for the portfolio could be compared to the quarterlyreturns on the target over, say, a five year period. The excess returnwould indicate the level of value added by the manager.

(iii)

� The performance will differ because the portfolio will be unlikely tohold stocks and sectors in weights which are wholly representative ofthe index.

� the portfolio’s beta over the period may have varied to levelssignificantly above or below 1.2 affecting returns

� the portfolio may have other objectives/constraints which effectperformance.

� The diversification (or lack of it ) may affect volatility of portfolioreturns;

� the volume and dealing cost impact of trades in the portfolio

� the effects of cash flow


Page 6

� the impact of tax

� the effects of expenses

Q4 The definition of beta was known by almost all candidates. In part (ii) a largeminority of candidates failed to record that the target returns should be calculated as 1.2times the market index return. The value added by the manager would be calculated bycomparing actual returns with target returns. A worrying number of candidates includedthe Economic Value Added formula in their response. EVA is a ratio used to measure theunderlying profitability of a company. It is irrelevant for an equity fund. Part (iii) wasreasonably well handled.

5 (i) An American option is one that can be exercised on any date before

expiry. A European option can only be exercised at expiry. Assuming allthe other terms and conditions of the two options are identical, theAmerican option will have the greater market price. Its value includesscenarios which can profitably be exercised prior to expiry, as well as atexpiry.

(ii) A futures contract places an obligation on the buyer to buy/the seller tosell, an asset on an agreed basis in the future. For an option contract, thebuyer of the contract has the right to buy/sell (depending on whether theoption is a call or put) an asset on an agreed basis in the future. Theseller of the contract must sell/buy the asset if the purchaser of the optionso elects. Under the futures contract the asset will change hands unlessthe option is closed out.

(iii) Delivery is the settlement process in the futures markets. Most positionsin exchange traded futures are closed out before delivery by taking anopposite position as this is a simpler process than making or takingdelivery. The counter party to each futures position is the exchange’sclearing house. The buyer of futures contract can close out his position byselling an equivalent contract and thereby reducing his net position withthe clearing house to nil. Without the exchange’s clearing house, deliverycould only be avoided by dealing direct with the original party with whomthe position was opened.

(iv) Each counterparty faces two kinds of risk – Market Risk and Credit Risk.

Market risk is the risk that market conditions will change, so that thepresent value of the net outgo under the agreement increases. Themarket maker will often attempt to hedge market risk by entering into anoffsetting agreement.

Credit risk is the risk that the other counterparty will default on itspayments. This will only occur if the swap has a negative value to thedefaulting party so the risk is not the same as the risk that thecounterparty would default on a loan of comparable maturity. Credit riskcan be mitigated by evaluating and monitoring the creditworthiness of thecounterparty, and to seek deposit back margining arrangements to limitthe degree of exposure.


Page 7

Q5 A straight-forward book work question with many candidates scoring high marks.Many did however demonstrate that they remained somewhat confused by the mechanicsof exchange traded futures and options. Future candidates may find it helpful to thinkthrough in advance of the examination the cash flows and contracts/ obligations enteredinto at purchase, during the time over which the contract is held and at the time thecontract is closed/ sold/ expired. For example, many candidates failed to appreciate theconsequence of margin calls at the expiry of an exchange traded cash settled futurescontract.

6 This answer is more fully developed than would be expected of a candidate.However, the question does ask candidates to describe and not merely list theimprovements, so they have to show how the proposal will improve return. Thequestion states this is a fixed interest unit trust, and so an unqualified proposal toinvest in equities is not an acceptable improvement - see last bullet.

� Benchmark to bond indices. Whilst not directly designed to improveperformance, investing in securities which are designed to produceaverage performance when compared with the competition shouldindirectly ensure that the returns are never far from average. Internalexpense savings might allow you to reduce charges to unit holders therebyimproving overall return to unit holders.

� Investing in listed corporate bonds. The yield will be higher thangovernment securities of comparative term reflecting the additional creditrisk, reduced marketability and any special terms and conditions.

� Investing in longer term securities in a positive yield curve environment.Obviously this strategy carries risks should interest rates rise. However,all else being equal, when your view of future movements in the yieldcurve is neutral, longer dated securities offer a higher yield in a positiveyield curve environment.

� Trading securities in a positive yield curve environment as their term tomaturity reduces. Similar point to item 4 above. Having invested in thelonger dated securities, they should be sold from time to time as theyreduce in term in a positive yield curve environment. The capital gainfrom the sale allows the trust to pick up a further increase in yieldproviding the proceeds can then be reinvested in the then longer datedsecurities.

� Ensuring that investment is not made into stocks which are particularlyattractive to other types of investors. Some types of investors e.g.individuals and/or foreign investors will bid up the price of a bond as tothem it is more attractive generally for tax reasons. It could also berelatively more attractive for regulatory reasons. There is little point ininvesting in these bonds if other bonds with suitable terms and conditionsare available to you.


Page 8

� Anomaly switching refers to monitoring a full range of potentialinvestments and continuously comparing their prices. In so doing it maybe possible to identify investments which appear relatively cheap and forwhich no explanation can be found. These investments could bepurchased in the belief that their price will correct to previous relativelevels.

� Policy switching refers to anticipating future changes in the shape of theyield curve. Policy switching can be extremely profitable if the market iscorrectly anticipated.

� Investing in asset backed securities. Similar to investing in corporatebonds. Also similar is investing in local authority bonds, except that manypeople believe that local government authorities are extremely unlikely todefault on their borrowings as they have a certain amount of governmentbacking and they have tax raising powers.

� Underwriting new issues for a fee can be attractive if the trust is happy tohold the issue being underwritten. Markets can move quickly and it canhappen that pricing will change significantly from the time ofunderwriting to the time of issue. Hence there is the risk of not being ableto sell on the investment.

Investing in convertibles or preference shares, if the objective of the trustgrants permission to do so.

Q6 The question was generally well answered.

7 This is a practical question – there are marks for what needs tobe done and marks for the precise timing of when thingshappen. This is about how the portfolio is changed, not howthe index is calculated. There are no derivative solutions!

Essentially the fund will offer index tracking with its currentportfolio up to the close of business on the day before themerged company forms part of the index.

In order to maintain the index tracking, the manager has tobuy the additional index weight (i.e. 2.5% of the value of thefund) in the stock

at its index opening price on the first day when it comprises6% of the fund.

At the same time, the manager has to dispose of the stockswhich no longer comprise the 2.5% of the index which themerged company now occupies.


Page 9

These disposals also need to take place at market openingprices, in order to match the index movement.

Q7 The question was apparently fully understood by almost all candidates with mostcandidates realising that the index fund manager must buy additional shares in the localcompany and hence sell shares in the correct proportions in the other companies makingup the index. However, most candidates failed to secure full marks as they failed todescribe the critically important timing of events necessary to track the index.

8 (i) The financial markets of all developed economies are regulated to a

greater or lesser extent. The principal aims of the regulation are mostlikely to be:

1. To maintain confidence in the financial system2. To protect consumers of financial products3. To promote efficient and orderly markets

(ii) A self-regulatory system is organised and operated by the industryparticipants without government intervention.

A statutory system is one in which the government sets out the rules and policesthem.

The main differences between a self-regulatory system and a statutory systemare as shown below:

1. Public Confidence – A Statutory system is less open to abuse by industryparticipants and may command a higher degree of public confidence. In aself-regulatory system, the closeness of the regulator and the firms andindividuals it is regulating could lead the regulator to regulating in favourof the industry. Even if this were not actually so, the public might believeit to be so and thereby undermining one of the principal aims ofregulation, namely, the promotion of public confidence in the financialsystem.

2. The direct and indirect costs of Regulation – In a self-regulatory systemthe regulators are made up of industry participants. As such they willhave the best incentive to operate the system so as to minimise the costsof regulation. The statutory system includes independent regulators whodo not have this direct incentive.

3. Flexibility – Regulators in a self-regulatory system should be much morequickly aware of the need to change regulation to suit changes in themarkets.

4. Enforceability – A Statutory system is more easily enforceable. Itincludes legal recourse. Under a self-regulatory system, a firm orindividual might expelled but there will be no legal compulsion for thatfirm or individual to cease trading.


Page 10

5. Market Knowledge – It is likely that the regulators in a self-regulatorysystem will have the greatest knowledge of the market. It is contendedthat these regulators are more likely to introduce rules and systems whichwork as intended.

6. Relationships with the Regulator – For any system to function it isimportant that the firms and individuals co-operate with the regulator. Itmay be easier for market participants and the regulator to co-operate in aself-regulatory system as compared with a wholly independent regulatorunder a statutory system.

Q8 A straight-forward book work question with many candidates scoring full marks.

9 (i) The four accrued liability aspects to be considered when determining

investment strategy are:

� nature of the liabilities;

� currency of the liabilities;

� term of the liabilities;

� the level of uncertainty, in timing and amount, of the liabilities.

[Not required part of answer] � By definition, the matching strategy willmost closely (as is practicable) match the liabilities by nature, currencyand term. It would also respond as well as is possible to the uncertaintyin the liabilities.

(ii) The covariance of the return for an individual investment with the returnon the portfolio indicates to what degree the two move in synch. If thereis a low covariance then the investment would have attraction as adiversifier for the portfolio as its inclusion in the portfolio would reducethe overall risk (i.e. volatility of return) of the portfolio, subject to howvolatile the investment return is for the individual investment.

(iii) (a) The answer to (iii)(a) has to refer to each of the 4 bulletpoints in part (i) and address those points. Sample solution below givesidea of type of answer expected and level of marks to be gained. NOTE –following discussion at Examiners’ Review Meeting we felt previous answerneeded re-focussed as shown below.

Require to determine the nature of the liabilities. Are they real,how do they relate to inflation? What is their amount? What is thecouple’ lifestyle and outgoings, e.g. mortgage interest or capitalrepayments ? Are there any other sources of income, e.g. thedirector might undertake consultancy within the business.

Are the liabilities denominated in the domestic currency.


Page 11

What life expectancy can be assumed? Is the term be limited by afactor depending on expectation of joint life. Do the two disabilitiesimpact on this?

What other aspects might affect the uncertainty concerning theassets, e.g. cost escalation of healthcare and support may not bepure RPI, may need periodic capital drawdown for medical needs,etc. What is the likely pattern of costs, e.g. does it escalate withage? Can the residence be sold, a last resort, when full timeresidential care is needed?

Is there a continuous need for disinvestment?

(b) There are a wide range of potential answers to this question. Myinterpretation of “Propose” means examine possibilities and explainyour reasoning. The main elements and marks are as follows (otheranswers possible)

There is a sufficient amount of funds to provide a mix of assets,which can be tailored into the liability needs. Need to think aboutsome ready income, some stable income sources and some realassets to provide growth of value for likely escalating incomeneeds.

Among asset classes, would conventionally think of cash, property,fixed interest and index linked bonds, UK and overseas equity.

Might also consider impaired life annuity or long term careproduct.

Conventional fixed interest will provide a high level of income toprovide for living expenses, but capital will be protected in nominalterms only.

Index linked will provide some protection against inflation (thoughmaybe not health care cost inflation).

Equities will provide the only likely means of providing escalationof capital values at a rate which keeps pace with cost of care.However, capital values of equities are volatile and there is acontinuing need for disinvestment. A degree of overseasinvestment will diversify risk, subject to introduction of currencyvolatility.

Property is unsuitable – inadequate spread, already exposedthrough existing residence.

Cash is required to avoid steady liquidation of investments.


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A suitable mix might be (other answers acceptable)

Domestic Equities 30-40%International Equities 15-25% Total Equities 45-65%Fixed Interest 20-35%Index Linked 0-10%Cash 5-10%

Re-balance periodically to maintain broad proportions and reviewmix over time as conditions change.

Q9 Part (i) was well handled

The responses to parts (ii) and (iii) were overall disappointing. Many candidates simplyprovided a virtually generic information list without regard to the specific circumstancesof the question. Candidates were awarded full marks if they categorised their informationlist by the four factors noted in part (i) and if the information requested was relevant tothe circumstances.

Turning to part (iii) most candidates appreciated that the couple concerned may well haverelatively heavy requirements for cash and that some investment in assets offeringprotection from inflation was required to defray increasing health care costs. High markswere awarded to candidates who also appreciated that for so long as the couple remainedalive, health care costs were likely to escalate considerably in advance of inflation as theircollective health deteriorated.

10 (i) The answer has to address the realistic problem. Unreasonable to expect

company prospects to have improved so that dividend doubles and not expect shareprice to react positively as well. Note question also says yield = 2 * market yield;this is not a dot.com doubling an insignificant dividend.

If the dividend yield has doubled, then either the dividend has beensubstantially increased or the share price has fallen dramatically, or acombination of these factors.

If the dividend has been increased substantially, then one would expectthe share price to have risen as well, which would tend to reduce the yield.This would imply that the dividend increase would likely have beenaccompanied by a statement concerning a change in dividend policy, forexample an increase in the payout ratio or a special dividend, i.e. a oneoff event.

The share price may have dropped dramatically due to a profits warningor a results statement. There may be fears of a dividend cut.

May be an unfashionable second tier share subject to persistent sellingbut nothing fundamentally wrong.


Page 13

(ii) Accounting ratios need to be relevant. Choose from Payout ratio ordividend cover or income cover – to check sustainability of dividend

Net asset value – to check whether share good value at this price.

PER is acceptable if it is qualified as a monitoring of the trend in PERover time.

Q10 The question was generally satisfactorily answered. Many candidatescould easily have scored higher if they had included an explanation of therelevance of the ratios given to the specific circumstances of the share.

11 This is a question about the prospective view of the suitability of the

alternative options and how they relate to the liabilities of the pension

fund. The portfolios are tracking portfolios so performance in-line with

benchmark is assumed.

You have not been asked to consider the absolute levels of the market, only thereallocation. All else held equal, the funds should be rebalanced from time totime in accordance with the asset allocation strategy adopted for the pensionfund.

The extent and timing of the rebalancing depends on the estimates of near andmid term expected total returns of each tracker fund.

The near to mid term future expected capital growth for each tracker fund shouldbe calculated using simple fundamental relationships for the companies makingup the index in each country. These relationships might be based on, forexample, the price/earnings ratio, the dividend yield and for non-financialcompanies, the ratio of stock-market value to net worth. When added to dividendyield estimates, calculations such as this help the investor to decide the near tomid term expected total return from each market.

Given estimates of future total return, the overseas market can be consideredrelatively cheap if:

Expected return in local currency + expected depreciation of home currency > expected

return in home country

The near to mid term expected returns of the funds and the value ofdiversification are the two key factors to consider in the extent and timing of therebalancing decision. Other issues to consider are as follows:

(i) The current equity allocations of other comparable institutional investorsshould be reviewed. [The trustees may consider that it is a desirableconstraint that performance be not too far away from that of othercomparable funds].


Page 14

(ii) Net returns from overseas investment can be different because of globalmarket inefficiencies including taxation and regulatory frictions. [Forexample, irrecoverable taxes and withholding taxes, if any, must beconsidered as a cost which might otherwise be avoided or delayed. This isnot likely to be the case here because both countries are major and welldeveloped countries].

(iii) Mismatching of assets and liabilities by country for the overseas trackingfund investment is a relatively minor risk if the liabilities are long termand real in nature. [It is not necessary to consider additional currencyhedges. Real liabilities can be approximately matched by realinvestments in a different currency. The linkage between inflation andexchange rates described by the purchasing power parity theory reducesthe long term exchange rate risk for real investments.]

(iv) Cash flow from the two funds is unlikely to be significantly different butshould be reviewed in line with the cash flow needs of the pension fund.

(v) Depending on the size of the holding and the actual arrangements withthe tracking funds, there may be some albeit remote possibility of shiftingmarket prices (both on the sale of the existing portfolio and on thepurchase of the new assets).

(vi) Any sale and repurchase will involve dealing costs; these costs must beconsidered but are unlikely to be of any significance to the decision.[Similarly any difference in ongoing fund charges should be considered butis highly unlikely to be significant.]

(vii) It will be necessary to liquidate the investments to rebalance the funds.This may take time. The pension fund might be exposed to beingunderweight in the equity markets for a short time.

Q11 The response to the question was generally poor. The question asked the candidatesto consider the issues and calculations to make before deciding whether it is appropriateto re-balance the holdings between the global index fund and the domestic index fund.Candidates were not asked to consider the wisdom of investing in one or other of thefunds nor the reasons for the difference in past performance. Put at its most simple, itis generally agreed that optimal risk adjusted performance requires a well diversifiedinvestment portfolio. Having made a number of different investments in the past, thepractical problem of monitoring and potentially re-balancing those investments tomaintain the original investment objectives arises.

12 (i) Risk is the uncertainty of timing and volatility of future cash flows. Risk

includes both upside and downside risk.

Probabilistic risk means risk that can be eliminated (or “average out”) byinvesting in a number of similar projects. Systematic risk is risk thatcannot be eliminated by investing in the same type of project many times,nor by diversification. Probabilistic risk should be allowed for by specific


Page 15

risk identification and analysis. Systematic risk should be allowed for byvarying the discount rate used in the model.

(ii) The steps necessary to achieve an effective identification of the risksfacing the project can be summarised as follows.

1. Make a high level preliminary risk analysis to confirm that theproject appears fundamentally viable.

2. Hold a brainstorming session of project experts including allrelevant internal and external people who have experience of thistype of project and who are used to thinking strategically about thelong term. Seek to identify risks, both likely and unlikely, todiscuss their likely interdependence and to attempt to place apreliminary evaluation of each risk both in terms of likelyfrequency, and distribution of amount. Generate potentialmitigation options. Risks identified at this time might include:

� The political risk of the two islands and the likelihood of therespective governments seeking to confiscate the bridge orimpose maximum charges

� The risk of the ferries dropping prices to extremely low levels

� The risk of the road system being let go so as to make thebridge unusable

� The risk of other bridges or tunnels being built either by one ofthe governments or by another private entity

� (Other reasonable risks are equally acceptable.)

3. Carry out a desktop analysis to supplement the results of thebrainstorming session. Identify additional risks and proposedmitigation options. Develop a general risk matrix for the project.Research other similar projects and obtain expert opinion whereavailable.

4. Set out the identified risks in a risk register with cross referencesto show interdependencies.

5. Ensure both upside and downside risks are catered for

(iii) For the risks identified any of the following mitigation options areacceptable provided the option is feasible for the risk.

1. Avoid the risk by redesigning the project2. Reduce the risk by redesigning the project3. Reduce the uncertainty through further research4. Transfer the risk to another entity e.g. Appoint a sub-contractor5. Insure the risk


Page 16

6. Share the risk with another party and particularly with a partywho is capable of mitigating the risk through expert control

Q12 A straight-forward book work question with many candidates scoring full and nearfull marks.


EXAMINATIONS

11 September 2000 (am)




1. You have 15 minutes at the start of the examination in which to read thequestions. You are strongly encouraged to use this time for reading onlybut notes may be made. You then have three hours to complete the paper.








� Faculty of Actuaries301—S2000 � Institute of Actuaries

301—2

1 (i) Explain four methods of valuing a corporate bond that is convertible intoordinary shares of the company after some future date.

[7]

(ii) Discuss briefly how all four methods might be used to assess the issueprice of a new convertible loan stock. [3]

[Total 10]

2 Discuss the limitations and disadvantages of assessing managers on theirinvestment portfolio performance. [8]

3 (i) State the key characteristics of money market instruments. [1]

(ii) Outline the reasons why a pension fund might find investment in moneymarket instruments attractive. [4]

(iii) Explain why pension funds would not normally invest a large proportionof their assets in money market instruments. [3]

[Total 8]

4 In a small European country, the performance and the asset allocation split bycountry of all the major funds are published on a quarterly basis about 6 weeksafter the quarter end. One of the fund managers manages a relatively smallportfolio of international equities. His portfolio mandate excludes domesticequities whereas his benchmark is the median return of managers running fundswhich do not have this constraint. In terms of style, the manager’s competitorsare very active.

(i) Discuss the difficulties facing the fund manager in seeking to manage theportfolio of international equities within the terms of his mandate and thebenchmark set. [7]

(ii) Suggest ways for overcoming these difficulties. [3][Total 10]

5 Discuss the characteristics and uses of two equity indices used in the UnitedStates and two equity indices used in Japan. [8]

6 Discuss reasons for using a notional portfolio approach in valuing the assets of apension fund in an actuarial valuation. [7]


7 A global asset management company has to date provided only active assetmanagement. The directors of the company are concerned that it is losingmarket share to passive asset managers. It is considering the launch of aninternational equity index tracker fund. The fund will aim to track the FT/S&PWorld index with a tracking error of 0.5%. The company will need to invest£25million in the fund in order to begin tracking the index from the launch date.The fund will have a management charge of 0.2% p.a.

You have been retained by the board of the company to carry out a preliminaryinvestigation of the viability of the project.

(i) List the information you would need from the directors concerning projectevaluation before drafting your report. [3]

(ii) Explain the issues which your report to the directors might cover. [8][Total 11]

8 A fund manager has just taken responsibility for a domestic equity portfolio thathas been managed on an index tracking basis using full replication. The portfoliocomprises 3% of the quoted capitalisation of the home country. He wishes tomanage the fund on an active basis, reducing the number of securities in theportfolio from 500 to approximately 100 stocks, but will maintain index weight ineach major industrial sector in the index.

Discuss the issues involved in implementing this proposal. [7]

9 (i) Explain why investors demand a higher yield on factories compared withthat on offices and shops. [4]

(ii) Discuss the factors that the property manager of a pension fund mightconsider when assessing the suitability of a factory for inclusion in theportfolio. [3]

[Total 7]

10 The government of a country has decided to introduce regulation of its financialservices industry, although it has not yet decided whether the system will bestatutory or self-regulated. It will appoint an executive responsible forimplementing the system and acting as Regulator in its initial phase. The threecandidates for the appointment are:

• a lawyer experienced in drafting legislation• a market practitioner operating in another developed market• an actuary who operates as an investment consultant

Discuss the skills which each of the candidates would be likely to bring to thisrole, explaining how these might differ depending on whether a statutory or self-regulated system is introduced. [12]

301—4

11 (i) Explain the difference between credit risk and market risk in the contextof a fixed-for-floating interest rate swap and describe the conditionsnecessary for a credit loss to occur. [3]

(ii) Explain why an investment bank which has arranged two offsettingsingle currency interest rate swap contracts still faces credit risk. [3]

(iii) UKL, a British software firm, wishes to borrow US dollars at a fixed rateof interest. USCorp, a US arms manufacturer, wishes to borrow sterlingat a fixed rate of interest. The companies have been quoted the followingfixed rates of interest by INVInc, a global investment bank:

Company US dollar rates Sterling rates

UKL 6.0% p.a. 10.0% p.a.USCorp 5.2% p.a. 9.6% p.a.

Design a swap that will give an apparent gain of 0.16% per annum toUKL and USCorp without exposing them to foreign exchange risk withinthe swap and discuss the risks faced by INVInc in the solution youpropose. [6]

[Total 12]


EXAMINATIONS

September 2000


EXAMINERS’ REPORT

� Faculty of Actuaries� Institute of Actuaries

Subject 301 (Investment and Asset Management) — September 2000 — Examiners’Report

Page 2

Question 1

Question (i) was, in the main, answered well; part (ii) proved problematical with fewcandidates scoring well.

Question 2

Question 2 was one of the better answered questions on the paper with most candidatesscoring well.

Question 3

Question 3 parts (i) and (ii) were answered well and most candidates made a reasonableattempt at part (iii), while most candidates made reference to the length of the pensionfund’s liabilities few referred to the fact that the liabilities were real, in addition fewerpointed out that pension funds can bear a higher level of risk.

Question 4

The answers to this question were very variable, a number of candidates made theassumption that the competitor funds would only invest in domestic equities whileothers seeing that the competitors were described as active automatically assumed thatthey would perform well.

Question 5

This question was answered well.

Question 6

Most candidates were able to score well on this question though a sizeable minority didnot seem to know what a notional fund was.

Question 7

This question was poorly answered, those that treated the question as a capital projectsquestion scored well on part (i) but often fell down on part (ii) as they just regurgitatedthe standard capital project answer without any attempt to adapt it to the project inquestion. Those candidates who did not treat the question as a capital projects questionwere still able to pick up some marks in part (i) but, in general, were unable to makemuch headway in part (ii).

Question 8

This question produced a varied response, some candidates were able to score veryhighly while others failed to score well. A number of candidates who didn’t score wellfelt that 3% of the domestic equity market was insignificant; while others assumed thatbecause the number of stocks was being reduced, the size of the fund was also beingreduced. Others failed to grasp the significance of maintaining the sector weights. Inaddition some candidates were under the mistaken belief that funds with a mandate totrack the index had to replicate the index within the portfolio.


Page 3

Question 9

This question was answered well.

Question 10

In this question most candidates scored well in what was a book work question.

Question 11

While most candidates picked up a number of marks on this question there were asizeable minority who did not score well. Many candidates seeing the word ‘actuary’immediately assumed that the examiners were expecting that candidates shouldconclude that the actuary was the ideal candidate and hence were prepared to attributeevery ideal characteristic to the actuary while dismissing the other two candidates.

Overall Comment

Overall the examiners were disappointed with the overall level of knowledge displayed bycandidate. There were many opportunities to pick up easy marks by reproducing bookwork, however few candidates took full advantage of these opportunities. Wherecandidates were expected to think laterally or apply their knowledge the answers were, inthe main, poor. The examiners would encourage careful thought about the specialcircumstances of some of the questions being asked since these are the areas wherecandidates can demonstrate their higher level skills.

There was a continuation of the disturbing trend noted in recent years of discussing "theliabilities" in circumstances where it did nothing to answer the question being asked. Alsoof concern was a minority of candidates who indiscriminately quoted the ActuarialControl Cycle, while the Actuarial Control Cycle is important it should only be quotedwhen relevant. The examiners are concerned that some candidates may hold the mistakenbelief that mentioning these two points will automatically score them marks, when in factit will only do so in relevant circumstances.


Page 4

1 (i)

There are four main methods.

Discounting the future income stream

Consider the convertible bond as having two components:

• A fixed income stream until the date of conversion and• A stream of dividends starting at the date of conversion

The date of conversion is then taken as the date for which this present value willbe maximised

This is calculated as the first date at which the dividend income on conversionwould exceed the initial fixed income from the bond

It is necessary to make the following assumptions when using the method:

• The rate of dividend growth on the underlying equity stock• The investor’s required rate of return

Comparison with the share price

A convertible can be valued by considering it as equivalent to the underlyingshare plus an extra amount of income for the period until conversion

Thus the value of the convertible is taken as the market price of the underlyingshare plus the discounted value of the income received in excess of ordinarydividends in the period before conversion.

Comparison with loan stock or preference share price

The minimum value of the convertible is the current value of the loan stock orpreference share ignoring the option to convert.

Option valuation method

The three methods above assume conversion at a certain date or ignore theconversion option and so ignore the value of the option to convert

Using option pricing theory a convertible can be valued as a loan stock orpreference share plus the value of the option to purchase the underlying shares.

The quoted market price of the convertible would also be considered if it wereavailable


Page 5

(ii)

The comparison with loan stock price or preference share price method gives afloor on the price and the manager would need to consider carefully if the price isless than this figure

The option valuation method gives an upper limit on price but this upper limit isheavily influenced by the share price volatility assumption used in the optionvaluation method.

The other two methods act as checks on the previous two methods ensuring thatthe results are reasonable.

2 Past performance is not a guide to the future.

There is a random element in investment returns.

It may be difficult to determine how much a fund manager’s results are due toprocess and method and how much are due to luck.

Techniques that proved successful in one set of economic circumstances ormarket conditions may not work so well in other economic circumstances ormarket conditions in the future.

In the long term, higher risk portfolios are expected to produce higher returns.

Investment portfolio performance measurement needs to be adjusted for the levelof risk before comparisons can be made between managers.

Investment portfolio performance measurement needs to be adjusted fordifferences in fund objectives and fund constraints before comparisons can bemade between managers. In practice, this is very difficult to do.

Investment portfolio performance measurement needs to consider the differencesbetween time-weighted and money-weighted rates of return to adjust for cashflows, etc.

Determining the frequency of performance measurement calculations requires adelicate balance between assessing performance frequently enough to spotproblems early and correct them and avoiding spurious conclusions based on veryshort measurement periods.

Performance measurement impacts fund manager behaviour.

For example, a manager whose performance is measured against the median ofher peers is unlikely to take asset allocation decisions that lead to her beingsignificantly different to that of her peers.

This may not be in the best interests of the fund manager’s client.


Page 6

Users of performance measurement services must balance the value of theservice against the cost.

For some assets, like property, valuation is difficult, expensive and in the endsomewhat subjective.

Detailed and frequent valuations of such assets is inappropriate.

3 (i)

The key characteristics of money market instruments are:

• Highly liquid• Stable capital values

(ii)

Pension funds might hold cash as a source of liquidity to meet outgoings, as atemporary holding strategy to avoid exposure to asset classes that are falling invalue.

Some economic conditions might make cash temporarily attractive to pensionfunds.

Generally speaking rising interest rates will depress both bond and equitymarkets; a pension fund may wish to shorten the duration of its bond portfolioand move some money out of the equity markets and into cash.

At the start of a recession when equity markets might suffer from low growthand when bond yields may rise from an oversupply of government paper apension fund manager may wish to put part of her portfolio in cash.

If the domestic currency is weak or expected to weaken further, a pension fundinvestment manager may place part of her portfolio in foreign money marketinstruments of a “safe haven” currency.

Cash may be held due to a contribution being paid which is awaiting investment.

Cash may be held as part of a derivative strategy.

(iii)

Historically cash has underperformed other asset classes over long periods oftime.

Pension funds can bear the higher level of risk associated with equityinvestments in return for the higher levels of return where there is no need torealise assets in the short term.


Page 7

Cash is not a good match for the nature of pension fund liabilities which tend togrow in line with salary inflation.

4 (i)

It will be difficult for the manager to know how the asset allocation of the“median manager” or the median return between the dates the information ispublished – which could be up to a month after a quarter end.

This makes it very difficult for the manager to assess the level of risk she istaking relative to the benchmark.

The size of the manager’s fund may be small compared with his competitorsmaking it difficult to get cost effective exposures to some international equitymarkets.

The mandate constraint – no domestic equities – may be a particularly difficultone in times when the local market is performing very well and the manager’scompetitors are heavily exposed to the local market as part of their“international equities” portfolio.

• Overseas investment expertise may be expensive in a small Europeancountry.

• For a relatively small fund, the costs of custody and settlement may be veryhigh relative to the returns generated.

• The manager will have to deal with the different accounting conventions,language problems and time zones.

• There are considerable fixed overheads in managing a portfolio ofinternational equities which may detract from the return or reduce themanager’s margin.

• Currency risk

(ii)

Grow the size of funds under management to make it move economically viableto operate an international equity portfolio – this could done by acquisition ororganically and to include domestic equities.

• Get the benchmark changed to say the relevant FT/S&P World Indexexcluding the country in question.

• Get the asset allocation and performance data produced more frequently –like monthly.

• Use index derivatives to cut the cost and increase the speed of assetallocation.


Page 8

• Act as an asset allocator across countries and contract out the investmentmanagement to an index manager to track the chosen indices.

5 The Dow Jones Industrial Average is made up of 30 shares.It is unrepresentative of the US market.It is an unweighted arithmetic average index.Movements in the index are a quick guide to daily movements in the prices ofshares mainly in the industrial sector.

S&P 500 index (also called the S&P Composite index) is made up of 500 shares.It is a weighted arithmetic average index.Its constituents are a broad cross-section of all the sectors in the US market.It is suitable for the performance measurement of a fund’s portfolio of USequities.

Nikkei Dow Industrial Average 225 (commonly know as the Nikkei 225) consistsof 225 shares.It is an unweighted arithmetic index.It is not representative of the Japanese market as it had changed little since itsinception. (Note: actually, this index has been revised quite considerably to bringits structure more into line with the broad market, but the Core Reading does notyet reflect this).It is nonetheless a widely used indicator of short term movements in theJapanese equity market.

Topix (Tokyo Stock Exchange First Selection Index) comprises approximately1,100 shares.It is a weighted arithmetic index.Constituents represent the leading companies in the market.The index is suitable for use in performance measurement.

MSCI should be allowed as an index (market cap weighted arithmetic, widesector and stock coverage, multi-currency versions, not readily available but goodfor performance measurement).

FT/S&P Actuaries World Index (Japan) should get credit and the key points are

• Arithmetic weighted average;

• Quoted indifferent major currencies as well as yen;

• Stocks not available to foreign investors excluded;

• Good/suitable for performance measurement

Nikkei 300 should be treated in the same way as Nikkei 225 but comment shouldbe made that it is a broader and more representative index of the domesticmarket.


Page 9

6 A notional portfolio is a tool to help smooth the results of actuarial valuations ofpension fund assets over time and thus avoid the volatility associated with amarket value approach to asset valuation.

Notional portfolios tend to be made up of assets that reflect the broadcharacteristics of the liability profile.

It tends to be influenced by the actuary’s desire not to change elements of theactuarial basis unnecessarily.

It is a discounted income approach to the valuation of assets where theassumptions used in valuing the assets are consistent with those used in valuingthe liabilities.

The approach produces a different ratio of the market value of each asset to itscalculated value in actuarial valuations.

The result of the valuation will be influenced by the assets held by theinvestment manager on the valuation date.

However, the actual distribution of the fund’s assets at the valuation daterepresents the investment manager’s views of short and long term prospects foreach asset class. The investments are replaced as a result of changes in thatview.

If the actuary replaces the actual assets with a notional portfolio, there is no riskthat the valuation process stands between the investment manager and the bestinvestment policy for the fund.

Using a notional portfolio also removes the problem of having to estimate cashflows on each individual asset and reduces the amount of calculation required.

The bookwork should be properly explained.

7 (i)

What criteria have been established by the directors for assessing the viability ofprojects under the following headings:

• Financial results expected (internal rate of return, net present value orpayback period)

• The consequences for the company if these results are not achieved• Achieving synergy with other projects undertaken by the company• Satisfying political and regulatory constraints within and outside the

company• Use of scarce capital and/or management resources in the best way possible• The extent of the upside potential in the project?


Page 10

(ii)

The capital investment of £25 million can only be repaid as new money is raisedfrom investors as £25m is the minimum fund size for such a portfolio.

The only source of income appears to be the fund management charge.

However, this will grow in line with inflows of new money to the fund and theincrease in the value of the fund due to investment performance.

The expenses consist of the costs of running, selling and marketing the fund.

Some discussion of the ability of the existing distribution channels of thecompany would be required in order to assess their ability to sell passive/indexfund management.

There does not seem to be much scope for significant upside in the project giventhe 0.2% p.a. management charge. However, the fund may be needed to holdfunds which are moving a core to passive mangers and retaining a satellite fundwith active managers.

As an alternative answer: The key issues in realising the upside from the projectare economies of scale and persistency of the business. Overheads are more fixedin nature and hence the business would become very profitable beyond a certainminimum fund size. Persistency is also important in recouping acquisition costs.

The risks in the project and the possible risk mitigation strategies.

The political issue of moving from active management to passive managementand its impact on the moral of individual fund managers.

Detailed analysis tends to be expensive. So more complex evaluations will be leftuntil it is clear that the effort is justified.

Draw the attention of the directors to the fact that there may be alternativeprojects which make better use of the scarce resources available.

The directors attention should be drawn to the sensitivity of the results tovarying assumptions as to new cash inflows, investment returns, lapses andsales, operational and marketing expenses.

8

Although there is no change to the sector weights, this is a very large change to theportfolio, turning over a large proportion of the stocks.

Given the 3% of market cap size, this is also likely to involve substantial turnover interms of the domestic market.

The main problems will be:


Page 11

• Moving prices against the fund – the size of the portfolio means stocks being sold arelikely to fall in value, stocks being bought are likely to rise.

• Judging the short term success of the switch will be difficult – the fund’s owndemand will push up the price of the stocks retained.

• Considerable time will be taken to effect the change if prices are not to be moved toomuch against the fund.

• There are difficulties in ensuring that timing of deals is advantageous.

• Dealing costs will reduce the return on the fund after taking account of expenses.

• There is a possibility of crystallising capital gains which may be subject to tax.

• There may be some infringement of asset percentage restrictions.

• The diversification of the portfolio will reduce and so the risk will increase.

• This places more weight on stock selection, and so on research and analysis(although this is not necessarily a disadvantage, given the active nature of themanager).

Some answers may cover “compliance” issues. The following may also be considered:

• What do product rules say, allow and what are product holders’ expectations?

• What implications are there for staff requirements to manage it?

• Are the fund management charges going to charge to cover the extra cost of activemanagement?

• How will the performance record and measurement be dealt with?

9 (i)

Factories are cheap and easy to build. So an under-supply in the market can bequickly corrected. Thus the potential for upside growth is limited.

Factories tend to become obsolete more quickly thus requiring a higher level ofrefurbishment expenditure compared with offices and shops.

Compared with shops and offices, the site value of factories tends to besignificantly lower. So deterioration of the building leads to depreciation coststhat are a high proportion of total value.

Manufacturing industry is particularly vulnerable to economic recession andbankruptcy of a tenant will result in a rent void. This applies particularly wherethe building is unsuitable for any other use.


Page 12

The fabric of factories is more vulnerable to deterioration compared with shopsand offices.

(ii)

The quality of the tenant’s covenant, the price and the rental income of theproperty.The state of repair of the factory.The ability to relet the property to another manufacturer or convert it to someother use in the event of a void.The general economic outlook for the economy including, inflation, interest ratesand the exchange rate.The outlook for the sector of the economy in which the factory operates.Location of factory in term of access to transport and a steady supply of suitablyskilled labour.The existing property holdings of the pension fund; will the factory add to theconcentration by geographical area or property type or will it improve thediversification of the fund.The potential for rezoning or development of the factory site.The size of the deal.Nature of lease and tenant’s responsibilities.

10 (i)

Credit risk is the risk that a counterparty to the swap transaction will default onits obligations to exchange cashflows.

For a credit loss to occur the counterparty must default when the swap has apositive value to the non-defaulting counterparty.

Market risk is the risk that the value of a swap may shift from being an asset inthe books of the counterparty to being a liability of the counterparty due tochanges in interest rates.

(ii)

Interest rates will change over the life of the swap so that to the bank one of theoffsetting swaps is an asset and the other one is a liability.

If bank’s counterparty to the swap which is an asset in the bank’s books defaults,the bank must still honour its commitments to the counterparty to the swapwhich is a liability in the bank’s books.

The banks still has a credit risk even though its market risk has been offsetbecause it has separate contracts with each counterparty.

It is important that the candidate differentiates properly between credit risk andmarket risk.


Page 13

(iii)

The total benefit that can be split between the parties is 40 basis points. If UKLand USCorp get a benefit of 16 basis points each, INVInc should get theremaining 8 basis points.

swap diagram split as follows: for getting the correct apparent gain to UKL andUSCorp and ensure that UKL and USCorp don’t have any foreign exchange raterisk

Risks faced by INVInc:

• INVInc faces credit risk if either counterparty default when the swap has apositive value to INVInc

• INVInc faces foreign exchange risk; it earns 64 basis points in US$ and pays54 basis points in sterling – this is in effect market risk.

11 Self-regulation is a system organised and operated by the participants in aparticular market. There is little or no government intervention in the market.

In statutory regulation, the government sets the rules and polices them.

The lawyer

Likely to be skilful in drafting government legislation – i.e. framework will belegally tightWill be close to government sources and able to understand government agendaLikely to be aware of known abuses (e.g. possible reasons for introduction)Should understand capabilities of local practitioners and consumersIndependent - not aligned to marketWill be viewed as consumer friendlyClose to aligned statutory bodies, e.g. competition authoritiesLikely to be able to tap into similar international regulatory networksMay lack the knowledge of the detailed workings of financial marketsUnder market practitionerMay lack consumers’ confidence due to “closeness to industry”.

The market practitioner

UKL INVInc USCorp

US$ 5.2%

Stg 10%

Stg 10%

US$ 5.84%US$ 5.2%

Stg 9.44%


Page 14

Likely to have good knowledge of other countries systemsWill have practical awareness of likely risks and potentially bad practice, e.g.cartels, insider activity, etc.Likely to be seen as reasonably “friendly” to industry needsLikely to be persuasive to companies on need for change since “close” to themGood awareness of quick win benefits, i.e. greatest inherent dangersLikely to understand cost / benefit trade-off from companies’ perspectiveWill have “rapid response” attitude to market practitioner needsSeen as independent from government

The actuary

Should have reasonable insight into market practice, wider internationalknowledgeNot aligned to business, so can be seen as consumer friendlyBut also seen as independent from consumer by businessBut appreciative of cost / benefit trade-offShould be technically up to speed with innovation and its risks for regulationCan liase with international professional networkShould adopt practical but strict guideline approach, e.g. freedom withpublicationStatistical gatherer to make cartels less likely.


EXAMINATIONS

10 April 2001 (am)

Subject 301 � Investment and Asset Management





3. Write your surname in full, the initials of your other names and yourCandidate�s Number on the front of the answer booklet.






� Faculty of Actuaries301�A2001 � Institute of Actuaries

301 A2001�2

1 Two countries have announced a full review of their respective regulatoryregimes for the investment management and securities industries. Country A isa substantial industrialised nation with a mature stock exchange. Country B isa substantial emerging market economy with a relatively small stock exchangeand an underdeveloped capital market.

For each country, state with reasons the type of regime that might be mostsuitable. [6]

2 (i) Describe briefly the �money market�. [2]

(ii) List the financial instruments that are traded and the other transactionsthat are typically undertaken in the money market. [2]

(iii) Outline the reasons why an investment manager would purchase theseinvestments. [3]

[Total 7]

3 (i) State two expressions for the expected real total return to a domesticinvestor on an overseas asset. [4]

(ii) The real return on equities over the ten years to end December 1999 wasnearly twice the average real return over the last century.

Give reasons why the most recent experience may not be a reliable guideto future performance. [8]

[Total 12]

4 List the possible uses for market indices and state the appropriateness forJapanese equities of using the Nikkei Dow 225 and Topix indices against theseuses. [6]

5 Compare the main features of investments in offices and shops. [4]

6 Mr and Mrs X are both aged over 70 and own an apartment. Mr and Mrs X willsell the apartment to their daughter Mrs Y on the basis that Mr and Mrs X canlive in the apartment rent-free until they are both dead.

(i) List the factors you would take into account when calculating the priceMrs Y should offer for the purchase of the apartment. [6]

(ii) State with reasons the other factors relevant to Mrs Y�s consideration ofthis investment. [4]

[Total 10]

301 A2001�3 PLEASE TURN OVER

7 You are the investment consultant to the trustees of a fund that has its assetssplit amongst several different fund managers. One of the trustees has writtento you and his letter includes the following information relating to one of themanagers:

1 January2000

1 July2000

31 December2000

Total Return Index 1,000 850 1,050Fund Value (including new money) $1bn $1.15bn $1.45bn

He states, �allowing for the $250m of new money received by this manager on1 July 2000, this portion of the fund has grown by $200m and therefore themanager has achieved a return of 20% over the year which compares to a 5%return on the index. This clearly indicates we should reallocate monies awayfrom the other managers to this manager.�

(i) Comment on the calculations the trustee has made and the comparison hehas drawn.

Suggest a comparison you believe to be more appropriate. [5]

(ii) State with reasons the other factors you would suggest the trusteeconsiders before allocating more money to this fund manager. [5]

[Total 10]

8 At October 2000 the assets of a fund stood at US$5bn and they were equally splitbetween the US, Europe and the rest of the world. Within each region the fundhad exposure to diversified investments. The fund manager expected returns inthe short term on European investments to exceed returns on US investmentsand considered a tactical switch.

(i) State two reasons why the fund manager might have expected higherreturns in the short term from European investments compared to USinvestments. [2]

(ii) State two alternative ways the fund manager could have implementedthis switch and comment on the advantages and disadvantages of eachapproach. [4]

[Total 6]

9 (i) Outline three different ways of financially evaluating a capital project. [3]

(ii) List the advantages and disadvantages of each method. [3]

(iii) The evaluation process has revealed that the project managers will have anumber of options at various stages of the project depending on thesuccess of the project at that stage.

Describe how these options could be incorporated into the evaluationmodel. [2]

[Total 8]

301 A2001�4

10 You have recently completed a regular review of a large defined benefit pensionfund. There has been a recent and major decline in the market value of thefund�s assets. The company is keen to avoid increasing its contribution rate bothnow and in the future. With this objective in mind, the company has asked youto report on the following matters.

(i) The fund surplus calculation has been made using the market value ofassets.

Discuss the appropriateness of such a potentially volatile measure ofvalue given the very long term nature of the future liabilities, including areference to alternative asset valuation approaches. [5]

(ii) The assets of the fund are invested in a range of equity, fixed interest andproperty investments without any formal regard to the matching of theassets to the liabilities.

Describe briefly the principles that might be employed by the fund tobetter match the value and timing of the assets with the value and timingof the liabilities. Outline the difficulties of trying to implement such astrategy in the case of a pension fund. [4]

(iii) For the past several years the fund�s investment objective has been toachieve an investment return in any given calendar year that is in the topquartile of returns earned by comparable pension funds. The fund�sinvestment managers have met this objective in four out of the past fiveyears. The fund�s investment managers are not constrained as to theirchoice of investments.

State with reasons a proposed replacement objective or change to thecurrent objective and/or any constraints that could be introduced in orderto help to meet the company�s objective of not increasing its contributionrate to the fund. [6]

[Total 15]

11 A large general industrial company has a fast developing information technologyand computer services division. This division is expected to generate themajority of the company�s earnings over the next five years and the company�sbroker has sent your fund management team a note recommending they buy thecompany�s latest stock issue. As the sector analyst, your colleagues have askedyou to comment on whether the company is likely to outperform its industrysector.

(i) List the principal features of general industrial companies. [4]

(ii) Discuss briefly the factors that will affect the investment performance ofall the companies in the sector. [4]

(iii) Comment on the broker�s recommendation, including any furtherinformation you would require. [8]

[Total 16]


EXAMINATIONS

April 2001


EXAMINERS� REPORT


Subject 301 (Investment and Asset Management) � April 2001 � Examiners� Report

Page 2

1 Country A is likely best suited to a mixed regime involving statutory regulation,self-regulation and codes of practices.

A system is already in place. New system should be a development of the oldrather than a step change. This would minimise costs, avoid unnecessaryconfusion and maintain confidence in the system.

Part self-regulation because the country is a substantial nation with a maturestock market. It therefore has skilled and experienced market participants whocan help to ensure good use of market knowledge, relatively rapid response tochanging market needs and help to minimise the costs of the system.

Part statutory regulation because it should help to maintain public confidenceand minimise abuse of the system.

Country B may also adopt a mixed regime involving statutory regulation, self-regulation and codes of practice. However, statutory regulation is likely to be afar more important component of the regime than for Country A. (A fullstatutory regime is also acceptable.)

Mainly statutory regulation because market development relies on the confidenceof both domestic and foreign investors, the promotion of efficient and orderlymarkets and the protection of consumers. Market participants are likely to berelatively scarce and inexperienced. Self regulation could therefore lead tomistakes, fraud and consequent inefficient markets and loss of confidence.

Partly self-regulation as regulatory systems should develop over time andeventually the depth and experience of the market participants will grow. Thesystem adopted now should allow for increasing emphasis on self-regulation inthe future.

Bookwork Question - Overall tackled fairly well. Most candidates got the basicmarks available but few candidates covered the other relevant points which werespecific to this particular question i.e concerning the establishment anddevelopment of a regulatory system where none existed and the furtherdevelopment of one where some structure is already in place.

2 (i) It is where short term liquid instruments are traded. The money marketis not a physical market. It relies on screens trading systems. Itsparticipants are government and official dealers/ market makers.Sometimes the unofficial inter-bank market is also considered to be a partof the money market.

(ii) Sale and purchase of treasury bills (or other short term government debtusually a note issued at a discount)Sale and purchase of other eligible bills (CDs, CP, FRNs)Repurchase agreements for the billsLending and borrowing of short term funds in the inter-bank market


Page 3

(iii) Liquidity to meet unexpected cash flowMatching near term future expected cash outflow needsInvestment restrictions � Hedging leveraged investment (e.g. futures,partly paid share) to avoid leveraging the fundShort term investment pending an anticipated near term futureinvestmentDefensive position � Expect longer term rates to rise in near futureRecently received funds awaiting investmentInvesting in an overseas money market in anticipation of a near termrelative decline in the local currency

Straightforward Question - In general done well by candidates.

3 (i) Expected return = Initial income yield+ Expected capital growth+ Expected appreciation of exchange rate of overseas currency over

domestic currency− expected inflation

and

Expected return = Initial income yield+ Expected income growth+ Change in yield+ Expected appreciation of exchange rate of overseas currency over

domestic currency− expected inflation

or

Expected return = Risk free real rate + Risk premium for type of asset +currency risk premium

(ii) Reasons why the most recent performance may not be a realistic guide tofuture performance are:

• we have had a long bull run and market valuations are high � priceearnings ratios high, dividend yields low

• returns on capital and equity have improved to high levels• demographics have pushed savings into longer term investments �

demand greater than supply• political climate has been more favourable to business• economic factors have been favourable as long term valuation/interest

rates have fallen• alternative investments have been in shorter supply � gilt sales

reduced


Page 4

• inflation has fallen to lower levels and been more stable thanhistorically

• labour has been more accommodating on wages and flexible workingpractices

• technology � the new paradigm � has taken valuations to higherlevels

Few candidates scored well on this question. In the first part many candidates failed towrite out logical expressions often confusing the risk premium, income and expectedgrowth components. Many left out the expected inflation component completely.

The second part was tackled poorly by many candidates where many seemed to miss thethrust of the question. There was very little discussion about the structural reasonswhich might account for the unusually strong returns seen over recent years.

4Nikkei Dow IndustrialAverage 255

Tokyo Stock ExchangeFirst Section Index(TOPIX)

Measure of short-termmarket movements

Most used Yes

Market history Limited More representativeFuture trend analysis Yes YesPerformance benchmark Not really YesValuation of notionalportfolio

Yes Yes

Sub-sector analysis Limited coverage YesBasis for index funds Limited coverage YesBasis for derivatives Limited coverage Yes

Very straightforward question which was done surprisingly badly by manycandidates. Often there was little or no attempt to link the general uses of indicesto the two specific cases in the question. Many candidates only gave a descriptionof the two indices rather than linking their description to these uses ie answeringthe question which was asked.

5 The average unit size for shops is smaller than for offices. Whilst the general location of an office is important, the precise position withinthat location is not critical. For shops, the exact position has a major influence on the rent that can becharged. Rent is normally a small proportion of an office tenant�s outgoings whereas rentis usually a big proportion of the total cost for a retailer.


Page 5

For offices, there is a wide range of prospective tenants with no concentration onany particular industry. The rents on shops are dependent on the profitability of the retail sector. Offices do depreciate to the extent that old offices can become obsolete. Usually for shops, the fabric of the building represents a small proportion of thevalue and the retailer is responsible for fitting the shop out; for these reasonsthere is little depreciation for the freeholder provided the basic shell of the shopis sound. For the investor, shops usually have lower running costs than offices.Initial yield is generally lower for shops than offices

Basic bookwork question which was, on the whole, well answered.

6 (i) A discounted cash flow calculation could be used to determine the price tooffer. Factors required for this calculation are:

• term of the lease and the ground rent, if leasehold• current market price for the apartment• current rental level appropriate for the apartment + expected rental

growth in order to calculate the income forgone.• the expected period until the apartment becomes vacant allowing for

the health of Mr and Mrs X• the expected growth in market price over the period until the

apartment becomes vacant• the transaction costs, both for the current purchase and the resale,

other costs e.g. insurance, maintenance etc.• tax• the rate of return required from such an investment

The calculation could be carried out on alternative assumptions to test forsensitivity e.g. using different rates of growth in the market price,allowing for different periods until both Mr and Mrs X are dead etc. Consideration should also be given to factors that could dramaticallyaffect the value of the apartment e.g. the risk of development blight,changes in the taxes on property investments, the possibility ofredevelopment etc.

(ii) This investment is real in nature, it is expected to be of medium to long term, its marketability would be poor, there is no income, it may entail a significant amount of management and there is a highlevel of uncertainty about the term and return of the investment. Are these characteristics consistent with Mrs Y�s objectives for herinvestments?

Is the size of the investment convenient and is this opportunitycompetitive relative to alternatives available to her? Would Mrs Y like to live in the apartment?


Page 6

Many candidates treated this as a pure property question and included everything theycould recall regarding residential property investment. Often the main pointssurrounding the price calculation, ie market price less the present value of expectedincome foregone became obscured or even missed.

In part (ii) the points about the part this particular investment would play in the overallinvestment portfolio of Mrs Y were often missed.

7 (i) The trustee has calculated the return on the index as:

(1,050/1,000 − 1) × 100 = 5%.

This is a time weighted return which is unaffected by the incidence of thefund�s cash flow.

The trustee has calculated the return on the fund as:

((1,450 − 250)/1,000 − 1) × 100 = 20%.

The result of this calculation is affected by the significant amount of newmoney received mid year when the market was at a relative low. When this result is compared to the return on the index of 5% thedifference may be due in large part to the effect of the cash flow and henceit is not possible to draw a conclusion about the value added by the fundmanager.

A more appropriate comparison would be either:

• the time weighted return on the index compared to the time weightedreturn on the fund, or

• the money weighted return on the index allowing for the fund�s cashflow compared to the money weighted return on the fund

The time weighted return on the fund is calculated as:

((1,150 − 250)/1,000 × 1,450/1,150 − 1) × 100 = 13.5%.

This return of 13.5% on the fund compares to the return on the index of5%.


Page 7

(ii) The other factors to be considered are:

• risk; the analysis takes no account of the degree of risk undertaken bythe manager

• what has the manager done; it would be necessary to carry out furtheranalysis to determine how the fund manager has achieved this resultand in particular, whether his actions were consistent with what hesaid he was going to do

• competition; the result would need to be put in the context of thereturns achieved by other managers with similar briefs

• credibility; the period observed is too short for the result to be givenmuch credibility and a longer period would need to be analysed

• strategic allocation; the initial allocation between the managers willhave been determined to give effect to the long term investmentstrategy and revisions to the managers� allocations would need to beconsistent with the long term strategy

• appropriateness of the index; is the index appropriate for the portfolioheld by the manager

On the whole this was done well. Most candidates explained the weaknesses of theTrustee�s approach and of the money-weighted return methodology in particular.

8 (i) Note: the question is seeking a common sense statement and so manydifferent reasons could be put forward which will score marks. However,the reasons should be short term factors i.e. not fundamental structuralchanges which might alter the long-term strategy. Possible reasonsinclude:

• belief that the euro was oversold and would outperform the US$

• concerns that US interest rates would rise and undermine USsecurities markets whilst European interest rates had peaked

• in connection with a thematic move away from high tech sectors towhich there may be a greater exposure in the US

• expecting higher short term inflation in Europe resulting in highernominal growth

(ii) Two alternative ways of implementing this switch are:

(a) by selling actual holdings in the US and buying more Europeansecurities and then later reversing the trades, or


Page 8

(b) leaving the underlying holdings alone and reducing the USexposure and increasing the European exposure by a derivativesoverlay e.g. selling appropriate US futures contracts and buyingappropriate European futures contracts and then later reversingthe trades

The principal advantages for (a) are that the exposures can be focussed inthe desired way and where the exposure is indirect i.e. via unitised funds,the switch may be affected relatively quickly. However, where directinvestments are held the switch may involve buying and selling many securities that will be relatively time consuming, administrativelycomplex and expensive.

The principal advantages for (b) are that the switch could be implementedrelatively quickly and cheaply without disturbing the underlying holdings.However, there may not be any suitable instruments for altering exposureto specific areas. The derivatives may not perform in line with theunderlying investments (although arbitragers should avoid significantdiscrepancies). There is an additional element of credit risk in respect ofthe counter party to the derivative contracts.

Tax considerations may result in one method producing a higher netreturn than the other for a given market movement.

On average this was tackled well. However many candidates seem to assume (wrongly)that the market impact of a large derivatives deal is negligible.

9 (i)

• Net Present Value (NPV) � The NPV is the discounted value of thepositive and negative cash flows at a chosen rate of interest. Ifpositive, the project might be viable.

• Investor internal rate of return (IRR) � The IRR is the interest ratethat equalises the net present value of the positive cash flows and thenegative cash flows of the project. If the IRR is equal to or greaterthan the chosen hurdle rate rate then the project could be viable.

• Payback Period (PP) � The length of time before the capital expendedon the project is recouped from the net revenues without discountingthe cash flows.

(ii)• IRR is a rate of return rather than an absolute amount. Hence, IRR

may be a better way of comparing several projects of differing sizes.• IRR assumes that surplus funds earn interest at the same rate as the

return on capital. This can lead to multiple IRR solutions althoughusually only one solution is a reasonable answer. Worse, theassumption that surplus funds earn interest at the IRR cost of capital


Page 9

can be over optimistic and significant if the project turns significantlycash positive at a given point.

• NPV and IRR do not give any guidance regarding the timing of thecash return on the investment. Payback period does.

• Payback period is only a partial evaluator as it does not consider whathappens to the project post the payback point. However, if the projectis well behaved then payback period gives a very good guide to thecash needs and long term potential of the project.

• NPV allows surplus cash to be invested at a separate investment rate.• NPV requires the discount rate to be chosen in advance. Choosing the

discount rate can be difficult and relatively arbitrary. The problem isone of presentation. The discount rate is an assumption and theassumptions are sometimes ignored when sponsors are considering theresults of the project evaluation. As IRR effectively blends NPV anddiscount rate together, IRR can sometimes be a better way ofpresenting results to sponsors.

(iii) Options are uncertain and can be modelled in the same way as risks areincorporated into the stochastic model.

If the option has significant impact to the project and for example leadsthe project from one stage to another stage then it is useful to model eachstage separately and then together.

[Alternatively an answer which suggests that the options be evaluatedusing option pricing formulae is acceptable if the answer notes thedifficulty of choosing the assumptions for the calculation and the answerdescribes how the result would be incorporated into the evaluation model.

Many candidates scored well here. Those who have grasped the overall concept of capitalprojects coped well with both the straight book-work parts and the later parts on theapplication of the theory. In particular most candidates who progressed to the third partdescribed well a method of coping with options.

10 (i) The valuation method used for the assets should be consistent with thevaluation method used for the liabilities. If the market value of assets isused then that would generally imply that the liabilities should be valuedusing a consistent rate of discount as no market value of liabilities willexist.

The valuation method of the assets should also take into account thepurpose of the valuation. If the valuation is concerned with the break upof the fund then clearly the market value and even less than the marketvalue may be the most appropriate value.

When valuing the fund on a going concern basis one might prefer to valueassets in a different way to avoid a misleading result and to ensure thatassets and liabilities are valued in a consistent way.


Page 10

One possible method is to adopt a rolling average or smoothed value ofassets and to correspondingly value the liabilities using relatively stableassumptions. The choice of the smoothing technique is of coursesubjective.Alternatively, the assets might be individually valued using a discountedcash flow approach and the liabilities would be valued using the same rateof discount. This approach involves a great deal of calculation. Also it isvery difficult to estimate the future cash flows of some investments.Further this approach would not smooth away short term departure fromthe long term asset allocation benchmark.

A third approach would be for the actuary to manufacture a notionalportfolio of assets and value these assets on a discounted cash flow basisat a long term stable rate of discount. The liabilities would be valued atthe same rate of discount. The notional portfolio could be based on thelong term investment allocation benchmark and perhaps with somerecognition for the current asset allocation. This approach would be consistent with liabilities, not calculation intensive and would beconsistent with valuing the fund on a long term and going concern basis.

(ii) The liabilities are extremely long term. The actual timing of thepayments are unknown.

Further the in-service liabilities increase as pensionable salaries increaseand the pensions in payment are likely to also be increasing to somedegree in line with inflation. The amounts of the future liabilities aretherefore unknown.

Full matching of investment receipts and payment outgo is therefore notpossible.

Even immunisation is not a practical approach as the liabilities are real,unknown and very long term in nature.

The principles of immunisation might be employed and particularly so ifthe company�s contribution rate objective is a long term one. Over thelong term shares are generally considered to be the most appropriateasset to meet long term real liabilities.

(iii) The relatively small surplus has been caused by a recent and majordecline in the market value of the assets. Hence, the fund is likely to havea healthy surplus if a notional portfolio method is employed. Hence if thevaluation assumptions prove to be broadly correct in aggregate in thefuture then the current contribution rate and the current investmentstrategy are both appropriate.

Nevertheless the current investment objective does not take any regard ofthe company�s desire to limit its contribution rate to the fund. In effect


Page 11

the company is seeking to reduce the relative risk of the investmentstrategy probably at the expense of some future returns performance.

The trustees should require the investment managers to adopt an assetallocation benchmark with a majority of shares and some propertyreflecting the large size of the fund and its real liabilities.

The trustees should require that the market value of the assets remainwithin a pre-agreed range around the benchmark. As market valueschange and these ranges are exceeded steps would be taken to rebalance the portfolio within a reasonable time frame given costs and marketopportunities.

The trustees could consider constraining the investments to domesticassets only although the diversification and additional expected return islikely to more than outweigh the associated risks of future return.

Further, if the company�s liabilities are solely domestic then it may bereasonable to constrain the fund to avoid investment in foreign shares andfixed interest investments. The benefits of further diversification may notoutweigh the currency risks. This constraint would be expected to reduceboth the risk and returns from the fund.

Overall not done particularly well. Many candidates coped with the first part, the secondwas less well tackled and the third was, in general, badly done. In covering the secondpart many candidates confined themselves to simply stating the mathematical conditionsfor immunisation. In the third there was a wide variety of attempts but few candidatessuccessfully tied together the ideas sought in the first two parts with the practicalsituation outlined in the question i.e. practical constraints leading to better matching ofassets and liabilities and a more stable contribution rate going forward.

11 Principal features of general industrial companies as per Unit 4 (3.2.3) pluscomment on it being one of FTSE economic groups.

Factors that will affect the investment performance of all the companies in thesector as per Unit 4 (3.1.2) i.e. resources, markets and structure with particularreference to general industrial companies

Comment on the broker�s recommendation, including any further informationrequired will include:

Company broker so bias/vested interest and so need to also consider otherindependent sources for recommendations, industry outlook, companyannouncements, views of suppliers and competitors

Fundamental analyses of company covering management, product, marketgrowth, competitive position, and accounting data. May need company visit


Page 12

Earnings not the same as profits � are other parts of business in decline, notreceiving investment or are earnings cyclical and temporarily depressed

What is point in economic cycleInvestor demand for IT sector high but volatile with limited profitability ordividend records. Assets generally intangible. Share price could (already) reflectpossibility of rerating or break-up.

Other companies in sector may have similar plans

What is purpose of share issue � is this the latest of many, perhaps against themarket trend? What are other investors perceptions of future capital anddividend growth and risk

What is existing house exposure to company and policy regarding stock weightsin portfolios? Does the recommendation come as part of an underwritingcommitment on preferential terms?

Few candidates scored highly here. Parts (i) and (ii) were done OK but full marks wererare. Part (iii) was not well done with most candidates being far too narrow in theirperspective and few covering all the relevant areas i.e. gather general information, doyour own analysis looking at all divisions of the company (not just the new IT area), lookat general market factors and take account of your own portfolio circumstances.


EXAMINATIONS







3. Write your surname in full, the initials of your other names and yourCandidate�s Number on the front of the answer booklet.






� Faculty of Actuaries301�S2001 (28.2.01) � Institute of Actuaries

301 S2001�2

1 Bank A and Bank B are two investment banks operating in the swaps marketaround highly developed and liquid bond markets in a country. A and B enter aswap agreement under which A �lends� cash to B in return for �borrowing�securities.

(i) Describe briefly the credit and market risk exposures faced by Bank Aunder the swap agreement. [2]

(ii) Describe briefly the steps that could be taken by A to mitigate the risks in(i) above. [4]

[Total 6]

2 Chart 1 below shows how the risk level of a portfolio of equities varies with thepercentage of the portfolio invested outside of the countries of the EuropeanMonetary Union (Eurozone).

(i) Discuss briefly the risk implications of Chart 1 for a Eurozone investorwho wishes to invest in equities outside the Eurozone but who hasdecided not to hedge the foreign currency exposure. [2]

(ii) Compare and contrast your answer to part (i) with the case where theEurozone investor decides to fully hedge the foreign currency exposure inthe portfolio. [4]

[Total 6]

Chart 1

13.0%

13.5%

14.0%

14.5%

15.0%

15.5%

16.0%

16.5%

17.0%

17.5%

18.0%

18.5%

19.0%

19.5%

20.0%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Percentage of equity portfolio invested outside of Eurozone

Ris

k le

vel (

vola

tility

of a

nnua

l ret

urns

)

100% HedgedUnhedged

301 S2001�3 PLEASE TURN OVER

3 (i) State the main aims of regulation in financial services markets. [2]

(ii) Discuss briefly the different ways a regulatory regime can be established. [4]

[Total 6]

4 (i) State briefly how you would expect returns from short-term and long-term fixed-interest government bonds to compare with originalexpectations:

(a) if inflation turns out to be lower than expected(b) if yields are falling more than expected [4]

(ii) In a particular country, over the last ten years government bonds haveoutperformed property. Suggest briefly possible reasons for this. [6]

[Total 10]

5 (i) Outline the features of:

(a) unit trusts [3](b) investment trusts [3]

(ii) State two differences between unit trusts and open-ended investmentcompanies. [1]

[Total 7]

6 (i) Describe briefly four methods of valuing an equity investment. [4]

(ii) For each method, comment on the main drawbacks. [4]

(iii) State with reasons your approach to valuing:

(a) a company operating in a number of different industries (b) a property company [4]

[Total 12]

7 Discuss how economic influences have an impact on the property market. [13]

8 (i) Define immunisation and state the conditions for it. [4]

(ii) Describe briefly the problems in putting immunisation theory intopractice. [7]

[Total 11]

301 S2001�4

9 You are the finance director of a motor car manufacturer who owns the freeholdon the manufacturing facility. A property developer has offered to purchase thefreehold. Outline the factors that you would need to take into account indeciding whether to recommend to your board the offer. [10]

10 You are an independent adviser to a French-based fashion clothing retailer,which is considering setting up a new internet subsidiary to sell its clothingrange into the US market. Currently it has no distribution outside France.

(i) Discuss the methods you would use to determine whether to pursue thisventure. [7]

(ii) Identify the major risks involved in launching the subsidiary togetherwith ways that these risks might be mitigated. [6]

(iii) Describe how you would choose the discount rate to be used in evaluatingthis project. [6]

[Total 19]


EXAMINATIONS

September 2001


EXAMINERS� REPORT

Introduction

The attached subject report has been written by the Principal Examiner with the aim ofhelping candidates. The examiners are mindful that a number of interpretations maybe drawn from the syllabus and Core Reading. The questions and comments are basedaround Core Reading as the interpretation of the syllabus to which the examiners areworking. They have however given credit for any alternative approach or interpretationwhich they consider to be reasonable.

The report does not attempt to offer a specimen solution for each question - that is, asolution that a well prepared candidate might have produced in the time allowed. Formost questions substantially more detail is given than would normally be necessary toobtain a clear pass. There can also be valid alternatives which would gain equal marks.

K FormanChairman of the Board of Examiners20 November 2001


Subject 301 (Investment and Asset Management) � Sept 2001 � Examiners� Report

Page 2

Examiners� Comments

The examiners are becoming increasingly concerned that candidates are relying moreand more on straight bookwork to provide them with enough marks to pass this paper.When a question requires application of the bookwork most candidates seem to feel thatwriting out the bookwork will gain them marks, in general this is not the case. Forinstance in question 10 part (iii) the question asked �Describe how you would choose thediscount rate to be used in evaluating this project�. Most candidates stated in theiranswers that if the project were risky they would add a margin to their discount rate toreflect the risk. From the question it was obvious that the project was riskier than theretailer�s normal operations and therefore this should have been stated and the answerframed on that basis.

Overall the examiners were disappointed by the level of understanding shown bycandidates.

Question 1

This question was poorly answered with most candidates gaining only a few marks. Thequestion was straightforward. However most candidates had not grasped the underlyingprinciples behind the swaps market and therefore were unable to provide satisfactorysolutions.

A large number of candidates suggested opening another position with a third bank. Bysuggesting this they failed to understand that this strategy not only would cost money,but also would open Bank A up to another set of risks.

Question 2

The answers to this question were marginally better than those seen in question 1.However few candidates provided much in the way of comparisons as required in part(ii).

A number of candidates spent time explaining why the chart looks as it does when thequestion did not request that information.

Question 3

Part (i) was answered well. However in part (ii) many candidates seemed to regardunregulated markets and voluntary codes of conduct as forms of regulated markets.

Question 4

In part (i) candidates seldom differentiated between real and nominal returns. Therewas also confusion concerning returns & prices.

Part (ii) was, in general, answered satisfactorily.


Page 3

Question 5

This was straightforward bookwork and, in general, allowed candidates to score well.

Question 6

Those candidates who read the question generally did well. However many chose toanswer a question on the valuation of a portfolio of equity investments. The latter courseproduced answers in which market value, smoothed market value & utility value weregiven.

If further clues as what was required were needed, part (iii) should have provided them.

Question 7

This question was not answered well. It required candidates to comment on how thesupply and demand of property would be impacted by changes in the economy. It alsorequired a description of the linkage between the economic changes and the propertymarket e.g. a buoyant economy means that tenants will require more space thus drivingup rents and hence property values. A surprising number of candidates managed toanswer this question without mentioning rents or rental values at all.

Question 8

This was answered very well. It was straightforward bookwork.

Question 9

This was not answered well. Many candidates failed to appreciate that they were thefinance director of the motor manufacturer and therefore would have knowledge of themotor industry. In addition few considered the impact of the proposed transaction on thebusiness.

Question 10

The question received a varied response. Part (i) asked candidates to discuss which didnot mean list. Part (ii) required candidates to identify risks associated with that projectnot projects in general. Therefore statements like market risk was not sufficient to gaina mark. Part (iii) has already been discussed in the opening remarks.


Page 4

1 (i)

Bank A has two credit exposures:

� In the first, Bank B may default on the termination date and therebynot return the cash in exchange for the bonds.

� In the second, the issuer of the bonds might default during the periodof the repo agreement.

Bank A faces the risk that the market value of the bonds acquired assecurity will drop below the amount of cash lent plus the interest thereon.

This risk increases with the duration of the bonds held as security.

(ii)

Under a repurchase agreement the lender of cash (Bank A in this case)acquires full title to the securities handed over as collateral.

The risk is really that the value of the collateral at the time of default isless than the repurchase price.

That risk is greater for bonds with high duration values than for bondswith low duration values.

To mitigate this risk one might:

(a) Insist on low duration bonds.

(b) Insist on margining the transaction each day.

(c) Insist on initial margin to cover, say 99%, of expected daily pricechanges.

If the issuer of the collateral defaults, the lender of cash (Bank A in thiscase) still has recourse to the counterparty (Bank B in this case) who mustbuy the bond back at the agreed repurchase price.

If the margining provisions are in place the lender of cash (Bank A in thiscase) could call for more collateral if the existing collateral were to be fallsignificantly in price because of a default.

This risk could be further reduced by insisting on AAA-rated or AA-rated(depending on the degree of comfort one is looking for) government bonds.


Page 5

2 (i) The investor can lower the risk level of the portfolio by investing almostany percentage of the portfolio outside the Eurozone.

The risk level falls steeply as the percentage invested outside theEurozone rises to approximately 50%.

As the percentage invested outside the Eurozone rises above 50%(approximately) the risk level begins to rise again.

(ii) With the possible exception of 100% invested outside the Eurozone wherethe foreign currency exposure is not hedged, the unhedged and 100%hedged graphs both show that increasing the percentage of the portfolioinvested outside the Eurozone reduces the risk of the portfolio whetherthe foreign currency exposure is hedged or not.

For small percentages (less than 10%) invested outside the Eurozone, thereduction in risk is similar whether the foreign currency exposure ishedged or not.However the reduction in risk varies in a U-shaped fashion with thepercentage of invested outside the Eurozone when the foreign currencyexposure is unhedged.

By contrast, the reduction in risk increases dramatically with thepercentage invested outside the Eurozone when the foreign exchange riskof the portfolio is fully hedged.

A massive reduction in risk can be achieved by investing all of theportfolio outside the Eurozone and fully hedging the foreign exchangeexposure.

Risk falls from about 19.5% to 13.75%.

Not much additional reduction in risk reduction is achieved where theforeign exchange risk is fully hedged when the percentage investedoutside the Eurozone is above 80%.

3 (i) The principle aims of regulation in financial services markets are:

� to correct market inefficiencies and promote efficient and orderlymarkets

� to protect consumers of financial products

� to maintain confidence in the financial system

Wherever possible, regulation should not place an unacceptable burden ofcost on either the providers or consumers of financial services.


Page 6

(ii) Self regulation:

� organised and managed by the providers

� can work because knowledge of markets high and arguably best placedto react to changes in the markets

� threat of government intervention and potentially associatedbureaucracy means great incentive to succeed

� can be viewed as too close to the industry and consequently mightsuffer (perhaps unfairly) from low public confidence

Statutory regulation:

� organised and managed by the government

� lack of direct market knowledge can mean more costly, less effectiveand less flexible

� distance from industry should control abuse and hence lead to moreconfidence from consumers (however, high profile failures can destroyconfidence just as rapidly as in self regulated markets)

Commonly, both self and statutory regulation operates in differentsections of financial services industries. For a successful system ofregulation, the professionalism of the providers and intermediaries is alsoparamount.

4 (i) Nominal yield = risk free yield + expected future inflation + inflation riskpremium.

(a) Real returns would rise for both short and long-term bonds.

Nominal returns would rise more for long-term than short-termbecause capital appreciation would be greater.

(b) Real returns would fall because expected future inflation and riskpremium would be constant.

Nominal returns would rise for both because of price appreciation.


Page 7

(ii) Change in supply and demand for bonds

� drawing up price (down yields)

change in taxes on property

lower economic growth � property demand lower� rental increases lower

lower inflation � lower rental increases

change in investment regulations

change in planning regulations � property management moredifficult

change in supply of appropriate properties

5 (i) (a)� trusts in legal sense� not subject to company law� stated investment objectives� open-ended� manager expands / contracts fund by creating / cancelling units� no borrowing� priced at net asset value

(b)� public company� closed-end fund� capital structure like any company� stated investment objective� can borrow (subject to limits)� normally listed on stock exchange� quoted price different (may be) to net asset value

(ii) OEICS governed by company rather than trust law.Entry / exit charges are explicit.


Page 8

6 (i) Discounted Dividend Model

This method values the share as the discounted value of the futuredividends. Dividend growth, the required rate of return and timingassumptions are needed.

Price Earnings Ratio

With an estimated value for future earnings per share and an appropriateprice earnings ratio, a price can be calculated by multiplying the twotogether. The price earnings ratio is best estimated using known resultsfor similar companies

Dividend Yield

In a similar way to the method involving the price earnings ratio,estimated dividends can be divided by an appropriate dividend yield togive an estimate of the share price.

Net Asset Value

The net asset value is a measure of the price based essentially on therealisable value of the assets. This method can be useful when a companyis not making profits.

Value Added Methods

A share price can be calculated by adding together the accounting value orbook value of a share and the �added value� being generated by the assetstied up in the company. The economic added value can be calculated as:

net operating profit after tax � (company�s weightedaverage cost of capital � capital retained for shareholders)

(ii) Discounted Dividend Model

� assumptions needed for required rate of return and dividend growth

� level and shape over time of assumptions crucial to correct valuation

Price Earnings Ratio

� need reliable estimate of earnings (finding suitable peer group to setprice earnings ratio challenging - company may be abnormal for goodreasons)

� consistency required between figures for meaningful results


Page 9

Dividend Yield

� need reliable estimate of dividends

� dividend yield too must be reliable and free from distortions due torecent abnormal distributions

Net Asset Value

� heavy reliance on correct valuation of assets (not necessarilyappropriate to use accounting figures)

particularly if using statistic to estimate break-up value of assets

(ii) Value added methods

� need to determine average weighted use of capital� book value needs to be determined by suitable method

(iii) (a) The group would be best valued as the sum of the value of its parts.

Because assumptions are required to estimate the value, it wouldbe very difficult to get meaningful results without breaking thecompany up into the different business units.

This is likely to be straightforward as available information will bebroken up in a similar way.

(b) Property company assets are dominated by the properties undermanagement and the intellectual capital built up in the employeesmanaging the portfolio.

On wind-up, the property would be expected to have a broadlyunchanged value.

A common valuation method used for valuing property companyshares would be based on the net asset value of the company.


Page 10

7 Economic influences have an impact on the property market in three inter-related areas: occupation market, supply of property, and investment market.

The interaction between occupational demand and supply of property for rentdetermines the market level of rents.The property investment market determines the capital value of rented property.

Occupation market

Any factor which has an effect on economic activity will affect occupationaldemand for property.

Tenant demand is closely linked to the buoyancy of trading conditions��and GDP.

Economic growth increases demand for commercial and industrial premises.However, the impact of economic growth will not necessarily be uniform acrossthe different property sectors��or throughout regions of the country.

Levels of employment on the service sector tend to influence occupier demand foroffices very significantly.

New patterns of economic activity, domestically and globally, change demandpatterns.If an example given. (no extra marks for more than one example).

Supply of Property

The peak of the property development cycle does not coincide with the peak of thebusiness cycle.Development may be frequently restricted by local planning authorities.Property takes time to develop. Therefore the time lag between gaining consent for a property development andcompleting construction of it, frequently results in substantial amounts of stockcoming on to the market as the economy slows down.A slow down in the economy, coupled with rising real interest rates, is harmful tothe property development industry.

The property investment market

The state of the property investment market relies to a significant extent on theoccupancy market, as it is the latter that provides the investment income and thepotential for rental growth.

Property investment returns have been a good hedge in the long run againstunexpected inflation.Assuming that there are no other external influences, freeholders should be ableto increase rents with inflation so that the real value of the rent is notcompromised.However, for properties which have infrequent rent reviews inflation erodes thereal value of the rental stream.


Page 11

Higher real interest rates should lead to a lower valuation of future rents andtherefore lower capital values.The relationship between interest rates and property yields is unclear in theshort term.In the longer term, high long term yields tend tom push up property investmentyields, other things being equal.

The sources of investment money, and whether they are positive or negative incash flow terms, are important in determining the state of the propertyinvestment market.The main sources are: institutional investors, public/private property companiesusing bank debt, and international investors (all three required for the mark).When overseas investors are significant purchasers of property the exchange ratewill have an effect on demand levels.

8 (i) Immunisation is the investment of the assets in such a way that thepresent value of the assets minus the present value of the liabilities isimmune to a general change in the rate of interest.

The conditions are:

(a) present value of asset-income equals the present-value of theliability outgo

(b) the mean term of the value of the asset-income must equal themean term of the value of the liability-outgo

(c) the spread about the mean term of the value of the asset-incomeshould be greater than the spread of the value of the liability-outgo

These conditions could be expressed as formulae if preferred.

(ii) Immunisation is generally aimed at meeting fixed monetary liabilities.Many investors need to match real life liabilities.

By immunising, the possibility of mismatching profits as well as losses isremoved��apart from a very small, second order effect

The theory relies upon small changes in interest rates.The fund may not be protected against large changes.

The theory assumes a flat yield curve and requires the same change ininterest rates at all terms.

In practice the yield curve does change shape from time to time.In practice the portfolio must be rearranged every day��to maintain the correct balance of equal discounted mean term�


Page 12

�and to maintain the correct balance of greater spread of asset proceeds

Assets of a suitably long discounted mean term may not exist.

The timing of asset proceeds may not be known.And the timing of liability outgo may not be known.

9 The factors that would need to be considered are:

(i) What price is being offered, is it reasonable given site�s use position etc?

� What have similar site�s fetched in recent sales?� What is book value, will there be a disposal gain, how will it be treated

in pcl account and are there tax implications?

(ii) What will leaseback terms be (if applicable) � rental, duration,covenants, refurbishment?

(iii) What alternative sites are there if not leasing back, cost of these, cost ofmoving, restrictions?

(iv) What development probabilities are being foregone, could planningconsent be obtained to increase value?

(v) What will repurchase rights be and what will basis be?

(vi) What mortgages are outstanding and what will impact be?

(vii) Is property used to secure loans or treated as such in credit rating? �What impact would sale have?

(viii) What will impact on workforce be of sale, change of facility?

10 (i)

The main purpose of the initial appraisal is to ascertain whether theproject is likely to satisfy the minimum criteria that have been establishedby the parent company for projects to proceed.

The main criteria are likely to be financial.

Other possible criteria:

Achieving synergy or compatibility with other projects undertaken by theparent company or any other of its subsidiaries.


Page 13

Satisfying political constraints, both within and without the parentcompany.

Net present value (NPV)

Internal Rate of Return (IRR)

Payback period.

Another measure which is sometimes used is receipts/costs ratio, this isdefined as the ratio of the NPV of gross revenues to the NPV of the capitaland running costs.

As IRR can give multiple solutions it is less popular than NPV.

The NPV method would yield a satisfactory result is the answer waspositive when an appropriate discount rate was used.

The result of the IRR, the payback period and the receipts/costs ratiowould be regarded as satisfactory if they exceeded the pre-set level of theparent company.

Following this analysis a sensitivity analysis should be conducted in orderto ascertain how sensitive the result is to varying the parameters aroundtheir most likely levels.

If the results proved very unsatisfactory then the subsidiary, as planned,should not be launched.

If the results show a satisfactory outcome then a proper risk analysisshould be conducted.

In the initial stages corporation tax should be ignored to reduce thecomplications, it will need to be included in the later stages of theanalysis.

(ii)

Risk MitigationLanguage Employ people who are bi-lingual.Web security i.e. risk thatdata supplied to theretailer is not secure.

Employ software firm to advise on suitablepackage.

Credit Card Fraud Ditto.Fashion i.e. thesubsidiary may beoffering the wrong type ofclothing for the Americanmarket

Make sure thorough market research hasbeen conducted and do not offer �highfashion� unless one is certain that it willsell.


Page 14

Stock i.e. ensuring thereis enough stock to meetdemand without meaningthere is an excess of stock.

Market research.

Supply i.e. ensuring thatthe clothes will bedelivered to the customerwithin the promisedtimescale.

Investigate the companies offering thirdparty delivery services and choose one thatcan fulfil the company�s needs.

Returns i.e. how willunwanted goods behandled.

Set up a suitable internal system to monitorreturns.

Competition i.e. what areother e-tailers doing andhow will it impact on thissubsidiary.

Monitor competition.

Presence i.e. how willcustomers be attracted tothe website and will theyrecognise the subsidiariesname.

Advertise.

Pricing i.e. is the pricecharged competitive withother retailers both on theinternet and in the shops.

Monitor prices.

Currency i.e. how willmoves in currency affectthe prices the subsidiarycan charge for its goodsand how will it affect theprofitability of thecompany when expressedin Euros.

It might be possible to hedge the currency,at least in part.

Market risk i.e. the stockmarket may regard thesubsidiary as very riskyand put a lower valuationon the whole group.

Explain to investors what the plans are andwhat strategies are being put in place tominimise the risk and maximise the return.

(iii) Assume that a real discount rate is required however a nominal discountrate can be used if inflation is allowed for in the cash flows.

The project might be considered as high risk given it is the first operationfor the retailer outside its home market and few, if any, retailersoperating via the internet are profitable; therefore the project should beappraised on a higher discount rate than would be considered for projectsexhibiting normal degrees of risk for the parent company.

The discount rate used should reflect the discount rates used by otherstart up dot com businesses however these rates may be hard to


Page 15

determine and therefore an arbitrary addition to the discount rate theparent company normally uses may be the only solution.

The determinants of the normal discount rate are:

The current cost of raising incremental capital for the parent company inorder to finance the subsidiary i.e. what is the rate of return that needs tobe earned on the capital if existing shareholders are to be no better off andno worse off.

The cost of debt capital should be taken as the cost in real terms of newborrowing for the parent company, by taking a suitable margin over thecurrent expected total real return on index linked bonds, having regard tothe company�s credit rating, and multiplying by (1 ��t), where t is theassumed rate of corporation tax. The cost of equity capital should be takenas the current expected total real return on index linked bonds plus asuitable margin to allow for the additional return which equity investorsseek to compensate them for the risk they run.


EXAMINATIONS

10 April 2002 (am)




1. Enter all the candidate and examination details as requested on the front of your answerbooklet.

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 thesupervisor.


5. Attempt all 11 questions, beginning your answer to each question on a separate sheet.


Hand in BOTH your answer booklet, with any additional sheets firmly attached, and thisquestion paper.

In addition to this paper you should have available Actuarial Tables andyour own electronic calculator.


301 A2002�2

1 Define the following terms:

(a) Capital cover(b) Certificate of deposit(c) Beta value(d) Systematic risk [6]

2 (i) Outline:

(a) the classical system of corporation tax [2]

(b) the imputation system of corporation tax [2]

(ii) List the factors regarding the taxation system that investors need to considerbefore deciding on the most appropriate investment strategy. [2]

[Total 6]

3 A national sports body is considering building a new national sports stadium togetherwith an office and shopping mall complex on the site of the now disused previousnational stadium, situated in the suburbs of the country�s capital city. As well asproviding some of the finance itself, the national sports body is reliant on both thenational government and commercial financial institutions to fund the project.

(i) Discuss the steps necessary to achieve an effective identification of the risksfacing the project. [12]

(ii) Suggest what the major risks may be. [3][Total 15]

4 (i) Enterprise Value (EV) of a company is defined as the sum of the marketcapitalisation of the equity and the net debt of the company. Two companiesin the same industry trade on different enterprise value to sales ratios. Explainwhy this difference may exist. [4]

(ii) Explain why it might be preferable to look at earnings before interest, tax,depreciation and amortisation (EBITDA) rather than basic earnings per sharewhen comparing two companies operating in a global industry. [3]

(iii) (a) Define what is meant by the weighted average cost of capital (WACC).[2]

(b) Explain why one company might have a higher WACC than anotherand what implications this has for the two companies. [2]

[Total 11]


5 Outline the main factors that will influence the asset allocation to bonds, equities andcash in setting a long-term investment strategy. [5]

6 You are given the following market data and information about a pension fund whollyinvested in domestic equities:

Date Market Value Domestic Dividend Yieldof fund Share Index on Domestic

(Capital only) Share Index

31 Dec 00 2,400 1,000 2.631 Mar 01 2,400 1,069 2.930 June 01 2,700 1,184 2.830 Sept 01 3,000 1,198 2.631 Dec 01 2,800 1,120 2.8

Period Contribution InvestmentIncome/Outgo Income

Q1 37 35Q2 20 40Q3 125 40Q4 �35 45

(i) (a) Stating any assumptions you make, calculate:

(1) the money weighted return for each period and over the year(2) the time-weighted return for each period and over the year(3) the index returns over the same period [9]

(ii) Comment on the returns [3]

(iii) Compare the investment income actually received by the fund with theinvestment income that would have been received if the fund had beeninvested in the index. [2]

(iv) Using the information from the answers to (ii) & (iii), what conclusions mightyou draw about the stock selection policy of the fund? [3]

[Total 17]

7 (i) Describe the different ways in which a futures exchange could manage itscredit risk exposure. [7]

(ii) Discuss the credit risks faced by participants in the over-the-counter (OTC)derivatives market and how these can be reduced. [5]

[Total 12]

301 A2002�4

8 (i) Outline the basis of construction for the FTSE Actuaries Share Indices [2]

(ii) List the uses to which these indices can be put. [3][Total 5]

9 An institutional investor based in a certain country has the equivalent of $500m inassets backing long-term, real liabilities denominated in the currency of that country.The fund has no current direct or indirect exposure to property investments.

The manager of the fund feels that commercial property in that country will increasein value in the next few years at a rate significantly above that of any other asset class.

(i) Outline the difficulties faced by the manager in gaining direct commercialproperty exposure. [4]

(ii) Describe briefly the difficulties the manager would face in using a propertyunit trust to gain exposure to commercial property. [2]

[Total 6]

10 A private investor, not subject to tax, wishes to construct a portfolio consisting ofbonds and equities. The investor proposes to use the long-term historical returns on,

and standard deviations of, the two asset classes as estimates of the expected future returns and risk of his portfolio. Based on this data, he wishes to construct a portfolio

with the minimum risk.

(i) Discuss the suitability of his estimates of expected returns and risk levels. [3]

(ii) Discuss the parameters that will influence the return on the portfolio and themix between bonds and equities needed to obtain the minimum risk portfolio.[For this part of the question, you may assume that the historical returns andstandard deviation are accurate estimates of expected future returns and risklevels.] [8]

[Total 11]

11 (i) List four economic factors which influence the level of Government bondyields. [2]

(ii) Discuss the additional influences which lead to different yields being availableon:

(a) corporate bonds(b) equities [2]

(iii) Comment on how the real yield premiums on equities over Government andcorporate bonds might be expected to move over a period of recession. [2] [Total 6]


REPORT OF THE BOARD OF EXAMINERS ONTHE EXAMINATIONS HELD IN

April 2002


Introduction


The report does not attempt to offer a specimen solution for each question � that is, asolution that a well prepared candidate might have produced in the time allowed. Formost questions substantially more detail is given than would normally be necessary toobtain a clear pass. There can also be valid alternatives which would gain equal marks.

K FormanChairman of the Board of Examiners

25 June 2002

� Faculty of Actuaries � Institute of Actuaries


Page 2

EXAMINERS� COMMENT

While the overall pass rate was in line with previous years; many more might have passed iffocused on the question that was asked. Many candidates instead answered the question theythought should be asked or just wrote all they knew on a particular subject without referenceto any question either real or imaginary. These approaches generally do not yield many markswhile candidates reduce the time they have to answer other questions.

As in previous years the examiners were disappointed in the candidates ability to applybookwork or to exercise any degree of judgement.

There was also a tendency assume that whenever an institution was mentioned examinersautomatically meant a life company was involved and the discussion soon centred aroundfree assets and the like. This is an examination in investment and asset management andtherefore and institutional shareholder could be a pension fund, an investment trust, an OEIC,a unit trust, a private client manager, a general fund or a life company.

Question 1 was bookwork and should have provided well-prepared candidates with sixmarks however many candidates had trouble pinning down the definition of a certificate ofdeposit.

Question 2, again this was bookwork and was generally answered well.

Question 3 was, in the main answered well.

The answers to Question 4 varied considerably, few candidates pointed to the fact that in part(i) the sales figure did not measure profitability. While in part (ii) the basis of the answer wasgiven in the question and yet many candidates failed to produce a satisfactory answer. Part(iii) was reasonably well answered.

Most candidates gained a few marks on Question 5 however a number of candidates spentsome time discussing the liabilities without paying due attention to the assets and the returnsand risks associated with them.

Candidates who read Question 6 and thought about their answer before starting on thecalculations were well rewarded in that they made the right assumption regarding cash flows,namely that they were received at the end of the period. Those candidates who assumed thatcash flows were received mid way through the period had trouble calculating the time-weighted return and usually changed their assumption in order to perform the calculation.While these candidates did not lose marks it did mean that they had more calculations toperform.

In general most candidates produced figures that were not far from the correct solutions,candidates were not penalised for making arithmetic mistakes providing the underlyingformulae were correct.

Parts (ii), (iii) & (iv) of question 6 were very poorly answered, if candidates had mademistakes in part (i) and had made reasonable comments in parts (ii) and (iv) then they could


Page 3

receive full marks for those sections. In general the comments made demonstrated a poorgrasp of what the figures that been calculated actually meant.

In part (iii), some candidates calculated total returns or in some cases capital returns, manycandidates failed to appreciate that the yield figure on the domestic share index was an annualyield.

Many candidates failed to read Question 7 and therefore produced unfocused answers. Thisusually involved looking at the question from the prospective of a participant in the futuresexchange rather than the futures exchange itself. These answers scored a few marks usuallyfor mentioning initial and variation margins.

Part (ii) was poorly answered.

Question 8 was bookwork and most candidates received full marks or near full marks.

Question 9 demonstrated the either candidates don�t read the question or that they do but failto grasp the significance of the facts given in the question.

Many candidates saw no contradiction in mentioning that sufficient properties may not bepurchased in order to provide a diversified property portfolio. At the same time they assumedthat the full $500m is invested in property thereby assuming the investment manager wouldnot want overall diversification between the various asset classes.

Candidates seem to lack any sense of what constitutes a large fund or a small fund and towhat extent liquidity would play a part in allowing a switch into property to take place.

What is basically the application of bookwork was not answered well.

Question 10 produced the poorest answers despite the examiners exercising a significantdegree of flexibility where candidates had chosen a different interpretation in answering part(ii). Candidates confused the word parameters for factors however the examiners gave creditfor a well-constructed discussion of the factors rather than the parameters.

In general candidates seemed at a loss to use what knowledge they possessed to provide anadequate answer.

In Question 11 parts (i) and (ii) were answered well with the answers to part (iii) being morevariable.


Page 4

1 (a) A calculation made for loans issued by companies. The capital cover is the number of times that the assets of the company(excluding intangibles and after notionally paying current liabilities) cover theamount of the loan (including prior ranking loans).

(b) A certificate issued by a bank��showing that a stated sum of money has been deposited for a specified timeat a specified rate of interest. Certificates of deposit can be traded (i.e. sold) by the original depositor

(c) A measure of a stock�s volatility relative to movements in the whole market.Usually defined as the covariance of the return on the stock with the return onthe market, divided by the variance of the market return.

(d) The risk of the individual share relative to the overall market which cannot beeliminated by diversification. It is measured by the Beta factor. A share with a Beta greater than 1 is said to be aggressive i.e. the share isexpected to do better than the market when prices rise. Conversely, a share with a Beta less than 1 is a defensive stock, i.e. its price will be expected to fall by less than the market whenprices fall.

2 (i) In the classical system company profits are taxed twice.Once in the hands of the company and once in the hands of the investor.The investor may pay both income tax and capital gains tax.The tax rates paid on income and capital gains may be different.

Under the imputation system the investor will receive their distributions afterthe company has paid some or all of their tax liability on the distribution.The sum paid by the company to the government is imputed to the investor.If the investor is not liable to tax they may be able to reclaim some or all of thetax paid.For some investors there may a further tax liability on the distribution.

(ii) The factors to be considered are:

The total rate of tax on an investment and how it is split between income andcapital gains.The timing of the tax payments e.g. whether the tax is deducted at source orhas to be paid subsequently.To what extent losses or gains can be aggregated over different investmentsand time scales.The extent to which tax deducted at source can be reclaimed.


Page 5

3 (i) Step 1

Make a high-level preliminary risk analysis to confirm that the project doesnot obviously have such a high risk profile that it is not worth analysingfurther.

A clear risk is that the finance cannot be raised�The government may decide that the capital required is too great to justifypolitically.The commercial financial institutions may doubt the ability of the nationalsports body to successfully manage the project to a successful conclusion.(these two marks for these or any other reasonable issue that each of thefinancial backers might have)

It would be important for the project to understand clearly the positions ofthese two parties before going further.

Step 2

Hold a brainstorming session of project experts and senior internal andexternal people who are used to thinking strategically about the long-term.The aim will be to identify project risks, both likely and unlikely,�to discuss these risks��and their interdependency,��to attempt to place a broad initial evaluation on each risk,��both for frequency of occurrence��and probable consequences if it does occur,��and to generate initial mitigation options and discuss them briefly.

Step 3

Carry out a desktop analysis to supplement the results from the brainstormingsession,��by identifying further risks and mitigation options,��using a general risk matrix,��researching similar projects undertaken by the sponsor or others in the past(including overseas experiences),��and obtaining the considered opinions of experts who are familiar with thedetails of the project and the outline plans for financing it.

Step 4

Carefully set out all the identified risks in a risk register,��with cross references to other risks where there is interdependency.

Step 5

Ensure that upside risks as well as downside risks are covered.


Page 6

A risk matrix could be used for the above purposes��with column headings relating to the cause of risk��and the rows relating to the risks in successive stages of the project

(ii) The major risks are

(a) finance not available from government (b) planning permission not being granted

(c) returns will not be sufficient to attract investors(d) sports body not financially strong enough(e) wrong position

(f) cost will be too great

Other risks will also be acceptable as there is no absolutely correct answer tothis part.

4 (i) The sales figure will represent the value of the sales made by the company in aparticular year. The sales figure does not give any information regarding howprofitable the company is whereas the enterprise value represents the totalvalue of the company. The value that investors place on a company will be areflection of the return they expect the company to make. Therefore acompany with a high value of sales but low profit margins is likely to have alower EV compared to a company with the same value of sales but a highprofit margin.

The company with the low profit margin may have a higher than expected EVif investors expect the profitability of the company to rise in the near future.

Given both companies are in the same industry the most likely reasons for onehaving a higher EV to sales ratio than the other are:

(1) Management ability.(2) A more efficient capital structure.(3) The possibility of a take over bid.(4) size or liquidity � ability to trade the stock(5) change of capital structure over the period

(ii) Basic earnings per share are calculated after taking into account:

(1) Interest on loans.(2) Tax on profits.(3) Depreciation of fixed assets.(4) Amortisation of goodwill.


Page 7

Each of these items can introduce distortions when trying to compare onecompany with another.

If an investor wishes to make a comparison of companies operating in a globalindustry, then the tax rate will vary from country to country as will the idealcapital structure. Equally the way accounting rules treat depreciation andamortisation can distort an investors view on the attractiveness of onecompany compared to that of another.

(iii) (a) The weighted average cost of capital is defined the aggregate returnrequired by the providers of debt and equity capital, allowing for theeffects of tax and the risks borne by the capital providers.

(b) The WACC of a company is a function of its capital structure, the costsof financing in the debt markets, the tax rate applicable and thecompany�s beta. All these items may change from company tocompany, even within the same industry.

A company with a high level of debt will have a greater proportion ofits WACC based on debt financing than a company with a low level ofdebt. Equally a company with a high beta will have a greaterproportion its WACC based on its cost of equity finance.

5 Before we could construct a portfolio for an investor we would need to have someidea of the nature and term of the liabilities of that investor.

This will determine the level of risk that the investor can afford to take in trying tomeet the liabilities.

Historically cash has been the asset with the lowest level of risk and return. Wherestability of capital values is prerequisite, cash is the appropriate low-risk asset but theprice of this low risk is low returns in the longer term relative to equities or bonds.

Where the investor can afford to take a somewhat higher level of risk in meeting theliabilities, bonds may be the appropriate asset class because of its slightly higher risk-return profile.

For investors who are looking for high or real returns and who can take bear thevolatility of equities, then an equity portfolio may be appropriate.

Benchmark or peer group comparison.


Page 8

6 (i) Contributions and investment income all occur on last day of each quarter.The index returns need to be calculated on a similar basis using the yield at theend of each quarter.

Time weighted return

Q1 Q2 Q3 Q4

(1.54) 11.67 6.48 (5.50) 10.64

Money weighted return

The quarterly returns are the same but the annual return is derived from

2,400 (1 + i) + 37(1 + i)¾+ 20(1 + i)½ + 125(1 + i)¼ = 2,835

(1.54) 11.67 6.48 (5.50) 10.25

Index time weighted return

R(t) = ((I(t)*(1 + Y(t)/4))/I(t � 1) � 1)*100

where R(t) = total return for period tI(t) = index value at time t

Y(t) = yield on index at time t

7.68 11.53 1.84 (5.86) 15.14

(ii) Money and time-weighted are same for each quarter because of assumptionbut annual is different and reflects time of cash flow v market movements.

Both under perform the index by a considerable amountThe first quarter is the period accounting for all the under performanceThere is strong out performance in Q3

Given the difference in income, capital return for the fund have been very poor

(iii) Period Fund Index

Income Income

Q1 35 18.6 [2,400*1,069/1,000*0.029/4]Q2 40 18.6Q3 40 17.8Q4 45 19.6

Total 160 74.6


Page 9

(iv) As can be seen the fund was invested in stocks that yielded over twice theaverage for the index.It is likely that high yield stocks under performed in the year in question asoverall the fund under performed the index by a considerable margin.The fund manager may have a yield requirement. If this is the case thenperhaps a different index should be used to monitor performance.

7 (i) The exchange protects its credit exposure to participants in the futures marketin several different ways.

Trades can only be cleared by members of the exchange with clearing status.Clearing status involves authorisation, having certain minimum capital andoperational standards.

Institutional investors, corporates and individuals who wish to effect futurestransactions must have their trades cleared by members of the exchange withclearing status.Clearing members of the exchange must pass on at least the initial marginrequirement and the variation margin calls to their clients. They can of coursepass on higher margin requirements.

The exchange imposes initial margin requirements on clearing firms (andhence their clients) as part of the procedure of entering into a futures contract.

Typically, the initial margin requirement would provide the exchange withsufficient capital (usually with 99.5% certainty) to weather an adverse pricemovement in the futures contract in the event that the client/clearing memberdefaulted.

The credit exposure of the client/clearing member to the exchange varies withthe value of the futures contract. For example, where the client has a shortfutures contract on the FTSE 100 index and the index rises the client�sexposure to the exchange via the clearing member increases.

Variation margin is also required where the initial margin falls below athreshold specific to the contract. This provides collateral movement from theclient to the exchange that varies with credit exposure of the client/clearingmember to the exchange.

Price movement limits allow the exchange to suspend trading in a contract ifits price moves up or down by more than set limits. Such limits allow theexchange to limit its credit exposure to clearing members/clients in the eventof sudden moves in the price of the futures contract.

The margin requirements for speculators may be different to those for hedgersas speculators may not have the underlying asset to deliver.


Page 10

Exchanges usually reserve the right to increase the margin requirements ifthey deed it fit. This was one of the problems that a well-known company inthe oil futures market (Metallgesellschaft) suffered.

Close contract if margin not produced.

(ii) In the OTC markets, there is generally1 no central counterparty that acts as thebuyer to every seller and the seller to every buyer. Hence the credit risk of thecounterparty must be assessed both initially and on an ongoing basis.

Settlement of OTC contracts tends to take place at the expiry of the contract sosignificant credit exposures can build up for the counterparties.

In addition, because of the nature of forward contracts they can swing frombeing an asset on a balance sheet to being a liability. So there can besignificant and sudden swings in credit risk.

Some participants in the OTC market call for collateral posting to the partywith the credit exposure to reduce credit risk.

1 Note that some swaps contracts have a central counterparty for all trades e.g. certain swapscleared with the London Clearing House (LCH).

8 (i) These indices are calculated on a weighted arithmetic average marketcapitalisation basis with weights reflecting free float in bands.

(ii) Any 6 of the 8 points listed in Unit 12, ¶ 2 on page 4.

9 (i) Prime commercial property comes in large unit sizes.

With a portfolio of $500m, even if the manager wishes to invest as much as10% of the portfolio in commercial property, this amounts to only $50m.

It is unlikely that the fund would get a diversified portfolio of direct propertycovering shops, offices and industrial properties across different geographicalareas of the country for $50m.

The manager would need to hire in or outsource the property investmentportfolio to a manager with property investment management skills. This willadd to the lead-time in getting the portfolio set up.

There is also a considerable lead time in finding commercial propertiessuitable for institutional portfolios, negotiating terms and effecting the legalconveyance of the property to the institutional investor.

The commercial property market may have moved significantly in the time ittakes to put the last two things in place.


Page 11

The costs of dealing in property are very high compared with say internationalequities or bonds. It is difficult to generate good investment returns fromtactical property investment.

The valuation of property investments is very different from say that ofequities or bonds which are quoted on a stock exchange. The manager wouldneed to consider the systems necessary to produce fund valuations when directproperty investments are held.

(ii) It may be difficult for the manager to redeem units in a property unit trustquickly. For example, property unit trusts may reserve the right to defercancellation of units for periods of six months or so.

Property unit trusts often maintain a significant amount of cash in theirportfolios in order to be able to meet redemptions. So the investment is acombination of cash and commercial property.

A pure commercial property unit trust may not exist.

He might represent a large percentage of a fund and therefore create liquidityproblems.

10 (i) The returns from and risk of bonds and equities varies depending on the timeperiod over which they are measured.

For example, the geometric mean of nominal returns on UK Gilts (as quoted inthe Core Reading for Subject 301) were 5.1% per annum over the period1899-2000, 13.1% per annum over the period 1975-2000 and 12.6% perannum over the period 1990-2000.

The investor would need to have some idea of his investment time horizon.Then examine the returns and risks over a number of periods of similar lengthto his time horizon to get a feel for the stability of returns and risk levels forthat that time horizon.

(ii) As equities have in the past outperformed bonds over any long period of time,the higher the proportion of equities in the fund the higher the expected return.

The risk of a portfolio consisting of two asset classes is not a linearcombination of the risks of the two asset classes.


Page 12

The risk of the portfolio, σn, is given by the equation:

σn = {p2 σb 2 + (1 � p)2 σe

2 + 2p(1 � p)ρ σb σe }½ Equation 1

Where σn is the expected risk of the portfolio, σb is the historical risk of bonds,σe is the historical risk of equities and ρ is the coefficient of correlationbetween bonds and equities.

Equation 1 can be minimised with respect to p to determine the proportion inbonds to give the minimum risk.

The value of p that minimises Equation 1, will determine the expected returnon the portfolio.

A key determinant of the minimum risk level is the coefficient of correlationbetween bonds and equities.

If bonds and equities were perfectly correlated the risk of the portfolio wouldbe a linear combination of the two risks.

As returns on bonds and equities are not perfectly correlated, the risk will besomewhat lower than that of a linear combination of the risks of bonds andequities.

return will be a combination of allocation to bonds and equitiesand the actual returns of binds and equities

actual returns will most likely differ from expected because of changes inrisk free (real) rate of returninflationrisk premiumsexchange rateseconomic/corporate profit growthsupply/demand constraints

If objective is to match particular liabilities, nature and term will dictate typeof assets

Specific types of bonds and equities may be necessary to minimise risk e.g.corporates, overseas, passive management, growth/value.


Page 13

11 (i) InflationShort-term interest ratesFiscal deficitThe exchange rateInstitutional cash flowOther economic factors

(ii) (a) Corporate bonds are unlikely to carry the same security as loans madeto a government. The yield differential will be based on thedifferences between the borrowers.

The risk of default requires investors to demand high yield. Thedefault risk (and hence the additional premium) increases withpressures on profits.

Liquidity will also be an issue. Corporate bonds are less liquid thangilts, again leading to investors demanding additional yield premium.Add to this, the potential impact of world events causing investors tomove to ultra secure investments will lead to an increase in the yieldpremium over government bond yields.

(b) Demand features dominate the drivers of the level of the equity market.Central to this will be investors� expectations for corporate profits.Investors will reflect the level of risk (over government securities) theyare willing to take. They will accept a lower premium if they areconfident about future corporate profitability.

Investor views on economic growth, interest rates and inflationexpectations as well as general market confidence will drive the equitymarket.

As growth starts to slow, equity markets start to fall in anticipation ofcorporate profitability being lower.

Demand shifts towards bond based securities and government bonds inparticular.

Company insolvency has increased the risk of corporate bonds. Theyield premium on corporates over government bonds increases. Actualdefaults also serve to drive underperformance relative to governmentbonds.

Short-term interest rates (expected and in time actual) reduce as thegovernment looks to stimulate demand. As economic confidencebegins to recover, investors are more willing to accept equity risk andcorporate default risk. After a period of underperforming the bondmarkets, equity returns improve.


EXAMINATIONS













� Faculty of Actuaries301�S2002 � Institute of Actuaries

301 S2002�2

1 You are the investment manager of a unitised fund which holds a diversified portfoliocovering all major asset categories. Equity markets have recently received a severeshock. There are concerns that your fund may experience a very high level ofencashments and it has been suggested you should protect the fund by selling futurescontracts.

State the main comments you would make in reply to this suggestion. [4]

2 A large pension fund holds a substantial diversified portfolio of US equities that ismanaged by a specialist manager. The manager�s brief is to modestly outperform overrolling three-year periods relative to a benchmark index. The return on his portfoliofor the latest twelve months was �20% as measured in US$ whilst the benchmarkindex fell 25%. The chairman of the trustees has written to you as the fund�sinvestment advisor stating this return is a disaster and that the fund has lost a fortune.He argues the manager should be sacked immediately and a claim commenced againstthe manager for the loss the fund has suffered.

Outline the main points you would make in your reply and identify what furtherinformation you would require. [5]

3 (i) State the different characteristics of offices and residential properties. [4]

(ii) A unitised fund invests in commercial properties. There are no derivativecontracts available which are relevant to the properties in which the fundinvests.

(a) Explain the particular difficulties that large encashments cause such afund.

(b) State two alternative approaches this fund could take to manage largeencashments and describe any adverse aspects associated with them.

[6][Total 10]

4 By the end of 2001 the global economy had slowed to the point where it wasn�tgrowing. The monetary authorities in many countries cut short term interest rates tohistorically low levels.

Explain what the monetary authorities were hoping to achieve and how equity andbond markets could be expected to react. [6]

5 State the formula used to incorporate liabilities in portfolio theory, defining allcomponents. [2]

Explain briefly how the formula may be used in practice. [2] [Total 4]

301 S2002�3 PLEASE TURN OVER

6 (i) Explain why a pension scheme might consider investing in non-governmentdebt securities. [4]

(ii) State the various factors that may influence the difference in yield betweengovernment and non-government debt securities. [2]

(iii) Describe briefly how risks associated with an individual corporate bond maybe reduced. [4]

[Total 10]

7 You have been called as an expert witness to advise on a suitable discount rate tocalculate the value of a lump sum award to a 50-year old individual in compensationfor his claim for loss of earnings following an injury at work. The amount of theaward is based on the annual earnings lost and the number of years out of work andmakes use of a discount rate in order to create a present value. In prior cases thediscount rate has been the real yield available on an index of long dated index-linkedgovernment securities with the individual stocks weighted by their respective marketcapitalisation.

(i) Give reasons why the yield on a long dated index-linked government securitiesindex could be an inappropriate discount rate at this time. [2]

(ii) Discuss whether the average yield on an unweighted index of all index-linkedgovernment securities available in the market could be a more appropriatediscount rate. [2]

(iii) It has been suggested that a more reasonable discount rate would be theexpected return above inflation on a portfolio of mixed assets.

Discuss the type of assets that a typical individual investor would hold in sucha portfolio and the factors you would need to consider in determining anappropriate discount rate. [4]

[Total 8]

8 You have been asked to develop an index against which to judge an equity portfolio.

(i) Set out the formula for measuring the relative changes in the constituents�share prices. [2]

(ii) Describe briefly the reasons for only including the level of �free float� ofshares available for investment. [2]

(iii) Modify your formula to take account of the �free float�. [2]

(iv) State two limitations of your formula. [2][Total 8]

301 S2002�4

9 A project sponsor has decided to build a small power plant to supply steam andelectricity to a paper mill. The sponsor has asked your bank to lend money to thespecial purpose company which will own the power plant.

Outline the various ways that the bank may be able to reduce its risk in respect of bothrepayment delay and default. Your answer should consider features of both the loanand the project. [10]

10 (i) Describe briefly the three main corporation tax systems. [3]

(ii) State with reasons which system(s):

(a) might be expected to encourage dividend payments [1](b) might be expected to encourage companies to diversify [1](c) might be expected to be favoured by tax exempt investors [1]

[Total 6]

11 (i) State a formula relating the expected return with the required return forconventional government bonds.

State another formula relating the expected return with the required return forproperty. [2]

(ii) List the main simplifying assumptions made to derive the above formulae. [2]

(iii) Discuss briefly why actual returns over a 12 month period may differ markedlyfrom the expected returns for:

(a) a portfolio of government bonds

(b) a portfolio of property leased to the same government [4][Total 8]

12 You are an analyst working for a merchant bank that is responsible for the first publicshare offering of a company. You have been asked to quote a price range for the shareoffer.

(i) Describe the process you will follow to determine the price range. [4]

(ii) List the information you will require to value the company. [3]

(iii) Give two reasons why you might recommend a price range lower than the fairmarket value. [2]

[Total 9]

301 S2002�5

13 You are given the following total return data for a fund and relevant indices:

Year 1 Year 2 Year 3Index Fund Index Fund Index Fund

Equities +31% +35% �2% +2% +24% +26%Fixed Interest Bonds +14% +13% +17% +14% +1% +2%Index Linked Bonds +11% +12% +17% +16% +7% +7%

The fund�s strategic benchmark was set at the start of year 1 as 60% Equities, 20%fixed interest bonds and 20% index linked bonds; it was not rebalanced. The fundmanager adopted a strategy of 50% equities, 40% fixed interest bonds and 10% indexlinked bonds at the start of the period and did not rebalance. Ignoring the fund�s cashflows and stating any assumptions you make:

(i) Calculate the total return on the fund and the strategic benchmark over theperiod and state the relative performance. [3]

(ii) Estimate how much of the fund�s relative performance is attributable to stockselection and how much is attributable to asset allocation and comment onyour results. [9]

[Total 12]


EXAMINATIONS

September 2002


EXAMINERS� REPORT

Introduction

The attached subject report has been written by the Principal Examiner with the aim ofhelping candidates. The examiners are mindful that a number of interpretations may bedrawn from the syllabus and Core Reading. The questions and comments are based aroundCore Reading as the interpretation of the syllabus to which the examiners are working. Theyhave however given credit for any alternative approach or interpretation which they considerto be reasonable.

The report does not attempt to offer a specimen solution for each question � that is, asolution that a well prepared candidate might have produced in the time allowed. For mostquestions substantially more detail is given than would normally be necessary to obtain aclear pass. There can also be valid alternatives which would gain equal marks.

K FormanChairman of the Board of Examiners

26 November 2002

� Faculty of Actuaries2.12.02 � Institute of Actuaries

Subject 301 (Investment and Asset Management) � September 2002 � Examiners� Report

Page 2

In general candidates did well on bookwork questions, made some reasonable attempts atknowledge parts but were disappointingly poor on the application parts of questions.

The paper had thirteen questions, more than have been set previously. As a consequence,however, the largest mark for a question was 12. Also the larger number of questions meantthat more of the syllabus was covered but this should not have affected students� ability toobtain a pass.

Specific comments on each question follow at the end of the individual solution.

1 If there is a heavy encashment then the fund will need cash to pay out in respect of theredeemed units. The main way cash can be generated is by selling the investmentsheld by the fund. Derivatives i.e. futures and options, will not generate much cashe.g. if futures are sold. Although they may lock into a particular level for selling,either markets or specific investments, this is not a particular issue as the fund�s unitprice is linked directly to the market prices for the fund�s underlying investments.Using derivatives to reduce market exposure may produce a performance advantagebut this is not a solution to the fund�s cash flow problem unless the fund can borrowagainst the receipts from the derivatives contracts. However, the markets may havealready adjusted to (or overreacted to) the recent severe shock with the result thatreducing market exposure will not actually bring in performance benefits. Whether ornot the fund is allowed to use derivatives is a point that would need to be confirmed.

This question was badly answered as candidates focussed on futures and derivative featuresrather than whether the suggestion was a suitable approach.

2 Whilst the return on the portfolio for the twelve months is a large negative return, thisneeds to be compared to the benchmark set for the manager and over a time periodconsistent with his brief i.e. 3 years. Over the twelve months referred to the USequity markets has fallen significantly e.g. the return on the S&P 500 index was �27%. Thus, even over the short time period quoted, the manager�s performance maynot be poor relative to his benchmark index; indeed he may have outperformed hisbenchmark.

A claim against the manager may be justified if the fund has suffered a loss as a resultof the manager not implementing his brief properly. However, this does not appear tobe the case on the information provided.

To address the question fully we would need details of the brief set, the history of thereturns achieved by the manager and details of the portfolio�s construction overtime.

If the trustees were concerned about nominal returns on the portfolio then it would beappropriate to review the investment strategy.

Most candidates covered the obvious points but many were not able to identify what furtherinformation would be required and what issues needed to be looked at.


Page 3

3 (i) The different characteristics of investments in offices and properties aresummarised as:

Offices ResidentialUnit Size Available in very large units. Relatively small units.Type of tenant Companies Individuals, or companies at

the luxury end of the market.Security of rental income Can be high if rent a small

part of tenants� outgoing,improved if office is multilet.

Relatively higher risk assingle tenant per unit.

Effect of political factors Not that affected. Historically more affectedthan other property sectorse.g. through rent controls andlaws protecting tenantsrights.

Sensitivity to level ofeconomic activity

Sensitive to corporatespending but not directly toconsumer spending.

Sensitive to factors effectingconsumers disposableincomes although a fallinghousing market may seeincreased demand for rentalaccommodation.

Depreciation Offices can become obsolete. Whilst houses may needrefurbishing they do notusually become obsolete.

Location General location importantbut precise location within ageneral area is not critical.

Precise location may becritical.

(ii) (a) Property is illiquid and hence there is a problem raising cash to pay theencahsing investors. The forced sale of one of the fund�s propertiesmay harm the interests of the remaining investors.

(b) The fund could maintain a high level of liquidity. The principledisadvantage of this option is that in anticipation of possibleencashments, the fund�s exposure to property is diluted and this willimpact on the fund�s return.

An alternative is to contractually impose a restriction saying largeencashments will be delayed for a period e.g. 12 months, at the optionof the manager of the fund. This enables the manager to sell propertiesin an orderly manner at a reasonable price. However, investors may beunhappy that they can�t get their money back when they want.

Part (i) was bookwork and was well answered.

Reasonable attempts were made at (ii) although a number of candidates chose to ignore theinformation given in the question regarding derivatives.


Page 4

4 By reducing interest rates the monetary authorities were seeking to stimulateconsumer and corporate spending by making money cheaper to borrow and byreducing the attractiveness of short term savings.

Of concern to the authorities would be the risk of economic growth being too stronggiving rise to inflationary pressures. This was not the case.

The yields on short dated bonds would be expected to fall in line with the cuts in shortterm rates by the authorities. The yields on long dated bonds would also be expectedto fall provided investors were comfortable about the expected levels of futureinflation.

The level of equity markets would be influenced by:

� the improved prospects for economic growth, if it was believed that the cuts ininterest rates would stimulate growth

� the reduced level of bond yields resulting in an increased value for futurecorporate profits, and

� fluctuations in the equity risk premium

The first two factors would serve to increase the equity market, the latter factor wouldundermine this to a degree if investors saw an increased risk to equity investment.

Candidates could explain what governments were trying to achieve and covered most of thepoints with regard to short-dated securities but were poorer on long-dated and equityimplications.

51

(1 )n

i ii

S A x R L�

� � �� ,

where S is the surplus at the end of the period;A is the value of the assets at the start of the period;xi is the proportion invested in security i;Ri is the return on security i;L is the projected value of the liabilities at the end of the period.

Mean-variance portfolio theory can then be applied to minimise the variance of thesurplus for a given expected return, treating the liability as a negative asset.

In practice it will be necessary to decide how to place values on the liabilities and todetermine, not only the expected value of the liability at the end of the period, but alsoits variance and covariances with the assets. One way of doing this is to use astochastic asset liability model.

Candidates either knew this part of the course or did not. Those that did scored close to fullmarks.


Page 5

6 (i) General references to how to set investment strategy and link of fixedliabilities to fixed assets

Maturing schemes (longevity, closed to new entrants) generally has led to asecular trend to bonds

Liabilities matched by bonds, particularly for international accountingstandardLimited supply of government debt, lack of new issues anticipated, markettightly held at long endCompanies issuing bonds in favour of equity, UK corporate market nowbigger than giltUtility companies issuing index-linked bondsInvestors want to diversifyHigher yield, limited credit riskScope for active management from greater diversity of issuesCould be self-investment drivenCould be a match for bulk transfer

(ii) The forecast strength of the economy during the term of the loanCorporate prospects, credit quality, during the term of the loanMarketability

(iii) Floating charge over some or all of the assets of the companyFixed charge over a given asset in addition to ranking in a wind upCollateral providedFinancial covenants e.g. income coverPrior ranking debt (e.g. subordinated debt will rank behind senior debt)Rights in a technical defaultRestrictions on further borrowingParent co. guarantees (e.g. loan issued by a subsidiary)Third party guarantees (e.g. insurance credit wrap)

It was disappointing that candidates did not do well on this question. In part (i) manyobvious points were missed while in (ii) only credit quality and marketability tended to becovered. Very few candidates got the point of (iii) which is extremely disappointing as this isan important facet of non-government bond valuation.

7 (i) Market may be distorted due to limited supply and excess demand from otherinvestors. Investing in such securities may not be what a reasonable personwould do given size of award. Claimant may expect earnings growth greaterthan prices.

(ii) Current and future market structure dependent on supply more than demandfrom any individual or group of investors and has developed due to historicaland political funding considerations. A low risk portfolio for an individualwould produce a stream of income and capital payments that would leavethem no worse off had the injury not occurred. Matched portfolio would havemixture of dates including very short.


Page 6

(iii) Tax, dealing costs and charges, cashflow needs, security, wealth enhancement� mix of cash, bonds, property and equity biased towards UK market. Couldbe individual shares but more likely to be collectives [301:16 � individualinvestment considerations].

Reasonable attempts were made at (i) and (ii) but in (iii) few comments were made about thefactors that need to be considered. Most spent too much time commenting on appropriateasset allocation.

8 (i)

,

,0( )

i ti

ii

ii

Pw

PI t K

w�

�

�

where I(t) is the capital index at time t;Pi,t is the price of the ith constituent at time t;Pi,0 is the price of the ith constituent at time 0 � the last time at which

there was a capital change;wi is the weight applied to the ith constituent;K is a constant related to the starting value of the index at time 0.

(ii) Removes strategic holdings, represents investable universe so more rationalfor index-tracking management.

(iii), ,

( )( )

i t i ti

N PI t

B t�

�

where Ni,t is the number of shares issued for the ith constituent at time t;B(t) is the base value, or divisor, at time t.B(t) is obtained from B(t � 1) through the chain-linking process.

(iv) Formula assesses capital values only � it does not allow for incomereceivable either by time or amount. Different companies will have differentdistribution policies. Formula takes no account of the charges (managementor dealing costs, commissions and duties) or taxes (income or capital gain)associated in running the client�s portfolio. These could be significant if thereare major changes in the makeup of the portfolio due to such events such as achange in assessment if the free float.

This was another bookwork question that was in the main well done.


Page 7

9 Project risks and their mitigation

� Construction risk� Power supply agreement with the paper mill� Operating/ maintenance agreement with the project sponsor� Residual value guarantee from a credit worthy entity� Raw materials supply agreement (water, coal, gas, sludge etc.)� Amount of equity� Amount of subordinated debt� Full project appraisal (incl. Identification and analysis of risks)� Cash flow� Liquidity account a minimum of 6 to 12 months interest� EBITDA/ Interest cover� Risk transfer to sub-contractors, raw material suppliers etc..� Risk insurance � full all risks cover� Risk sharing � potentially with the paper mill� No dividends period

Loan terms and conditions

� Timing of the loan, pre or post construction

� Loan guarantee from the sponsor

� Loan guarantee from the builder during the construction period

� Term of loan � the power plant will have a very long useful life. As a lenderyour interest in the project is limited to the term of the loan. In this case, thesponsor is likely to have a contract to supply heat and power to the mill for aperiod of say 10 to 15 years. The sponsor is likely to ask for a loan term equalto the power supply agreement term.

� Restrictions on further borrowings

� Principal repayment schedule � likely to be as fast as the cash flows willallow for the first say three to five years. Decreasing the leverage in thespecial purpose company will allow the sponsor to refinance the loan at lowercost. It is unlikely that the sponsor will wish to repay the whole of the debt.Debt is less expensive than equity.


Page 8

� Financial covenants � the main financial covenant will be a coverage such asEBITDA to interest expense ratio of at least 1.5. Lender may have rights totake control at this point. Also restrictions on further borrowing. Interestcover

� Fixed security over all assets

This question was poorly answered by most candidates. There was a tendency to write downall they knew about project management and not look at it in the context of the questionposed. It was disappointing that the guidance in the question on what needed to be looked atwas ignored.

10 (i) Classical � A company�s profits are taxed twice: once in the hands of thecompany and once in the hands of the shareholder. The shareholder may besubject to tax on dividends and/or capital gains arising from increases in theshare price.

Split-rate � Similar to the classical system excepting that different tax ratesmay be levied on retained profits and distributed profits. The system might beused in conjunction with a system that taxes investor�s income and capitalgains at different rates.

Imputation � A system designed to enable a company�s profit to be taxedonce rather than twice. Dividends paid from taxed profits are paid toshareholders together with a tax credit. The rules vary greatly and can bequite complex but it is often the case that the tax credit received is sufficient tooffset the tax due on the net dividend. Also, lower taxed investors can oftenreclaim the tax credit.

(ii) (a) All else equal under the imputation system dividends are taxed once.Retained profits lead to increased share prices and capital gains.Hence retained profits in an imputation system might be effectivelytaxed twice. The imputation system encourages dividends. Split-ratewould be an alternative depending on the tax rates being levied.

(b) The classical and potentially the split-rate systems are more likely toencourage retained profits and capital gains. Companies are morelikely to grow and hence are more likely to become conglomerates.

(c) All else equal the dividend imputation system should be most attractiveto tax exempt investors as it potentially allows them to reclaim the taxpaid by the company.

(Where different answers were possible marks were given for either solution)

Candidates scored well on this question in the main with most getting close to full marks on(i). There were mixed results on part (ii) tending to indicate that candidates may havelearned the tax regimes but not fully understood them.


Page 9

11 (i) Conventional Government Bond

Gross redemption yield = required risk free real yield + expected inflation +inflation risk premium

Property

Rental yield + expected growth in rents = required risk free real yield +expected inflation + property risk premium

(ii) Assumptions:

All investors want a real rate of returnAll investors have the same time horizon for investment decisionsAll investors have the same tax positionReinvestment rates equal the expected total return from each asset

(iii) The theoretical relationship is a very long term one. Actual returns over arelatively short period often are different from those expected.

Many differences will relate to inaccurate estimation of the variables.

Short term changes in supply and demand etc. will cause markets to divergefrom fair value.Accrual of income and expenses can be difficult. The amount and timing offuture rent reviews, major repairs etc.. is often unknown.

Property valuations are often done infrequently whereas bonds are valued inreal time.

Reasonable attempts were made at part (i) but candidates did not score as well on (ii)missing out the time, tax and real return assumption points. Part (iii) also had mixed results.

12 (i) [Reference 301: Unit 10, section 2, 301:4:3.1, 17:1,3.7, 19:2,3] Need toconstruct a model of the company which allows future cashflows and earningsto be estimated. This will take account of management ability, quality ofproduct, prospects for market growth, competition, input costs, retainedprofits, company, sector and market history. From this a share value can bederived using a discounted dividend model or sector price/earnings ratio. It islikely that the price range will be set lower than the most optimistic forecaststo encourage take-up by other investors

(ii) Financial accounts and accounting ratios, dividend and earnings cover,revenue and expenditure and so profit variability and growth, levels andstructure of borrowings, levels of liquidity and lines of credit available, growthin asset values (which may be mainly intangible e.g. intellectual capital),comparative figures for other companies (similar in terms of market or stageof development), public statements made by the company and trade/presscomment, listing information and criteria for the exchange on which the stock


Page 10

is to be launched, opinions of company management, competitors, customers,suppliers and market analysts.

(iii) [Reference Unit 10, section 3 and Unit 11] Economy or trade cycle may effectshort-term market sentiment and so valuation of companies generally orspecific. Liquidity in the market may be poor so investors need to beencouraged to switch out of existing holdings to fund purchase, particularly ifthere is a high level of new issuance generally. Improved investor sentiment ifissue rises on opening (good for future business of bank). Avoids take up ofstock underwritten so improves profitability of deal for the bank.

Another question where candidates failed to make use of all the information given to them, inthis case that it was a �first public offering�. Parts (i) and (ii) were marked together as manycandidates made the comments expected in part (i) when answering (ii) and vice-versa. Part(iii) was not well answered.

13 The table below shows the results:

Fund Wt Index Wt FundReturn

IndexReturn

AssetAlloc

Sector Total

Equity 50.00% 60.00% 73.50% 59.19% �0.89% 7.16% 6.26%Fixed Interest 40.00% 20.00% 31.40% 34.71% �3.11% �1.33% �4.43%Index Linked 10.00% 20.00% 39.01% 38.96% 1.13% 0.01% 1.13%Total 100.00% 100.00% 53.21% 50.25% �2.87% 5.83% 2.96%

(i) The fund has outperformed its benchmark by 3%, having returned 53% againstthe benchmark�s 50%.

(ii) Asset allocation gave a negative contribution of 3% whilst stock selectionmade a positive contribution of 6%. Over weighting fixed interest was a poordecision which was further compounded by poor stock selection in this sector.Equity asset allocation was negative but this was more than made up for byexcellent stock selection. Under weighting index-linked also produced apositive contribution.

It was disappointing not to see logical application of theory in this question and manycandidates obviously dived straight in to answering it without taking in all that was required.Many missed the point that there was no rebalancing. Arithmetical errors were not penalisedbut use of wrong formulae resulted in the loss of about one third of the marks being awarded.


EXAMINATIONS

8 April 2003 (am)













301 A2003�2

1 Outline the key issues to be considered when forming a long-term investment strategyfor a charitable trust. [5]

2 (i) Define a generalised formula for a total return index suitable for propertyperformance measurement purposes, stating any assumptions you would needto make. [2]

(ii) Outline the problems in constructing such an index for quarterly publication.[4]

[Total 6]

3 Over the last five years, a general industrial company has restructured itself,principally through acquisition into an information technology and communicationservices company. The company has borrowed heavily to support its activities. Due toa recession in the market, the company is struggling to cover its debt repayments andalso needs further capital to complete research into a new component that themanagement believes will generate 60% of revenues over the next 10 years. Thecompany has recently appointed a debt management consultant who has approachedthe bank with a proposal to swap its loans to the company for equity.

(i) Set out the principal characteristics of this company. [4]

(ii) Outline the factors that will affect the bank�s preference for debt or equityinvestment in the company stating any further information you would requirein order that a decision may be made. [8]

[Total 12]

4 (i) Define �rack rent� and �marriage value�. [2]

(ii) List reasons why the rack rent might be higher than the rent currently beingreceived. [2]

(iii) Describe a situation where a tenant may have no option but to pay a renthigher than the rack rent. [2]

[Total 6]


5 List the problems that may be encountered with overseas investments. [5]

6 (i) State reasons why an individual might be attracted to collective investmentvehicles or policies, rather than direct holdings. [3]

(ii) List the key differences between an investment trust and a unit trust. [4]

(iii) Explain why an investment trust would typically have a more volatile shareprice than the offer price of a unit trust. [4]

[Total 11]

7 An investment bank is pricing a 15 year swap using its internal cost of capital of 8%per annum. In return for a swap premium, the bank will pay its client the excessinterest payable on a variable rate loan of LIBOR + 100bps above a fixed rate loan of5.5% (the client will pay the bank in the event of the fixed rate loan giving rise tohigher payments than the variable rate loan). These payments are made at the end ofeach quarter. The capital payment under the client�s loan is not covered by the swaparrangement.

(i) Assume LIBOR is initially 4%, and remains at this level for the first 7 years ofthe term, and is 6% thereafter. Calculate the present value of the cashflowscovered by the swap based on a principal sum of £10 million. [6]

(ii) Explain why in practice the bank will charge more than the present valuecalculated in (i) above. [5]

[Total 11]

8 (i) Describe a classical split rate system of corporation tax. [2]

A government of a developing country has approached you as an investmentconsultant to advise them on restructuring the taxation system to encourage longerterm investment in companies listed on their local stock exchange.

(ii) Describe methods of taxation that would encourage longer term investment.[4]

[Total 6]

301 A2003�4

9 Lifeco is a major insurance company operating mainly in its domestic market. Inorder to raise additional finance, it has decided to issue a new convertible bond. Thedetails of the convertible bond are:

� Coupon 2.75% payable annually.

� Term 5 years.

� Conversion price 125% of the share price at issue at any time before redemptionprovided the share price has increased by 30% at any time since issue.

� The company may redeem the convertible after 4 years, and thereafter at theoption of the company, at par, providing the price exceeds 120% of the conversionprice.

(i) Explain why Lifeco might choose to raise additional finance by issuing aconvertible bond. [3]

(ii) Explain why Lifeco might have set the redemption terms it has. [2]

The share price at issue is �1.00 and the current prospective dividend yield is 3%.

The dividend of the company over the past year grew by 15%. Having analysed theprospects for Lifeco, you estimate that the dividend growth rate experienced in eachsubsequent year will fall by 2% p.a. in each of the next 6 years, before ultimatelystabilising at 3% p.a.

(iii) Estimate the value of the convertible bond to an investor who requires a returnfrom equities of 6.09% p.a. Ignore taxation. State your assumptions. [9]

(iv) After 4 years the market price has just reached �1.25. The company made anopen offer to repurchase the convertible bond at �101.6 per �100 nominal.Suggest possible reasons why the company has made this offer. [4]

[Total 18]

10 An investment bank is establishing a series of bond indices to be used in combinationsas benchmarks for bond portfolios which it manages.

List the features of bonds that should be taken into account in establishing theseindices.

[4]

11 A developing country is reviewing the extent and form of regulation of its investmentmarkets because of complaints about the cost of regulation.

Explain the economic costs of regulation. [5]

301 A2003�5

12 An insurance company operates a unitised with-profit fund. Valuations are carried outat each month end. These valuations are available 3 weeks after each month end andform the basis for the market value adjustment factors used for adjusting surrendervalues.

The appointed actuary is concerned that because of the market volatility there hasbeen adverse selection against the with-profits fund. You have been asked to submit aproposal to update valuations and investment performance on a more frequent basis.In particular you have been asked to be able to provide an update immediately after anadverse market movement.

The unitised with-profits fund has been divided into separately managed funds foreach asset class as follows:

Asset class % of the fund

Fixed interest medium term corporate bonds 18%Fixed interest medium term gilts 4%UK equities 45%Non-UK equities 15%Property 15%Cash 2%Commercial Mortgages 1%

Outline the investigations you would undertake and set out the points you would makein your reply to the appointed actuary. [11]


EXAMINATIONS

April 2003


EXAMINERS� REPORT

Introduction


The report does not attempt to offer a specimen solution for each question � that is, asolution that a well prepared candidate might have produced in the time allowed. Formost questions substantially more detail is given than would normally be necessary toobtain a clear pass. There can also be valid alternatives which would gain equal marks.

Mrs J CurtisChairman of the Board of Examiners

17 June 2003



Page 2

1 Legal constitution of charity and objectives and constraintsDuties, authorities and responsibilities of trustees and other parties in processExperience and resources available to trustees to decide, implement and monitorExternal advice availableDifferences between strategy and tacticsObjectives and their prioritisation � look at purpose of charity, operatingconsiderations, need for income and capital, existing commitments and plansSize and appraisal of current portfolioBroad theoretical alternative options to consider including expected returns and risksfor equities, bonds, cash/other and property (may have operational use as well asinvestment aim)Secondary issues e.g. domestic/overseas split, nature of bonds, choice of benchmark,tactical limits, timingRisks affecting fund and stakeholders and their priority/relevance � short and longterm income requirements, fund raising, inflation, capital protection, statutory returns,general market volatility, currency, peer group comparisons, ethical or SRIconsiderationsImpact of tax exempt status on expected returns and risksAttitude to risk of trustees and contributorsImplementation factors nature of existing and proposed investments, timing, liquidity,income requirements, dealing frequencies, costs of reconstruction and ongoingmanagementExisting and prospective compliance requirements (could Myners and trusteelegislation be extended to charities)

Overall this was done �reasonably� well by candidates although few scored high marks.Most got the obvious points re the fund objectives, restrictions and attitude to risk but fewwent further and developed their answers into the more detailed points which were needed toscore better.

2 (i) General formula and assumptions as per unit 12, section 1 plus allowance forfactors referred to in 12.4 for portfolio based indices including costs

(ii) Issues as per 12.4:Uniqueness of property � lack of homogeneity and available comparators,definition of sector , investability restricted with large lot sizes indivisible,rules required for changes to index constituents, impact of obsolescence andredevelopment or other change of characteristics (e.g. tenancy) on constituentsCashflow pattern for deciding typical yieldSubjectivity, timing and variation of valuation methods and cost of frequentappraisalActual return only known at point of sale with price kept confidentialInfrequency of sales in some sectors

(i) Most candidates scored well.(ii) The standard points re the difficulties in valuation (subjectivity, frequency, cost, etc.)

were made by most candidates. Few however, went on to explain sufficiently howthese and other points created problems when constructing a quarterly index. Thiswas the essence of the question.


Page 3

3 (i) Principal features of IT and communication (and service/ non-generalindustrial companies by implication) companies as per Unit 4 (3.2.3, 3.2.5 and3.2.8) plus general comment on current market trend.

(ii) Consider prospects for equity and bonds generally plus specifically factors thatwill affect the investment performance of all the companies in the sector andthe particular company concernedLook at level of existing debt and equity (if any) exposure to this and sectorgenerally, security available, expected return, costs of restructure, businessplan, priorities on income and capital repayment, levels of cover, actions ofpeers, bank policy and experience, statutory requirements, secondarymarketabilityLook at existing capital structure and change proposedLook at actual swap terms proposedLooking for formal recommendation (yes or no) with argument and commenton the consultant�s recommendation, including any further informationrequired. Points to cover include:� Consultant may be biased (has vested interest) and so need to also consider

other independent sources for recommendations, industry outlook,company announcements, views of suppliers and competitors

� What is negotiating strength � are we lead lender?� Fundamental analyses of company covering management, product, market

growth, competitive position, and accounting data. May need companyvisit

� Earnings not the same as profits � what is real impact of new product andhow close to completion is it

� What is point in economic cycle and general outlook for sector/market� Investor demand for IT sector low and �burnt fingers� but volatile with

limited profitability or dividend records. Assets generally intangible.� Other companies in sector may have similar plans or products with better

prospects� What are other investors perceptions of future capital and dividend growth

and risk

(i) Surprisingly badly done for a largely bookwork question. Very few candidates scoredfull marks here although most got at least some of the points.

(ii) Not well done by the majority of candidates. Few made the various points aboutlooking around on a broader basis to establish the health of the sector etc. and evenfewer made the point that revenues are not the same as profits.

4 (i) Rack rent is the rent that would be received from a property if it were subjectto an immediate open market rent review.Marriage value is the value added by combining several different interests in aproperty.

(ii) Sale and leaseback situation, so rent is below market rateRack rents have increased since the last review


Page 4

Rent linked to an index (e.g. RPI) between infrequent full reviews, leading todrift over timeGovernment controls on permissible rentsStrong covenant of tenant, leading to lower rent

(iii) The tenant may have purchased a lease with an upwards only rent reviewclause. Rents have since fallen, but the tenant is unable to react to changedconditions without surrendering the lease.

Parts (i) and( ii) were done well, but many dropped some marks in part (iii).

5 Unrecoverable taxes (withholding tax)Accounting information may be less reliableAccounting standards may be different compared to the domestic marketLess information may be available than in the domestic market��.and this may be less timelyLanguage problems may exist/translation delaysTime delays may existMarket regulation may be weaker in some countries than othersPolitical changes may result in changes in how overseas investors are treatedMarketability � many overseas markets have low liquidity or concentratedownership (e.g. cross shareholdings)Currency complicationsOwnership restrictions may exist in certain industries (e.g. airlines, utilities)All adds to overall costs and the level of admin expertise required

Standard bookwork question which was answered well in most cases.

6 (i) Can invest small sumsDiversification possible with small sumsSpecialist expertiseSimpler to arrange (e.g. salesman/bank teller)Tax advantages in some casesSmoothed investment return (with profits)

(ii)Investment trust Unit trustClosed fund Open fundPrice may be above or below net assetvalue of underlying assets

Always priced at net asset value

Company � governed by company law Trust � governed by trust lawPrice may be more volatile due todiscount varying over time

No discount, so volatilityfollows underlying assets only

Can borrow (gearing possible) Not permitted to borrowShares traded on a stock exchange Units bought/sold by trust

manager


Page 5

(iii) Discount � The discount will vary over time, due to market sentiment aboutthe managers and their investment style.Marketability � Investment trust shares are often less liquid than theunderlying investments, whereas the unit trust manager guarantees that unitswill always be marketable (with a few exceptions, e.g. property unit trusts).Unquoted investments � Investment trusts typically have higher holdings inunquoted or unmarketable assets, for which market values are not readilyavailable.Gearing � Investment trusts are often geared, so they will have a highervolatility than the value of the underlying assets.Closed vehicle � When demand is rising for a particular investment trust,new shares cannot be created unlike in a unit trust where the manager wouldissue new units. The converse also applies when a trust falls out of favour.This creates additional volatility.

Most candidates scored well on parts (i) and (ii). In part (iii) few candidates scored well. Thebasic points that gearing and changes in the level of discount would introduce volatility wereoften made but most did not explain them sufficiently. Very few mentioned the three otherfactors at all.

7 (i) Discount rate of 8% p.a.

i(4) = 7.77% p.a.

PV variable interest rate loan = � � � �4 477 8

10,000,000 5% 7%a v a� �� = £5,096,491

PV fixed rate loan = � �415

10,000,000 5.5% a� �� = £4,846,680

Premium = £5,096,491 � £4,846,680 = £249,811

i4 0.0777

Fixed VariableAnnuity1 8.812 5.360Annuity2 3.452

PV 0.485 0.510

PV � 10m 4,846,680 5,096,491

Difference 249,811


Page 6

(ii) The bank is taking a credit risk in the event of a client default... �but the bank will only lose out if the lost future quarterly payments areexpected to be paid from the client to the bankThis risk is much more significant if the fixed rate is lower than the initialvariable rate��which is more likely if the yield curve is downwards slopingThe bank may have entered into offsetting transactions, so it will be exposedto interest rate fluctuations if the client defaultsThe calculation does not allow for the expenses of setting up a swap (e.g. legalexpenses, sale and negotiation)��nor the cost of any additional regulatory capital requiredThe bank is exposed to an interest rate risk��which the client is notThis risk can be valued using a Black-Scholes approach, or a proprietarymodelThe bank will have priced the swap based on the client�s current credit rating,and is locking into the rate for a 10 year period. This may result in capitalstrains if the client�s credit rating worsens and more capital is required to backthe swap

(i) Many candidates scored quite well here with the majority understanding the basicidea as to the cash flows involved. However, an alarming number made elementaryarithmetic mistakes resulting in odd answers which should have raised alarm bells. Afew demonstrated that they have little or no idea how to value a simple annuity!

(ii) Not well done in general. The points on credit risk, interest rate risk, expenses andmargin for profit were generally the only ones made and frequently only some of thesewere made.

8 (i)� company taxed at one rate on retained profits and another on distributed

profits� an investor is subject to income tax on the whole of distributions and

capital gains tax arising from increases in the share price.

(ii) Each investor, individual or institutional, will attempt to maximise after taxreturns and will therefore attempt to find tax-efficient investments.The government wants to encourage longer term investment, however, itwould prefer to avoid a taxation system that curtails an efficient market fromoperating

Purchase & Sales of investmentsTax on purchase of investmentsTax on sale of investmentBoth of these will discourage frequent purchase and selling of investments

Income (Dividends etc.)Income is effectively a withdrawal of value from an investment, so toencourage longer term investment the government could:


Page 7

Tax income at a higher rateReduce tax on income reinvested in same company

CapitalHigher rate of tax on gains for investment held for a short period, say a monthReducing rate of tax on gains or proportion of gains taxable depending on thelength the investment is heldReduced or deferred tax on gains where capital is reinvestedTaxing capital gains only when an asset is disposed of

(i) Most scored well here.

(ii) It seems that many candidates overcomplicated this part. Many answers developedideas designed to encourage capital investment on the part of companies e.g.encouraging retained earnings, etc. Few made the simple points re transaction taxesand stepped CGT rates. Very few introduced any ideas designed to encourage re-investment of gains or income.

9 (i) The option premium reduces the cost of raising capital.Convertible delays any dilution of the existing ordinary share capital.Conversion only occurs if the share price increases sufficiently.Interest payments on the convertible loan stock are normally made out of pretax profits, unlike dividends on ordinary shares. This may appeal to grossinvestors.Lifeco may be unable to issue additional shares because either a rights issuewould be extremely unpopular with shareholders or because it is constrainedby restrictions on the issue of further share capital.Lifeco may be constrained by restrictions that prevent it from issuing furtherconventional loan stock.

(ii) By maximising the option premium it reduces the cost of raising additionalcapital.The dividend yield is higher than the coupon rate so setting a hurdle price willdelay exercise of the convertible from the first point the price exceeds theconversion price.The limitation on when Lifeco can redeem the convertible increases the optionvalue because provided the convertible exercise conditions have been satisfiedthere is effectively a call option operating.

(iii) Assume dividends are paid annually in arrears.The optimal conversion date occurs when the price of the ordinary share firstexceeds the conversion price (�1.00 � 1.25 = �1.25)

Dividend growth rate year 1, 13%, year 2, 11%, year 3, 9%, year 4, 7%, year5, 5% and therafter 3%, assuming that a dividend yield of 3% is maintained.

Price at issue: �1.001 year �1.00 � 113% = �1.132 year �1.13 � 111% = �1.2543


Page 8

2.5 years �1.2543 � 1.09.5 = �1.3103 years �1.2543 � 1.09 = �1.3674 years �1.367 � 1.07 = �1.4635 years �1.463 � 1.05 = �1.536

The earliest we can convert is about 2.5 years when we anticipate that thetrigger price will be above �1.30, i.e. forego the dividends in the first 2 yearsand receive the coupon instead.�100 nominal of loan stock converts to 80 shares.

3 46.09% 6.09%2 6.09%

56.09%

56.09%

2.75 80*0.03*(1.13*1.11*1.09 1.13*1.11*1.09*1.07

1.13*1.11*1.09*1.07*1.05 )

80*(0.03*1.13*1.11*1.09*1.07*1.05 / 0.03)

a v v

v

v

� �

�

� �

5.035 + 8.2626 + 91.4363 = �104.73 plus option premium/time value

Assuming that conversion does not occur is equal to: �100 nominal of loanstock pays annual interest of �2.75. The value as a loan stock is:

552.75 100a v� @6.09% = �85.97

Thus, the value of the convertible loan stock will be equal to 104.73%, plus anelement of time value.

(iv) The company wants to avoid a dilution of existing share capital.It is more capital efficient to pay the invested out of pre-tax profits rather thandividends out of post tax profits.The capital loss of purchasing the bond at �101.6 and cancelling it at �100could be used to reduce the company�s corporation tax.This is akin to the company repurchasing its own shares, without theregulatory difficulty this might entail.The company believes it�s shares are undervalued

Poorly done in general. Very few candidates really grasped what was involved. This wasespecially noticeable in the very few marks gained (in general) from parts i) ii) and iv). Mostof the marks which were gained were scored in section iii) where many candidates had a goat calculating the value of the convertible. However, in many cases, these attempts wereundermined by a basic misinterpretation of the terms involved e.g. often candidates missedthe point that conversion price was 125% of the share price at issue i.e. that every £100nominal of loan stock would become 80 shares or that the dividend growth rate dropped by2% each year i.e. 13, 11, 9, 7, 5, etc.

10 Coupon/yieldCredit ratingDurationTerm


Page 9

Size of issueLiquidityCountry of originExchange traded on e.g. EurobondsType Fixed/Index linked/Hybrid

Quite well done on the whole although few achieved full marks.

11 All forms of regulation have a cost.

The aim of regulation should be to maximise the benefits and minimise cost so thatthe benefits outweigh the costs

Direct costs arising from regulation:

Administering the regulation

Compliance for regulated firms

Other economic costs of regulation:

Altering behaviour of consumers, who may be given a false sense of security�� and a reduced sense of responsibility for their own actions.

An undermining of the sense of professional responsibility amongst intermediariesand advisors.

A reduction in consumer protection mechanisms developed by the market itself.

Reduction in product innovation

Reduction in competition

A fairly standard bookwork question which was tackled quite well by the majority.

12 The investment mix and performance information of the unitised with-profit (UWP)fund unitised at any will be between 3 and 7 weeks out of date

The actual investment performance of the UWP fund will depend on:

� The actual asset mix at any point in time, and� The actual investment performance of each separately managed fund

The actual investment mix at any time will depend on the relative investmentperformance of each separately managed fund and the net inflow/outflow of moneyfrom each fund.


Page 10

To avoid very frequent trades and money movements most fund operate an accountfor everyday cash movements, for example premiums, claims and expenses, and on aperiodical basis will transfer larger amounts between the account and the investmentfunds.

The investment manager may make a tactical investment switch of money betweenindividual funds that could significantly alter the investment mix. A procedure isrequired for the investment manager to notify where money is moved into or out ofthe individual funds. This will allow the reported investment mix to be adjusted on amore frequent basis.The investment performance of each fund, and fund valuations are not known on adaily basis, so more frequent data is not available. Therefore it will be necessary toestimate the investment performance between valuations and to update theperformance when the actual investment mix and performance data becomesavailable.

The investment performance needs to be monitored on a daily basis.

The required accuracy of the fund performance estimate depends on importance of thesub-fund, and the volatility of the investment performance, i.e. there is a need to bemore accurate for UK equity that forms 45% of the UWP fund than the Cash thatforms 2% of the fund.

For each of the segregated fund the appropriate indices to be investigated andcompared with previous actual investment performance to determine appropriateinvestment performance indicators are:

UK Equities

An insurance company is likely to have a broad spread of UK equity investmentcovering both small and large companies.

Therefore the FT-SE All Share index investment performance should be investigated

It will be necessary to compare the actual investment held by the UK equity fund toFT-SE All Share in order to verify that this is a suitable index, rather than using aweighted combination of sub-indices

Non-UK Equities

This fund could hold investment in any non-UK equity. The actual investment mixby country needs to be investigated.

Available international equity indices that could be investigated include FTSE WorldIndices series and Morgan Stanley Capital International Indices series as they bothcover both developed and emerging markets.


Page 11

Based on the actual investment mix by country it is likely that no one index will besuitable, but that a weighted combination reflecting the actual distribution by countryor region will be required

It is important that the price indices and XD adjustments are in the domestic currency,i.e. already adjusted currency fluctuations.Fixed interest medium gilts

The FTSE Actuaries Government Securities UK Indices provides a series of priceindices sub-divided by term

Investigate the current holdings and amounts of those holdings and compare thesewith each category of the price indices to determine appropriate weights.

Check with the investment manager whether a short term policy switch has beenundertaken in case the investment holdings being analysed are not representative.

It is unlikely that any one index will be appropriate by itself however; gilts only formabout 4% of the whole UWP fund, so there will be less impact of a simplification touse one index that broadly represents the fund.

Property

Investigate the current holdings of the property fund to determine the level of directproperty holding to indirect property holding (property shares)

For the indirect property proportion a sub-index of FTSE actuaries share indices islikely to be appropriate

Direct property investment tends to have a stable performance over a short periodbecause valuations are only carried out only periodically for each property

Investigate the recent monthly past performance and, say calculate an averageperformance for use.

If the recent performance has not been reasonably stable because of the effect ofproperty revaluations, then a procedure for the investment manager to notify you ofsignificant property revaluations will be required.

Fixed Interest medium corporate bonds

A suitable benchmark for a bond portfolio can be more complicated because they areconstructed subject to specific constraints such as duration or credit rating.

Many different series of international bond indices are produced, mostly by brokers.The exact calculation methods and input data vary and no single series is likely to besuitable.

To estimate the fund performance between valuations it would be suitable to use thebenchmark combination of indices


Page 12

Cash and commercial mortgages

Both these funds only constitute a very small part of the UWP fund, so we do nothave to do anything too complicated.The fund performance is unlikely to be volatile for either cash or commercialmortgages, so could use the average performance from say, the pervious three months

Undoubtedly the question which caused the most difficulty in the paper. The vast majority ofanswers concentrated almost entirely on whether or not more frequent valuations werenecessary or even desirable. There were many suggestions as to what else would be done tostop selection against the office e.g. closing the fund, arbitrary MVAs, etc. and a lot ofsuggestions as to how the fund assets could be restructured so as to remove or reducevolatility, e.g. switch it all into bonds or cash!

However relatively few candidates answered the question actually asked i.e. how to providemore frequent valuations and estimates of performance especially after sudden adversemarket moves.


EXAMINATIONS













� Faculty of Actuaries301—S2003 � Institute of Actuaries

301 S2003—2

1 Describe three instruments that are used in the money markets. [6]

2 (i) Define the term equity risk premium. [1]

(ii) Describe why a change in the equity risk premium will alter the valuation ofequities. [3]

(iii) Give examples of two events that would alter the equity risk premium. [2][Total 6]

3 A major institutional investor has decided to make a direct investment in property.List the advantages of large offices relative to other types of property. [5]

4 An institutional investor has conducted an asset-liability modelling exercise, and as aresult has decided to invest a proportion of its portfolio in the Global Equity assetcategory via an external fund manager.

List the decisions that need to be made by the institutional investor with regard to thisinvestment in Global Equity (but not about the choice of fund manager). [8]

5 You are an analyst at a firm of global equity investment managers. Your firm’sapproach to stock picking is based on fundamental share analysis and your day-to-daywork involves carrying out this analysis for a particular sector of the global market.

(i) List the sources of information you would expect to use in your work. [5]

(ii) Describe the process you would expect to go through in order to establishwhether a stock should or should not be part of your clients’ portfolios. [5]

One of your stock recommendations held across all your clients’ portfolios has seen asubstantial fall in its market price over a calendar quarter. Your analysis suggests thatthe price now represents extremely good value. Based on this view, yourrecommendation to colleagues would be to substantially increase the allocation to thestock.

(iii) Suggest possible reasons for the difference between your and the market’sview of the fair price for the stock and outline the risk faced by your firm ifyour recommendation is made and adopted. [3]

You have added to your holding and the price continues to fall.

(iv) Describe briefly what actions the firm may take when reassessing the position.[3]

[Total 16]

301 S2003—3 PLEASE TURN OVER

6 List the ways in which costs can arise when an investment regulatory system isdeveloped. [6]

7 (i) Outline the process used by futures exchanges to remove the credit risk ofindividual participants. [2]

(ii) Table 1 below shows part of the operation of a margin account for a shortposition in two gold futures contracts. The initial margin is US$2,000 percontract and each contract is for delivery of 100 ounces of gold. The closingfutures prices are in US$ per ounce of gold.

Copy the table into your answer book and fill in the entries in the blankcolumns.

Table 1Operation of the margin account for two gold futures contracts.

Date ClosingFuturesPriceUS$

Daily Gain(Loss)

US$

CumulativeGain (Loss)

US$

MarginAccountBalance

US$Futures price atwhich contractis entered intoon: May 3rd 400

May 3rd 396.5May 4th 399.4May 5th 400.4May 6th 399.7May 7th 405.9May 8th 397.9

[6]

(iii) Describe briefly two major differences between the trading of currency futurescontracts on an exchange and the trading of forward currency contracts in theOver-the-Counter (OTC) market. [2]

[Total 10]

8 (i) Write down a formula for the after tax return for an investment whosedividend is d and capital gain is g. [1]

(ii) State any assumptions that you have made in this formula. [1]

(iii) Describe what other factors an individual will need to take into account inpractice to determine his after tax return. [3]

[Total 5]

301 S2003—4

9 An open-ended investment company (OEIC) invests the capital of its shareholders in aportfolio of not less than twenty bonds issued by US companies that have a MMM,non-investment grade, credit rating. All bonds are denominated in US Dollars. Onaverage, five percent (5%) of bonds with a credit rating of MMM default over a12-month period. The share price of the OEIC is always equal to its net asset valueper share.

Over the last five years none of the bonds held by the OEIC have defaulted and theshare price of the OEIC has increased by 14% per annum compound with a standarddeviation of return of 5% per annum. Over the same period the risk-free rate ofinterest has been 4% per annum.

(i) State the formula for and calculate the Sharpe ratio for the risk-adjustedperformance of the OEIC over the last five years. [2]

Over the same period, an index of US government bonds and an index of MMM-ratedUS companies gave total returns (capital growth and income) of 8% and 2% perannum respectively. Both of these indices are made up of about twenty bonds whichhave a similar coupon and maturity profile to the OEIC’s portfolio.

(ii) Suggest reasons why the investment company’s portfolio has out performed:

(a) the US government bond index and(b) the index of MMM-rated US companies.

[4]

(iii) Discuss the usefulness of the Sharpe ratio in assessing the risk-adjustedinvestment performance of this manager and comment on the skills of themanager of the investment company’s portfolio. [5]

[Total 11]

10 A city in a developing country is contemplating bidding to host the Olympic Games in2016. History shows that the costs involved in hosting such events have been muchgreater than expected. Your merchant bank has been asked to advise the committeeoverseeing the bid.

(i) Outline the procedure you would adopt in establishing the feasibility of the bidby the city. [8]

(ii) List the risk factors you would include in your risk matrix. [4]

(iii) Describe briefly the ways in which the bid could be financed and the factorsthat need to be taken into account. [5]

[Total 17]

301 S2003—5

11 Following the death of a relative, you have inherited a sum of money worthapproximately five times your net annual salary. Your personal circumstances are asfollows:

� You are working and belong to an occupational pension scheme.� You have ten years to work before normal retirement.� You are married with no children.� You are a home owner with an accompanying mortgage.� Your mortgage has five years to run and currently monthly mortgage payments

amount to around one-third of your net monthly income.� You have cash savings amounting to approximately one year’s net salary.� You use credit and store cards to manage cash flow on a monthly basis.� You are in good health but have for some years taken part in a private healthcare

scheme.

(i) Using the details above and stating any additional necessary assumptions,describe your liabilities and your assets excluding your inheritance. [4]

(ii) Comment on the degree of matching between the two. [2]

(iii) Suggest possible uses for your inheritance commenting briefly on thesuitability of the various options. [4]

[Total 10]


EXAMINATIONS

September 2003


EXAMINERS’ REPORT

Introduction The attached subject report has been written by the Principal Examiner with the aim of helping candidates. The examiners are mindful that a number of interpretations may be drawn from the syllabus and Core Reading. 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. The report does not attempt to offer a specimen solution for each question — that is, a solution that a well prepared candidate might have produced in the time allowed. For most questions substantially more detail is given than would normally be necessary to obtain a clear pass. There can also be valid alternatives which would gain equal marks. J Curtis Chairman of the Board of Examiners 25 November 2003 © Faculty of Actuaries © Institute of Actuaries


EXAMINATIONS

September 2003


EXAMINERS’ REPORT

© Faculty of Actuaries © Institute of Actuaries


Page 3

Candidates appeared better prepared than has been the case previously and as a consequence we had a higher pass rate. Bookwork was done reasonably well but poorer candidates are still unable to apply the theory to problems and even fewer appear able to draw implications and conclusions out of results. We continue to be concerned that candidates do not answer the question set. A good example of this was Q3 where candidates were asked for “advantages” but many gave us a mind dump of all they knew about property investment. Whilst they invariably pick up a number of points, the amount that candidates write and the time taken to answer such a question could be put to better use. 1 Any three of the instruments given below are acceptable. Deposits — The simplest of all money market instruments. In the deposits market

banks simply take and lay off deposits from each other. The market is liquid over a wide range of maturities, although primarily less than one

year. Treasury Bills — A treasury bill is a promise to repay a set sum of money by the

treasury at a specified date in the future, normally not longer than 91 days.

T bills are issued by way of auction and trade a discount to their face value. They are not part of the Government’s funding programme per se but are much more

an instrument of monetary policy.

Bills of Exchange — A bill of exchange is an instrument which is drawn and issued by the seller of goods to the buyer, specifying the amount to be paid, either immediately or at some point in the future.

Once the bill has been accepted by the buyer the bearer of the bill is entitled to the

proceeds at maturity. The accepted bill may then be discounted provided the purchaser is willing to take on

the credit risk of the bills acceptor, which is the promise of repayment. Commercial Paper — is a promissory note issued by a company at a discount to the

face value with maturities normally up to twelve months. It may be issued via the auspices of a bank guaranteed programme or directly into the

market. Certificates of Deposit — it is, in effect, a securitised bank deposit. They carry a fixed coupon rate and have a maturity of up to five years. Like any other security, the certificate can be traded enabling the deposit holder to

realise the deposit through the sales proceeds and not by withdrawal.


Page 4

Short Term Gov Bonds — With their status as a relatively risk free investment the money markets also trade in short term (usually less than five years) Government bonds.

The Government is the issuer and the bonds usually pay a twice yearly coupon, they

are highly liquid. Floating rate notes — which are linked to the short-term money markets and are

widely traded. They are issued highly rated corporates, usually banks since they carry very limited

credit risk.

This was bookwork and candidates scored reasonably well. 2 (i) The equity risk premium is the extra return that the overall stock market or a

particular stock must provide over the rate of a risk free asset, normally treasury bills, to compensate for the additional risk being taken.

(ii) The equity risk premium is used in the calculation of the weighted average

cost of capital (WACC) for a stock. The WACC is given by ke*E/V + kd*D/V The cost of equity is given as ke = kf + β*(km − kf) Therefore when the equity risk premium, km − kf , rises so does the WACC. The WACC is used in discounted cash flow valuations, the higher the WACC

the lower the valuation, therefore increasing the equity risk premium increases the WACC and thus decreases valuations. The converse is true for a fall in the equity risk premium.

(iii) Any two reasonable events that would change the risks associated with

holding equities in general or a particular sector are acceptable including terrorism, major accounting scandals, oil crises, war etc.

In hindsight this question might have been better phrased to point candidates to the sort of answer shown in the solution. However marks were given for more general answers. It was, however, a concern that candidates generally went for low-key events rather than shocks in answering (iii). 3 They can be purchased in large units. Rental income tends to be secure as rents normally represent a small part of the

tenants’ outgoings.


Page 5

There is a wide range of prospective tenants, with no concentration on any particular industry.

Many large offices are multi-let. This spreads the risk of tenant default… …and helps provide comparable evidence in the rent review process. For offices in large towns there are usually comparable properties for the purpose of

reviewing rents. A typical 25 year institutional lease has 5 yearly “upward only” rent reviews. When let to a single tenant on a full repairing and insuring lease, management costs

are relatively low (must have both first and second parts of sentence to score marks — no marks for only part of the answer)

There is a wide range of different properties available. Precise location not critical… …so long as easily accessible by car and public transport. Bookwork, but see comment in introduction. 4 Choice of benchmark. Need to decide whether benchmark should be a market cap index benchmark… …such as FTSE All World or MSCI World… or a regional composite benchmark… …which takes for example equal weightings in the regional markets of North

America, Europe, and the Far East The proportion of domestic equity in the Global mandate must be decided… This could be 0% if a separate domestic equity mandate is to be managed… …or set at a larger percentage of the total mandate if a higher proportion of domestic

equity than implied by the choice of benchmark is required Need to decide whether to include Emerging Market Equity within the Global Equity

mandate… …because often a Global Equity mandate is taken to mean Developed World only Purpose of allocation (match liabilities or investing excess over liabs.) And the extent to which the fund manager will be permitted to diverge from the

benchmark in terms of region, or country, or sector, or stock. Need to consider style (value, growth, large/small cap, passive/active etc.) Regional/sector approach This was a more poorly answered question. Some candidates failed to accept that the decision had been made and the question was about issues of pre-implementation. 5 (i) Company accounts Company trading statement Visits to company Management meetings Financial press Trade papers Competitor intelligence


Page 6

Stock broker papers Stock exchange information Government sources of statutory information (ii) Your role will involve stock analysis within your sector. Additionally, you

will be involved in assessing the prospects for your sector within the overall economy.

You will attempt to establish whether a stock is, according to your analysis,

under or over valued by the market. Part of the assessment will involve construction of a model to help estimate

future cashflows in earnings. Your success will depend upon the quality of your model and the quality of the data that goes into the model.

The modelling process will deliver data on a variety of financial features of

the company and its market place. This will help identify the key drivers to profitability.

Further analysis can then be targeted at the most important areas. Cashflow analysis can be used with economic projections to assess the

robustness of the profit stream. The output will be an indication of the fundamental value of a share given

your assumptions and input data. (iii) Potential for Differences Model — No model can expect to be perfect. A subtle but important feature

might be missing or not working properly. Input Data — The model can be only as good as the information on which it is

based. Again, something might be missing or incorrect. Assumptions — Even the perfect model would give a share value different to

that of the market if assumptions about future inflation, required rate of return or perceived level of risk are different to market expectation.

The risk for your company of continuing to increase exposure to the

underperforming stock is essentially the risk of you being wrong and the issues associated with the underperformance that would arise.

(iv) Ask another analyst in the firm to review the stock and make a

recommendation. Cut your losses, sell the position and put it down to experience. Seek a meeting with the company’s management to discuss the share price

weakness and what plans they may have to address it.


Page 7

Examine if any derivative options are available to add value.

A number of candidates were unable to set out the day-to-day work of an investment analyst. Whilst (i) was bookwork and reasonably done, (ii), (iii) and especially (iv) were poorly answered overall. One or two candidates did, however, give very full answers. 6 Direct costs arise in administering the regulation and in compliance for the regulated

firms. Other economic costs can arise:

• an alteration in the behaviour of consumers, who may be given a false sense of security and a reduced sense of responsibility for their own actions

• an undermining of the sense of professional responsibility amongst intermediaries and advisors

• a reduction in consumer protection mechanisms developed by the market itself • reduced product innovation • reduced competition • education • development of additional administration systems • cost of government regulation

Thankfully most candidates appear to have studied the regulation units well and gave reasonable answers to this question. 7 (i)

• When two traders deal, a contract is created. • The floor traders acting for the parties involved fill out clearing slips. • The clearing slips are matched by the exchange. • Details of the trade are registered with the exchange’s clearing house. • In turn the clearing house guarantees each side of the original bargain.

(ii) Award 1 mark for getting the correct amount of initial margin $4,000. Table 1

Date

ClosingFutures Price US$

Daily Gain (Loss)

US$

Cumulative Gain (Loss)

US$

Margin Account Balance

US$ Futures price at which contract is entered into on: May 3rd

400

4000 May 3rd 396.5 700 700 4700


Page 8

May 4th 399.4 −580 120 4120 May 5th 400.4 −200 −80 3920 May 6th 399.7 140 60 4060 May 7th 405.9 −1240 −1180 2820 May 8th 397.9 1600 420 4420

(iii) In the forward foreign exchange markets, contracts can be tailored by the

investment bank to suit the needs of the client in terms of maturity date, contract size, choice of currencies, etc.

In the futures markets currency futures contracts are standardised as to

maturity date, contract size, currency pairs, etc. In the OTC market participants need to pay much closer attention to credit risk

than participants in the currency futures market where at least some1 participants have the guarantee of the exchange clearing house.

(i) The use of the word “process” in this question appears to have caused some confusion to candidates. Many wrote about margin etc. rather than the mechanics of the market. (ii) Was done reasonably although common mistakes were to use only one contract and one ounce of gold. Also some subtracted when they should have added. Such mistakes were only penalised once and so only a couple of marks were lost on this section. (iii) Was reasonably answered although a number of candidates did get the differences back to front.

1 Only general clearing members of the exchange get the guarantee of the exchange clearing house. All other participants are dependent on their futures broker for performance of the contract.


Page 9

8 (i) r = d*(1 − ti) + g*(1 − tc) (ii) d and g are assumed to be dividend yield and capital return as a percentage of

initial investment respectively d is assumed not to be re-invested if payments have occurred during the period

(iii) The overall tax system e.g. tax rates and exemptions. Particular rules for individual types of asset The investor’s own status (individual or particular type of institution). The investor’s financial position. The tax efficiency of the vehicle used to hold the assets. To what extent losses or gains can be aggregated between different

investments or over different time periods for tax purposes. Whether the tax is deducted at source or has to be paid subsequently.

The extent to which tax deducted at source can be reclaimed by the investor (i) and (ii) were straightforward with reasonably good answers being given. (iii) was poor with answers not focusing on specifics. 9 (i) The formula is S = (Rp – r)/σp. The Sharpe ratio is (14 − 4)/5 = 2. (ii) (a) Except in times of stress in credit markets, one would expect the return

on a portfolio of corporate bonds of this credit rating to give higher returns than a similar portfolio of government bonds for credit risk and liquidity reasons alone.

(b) In relation to the MMM-rated corporate bond index, the manager

seems to have been particularly good at avoiding MMM-rated companies that defaulted and at picking up the higher yield on those that did not default.

(iii) None of the bonds held by the company has ever defaulted. If one of the

bonds had defaulted and if it had no recovery value, then the fund could lose up to 5% of its value.

As the company has not experienced any defaults the standard deviation is not

really a good measure of the risk of the company’s risk. The Sharpe ratio is likely to fall substantially if the investment company were

to experience a default on one of the bonds in its portfolio.


Page 10

On average, the manager should have had at least five (at least 1 per year of exposure) defaulting bonds in his portfolio over the five-year period.

Either the manager has been very lucky or he is very skilful at choosing

MMM-rated corporate bonds that don’t default. While most candidates could write down the formulae, (ii) and (iii) were good examples of candidates being unable to explain results and comment upon them. Where candidates found themselves under time pressure, we suspect that this was the question left to the end. 10 (i) Order to determine the feasibility of the Olympic bid the process should be

divided up into a number of steps: Step 1 Make a high-level preliminary risk analysis to confirm that the bid does not

obviously have such a high risk profile that it is not worth analysing further.

A clear risk is that the finance cannot be raised The government may decide that the capital required is too great to justify

politically. It would be important to determine where the finance was likely to come from

and who would be managing the process. Who would pay for the initial bidding costs in the event that the bid were

unsuccessful? Step 2 Hold a brainstorming session of project experts and senior internal and

external people who are used to thinking strategically about the long-term. The aim will be to identify project risks, both likely and unlikely, …to discuss these risks… …and their interdependency,… …to attempt to place a broad initial evaluation on each risk,… …both for frequency of occurrence… …and probable consequences if it does occur,… …and to generate initial mitigation options and discuss them briefly. Step 3 Carry out a desktop analysis to supplement the results from the brainstorming

session,… …by identifying further risks and mitigation options,… …using a general risk matrix,… …researching previous Olympic bids and the problems that were encountered.


Page 11

…and obtaining the considered opinions of experts who are familiar with the details of the project and the outline plans for financing it.

Step 4 Carefully set out all the identified risks in a risk register,… …with cross references to other risks where there is interdependency. Step 5 Ensure that upside risks as well as downside risks are covered. A risk matrix could be used for the above purposes… …with column headings relating to the cause of risk… …and the rows relating to the risks in successive stages of the project (ii) Items that should be included in the risk matrix: 1 Mark for each risk, maximum 8 marks. Is climate suitable for the games? Does the City have a pollution problem? Can the City’s infrastructure cope with the massive inflows? Is the Government keen to see the City win? Can security issues be addressed? The attitude of the international community towards the country. Will the time zone of the country mean that all the major TV networks are less

interested? Are the local population likely to be interested? Will the facilities be used after the games? Natural disasters (earthquake, volcanic eruption etc.) (iii) To answer this part one needs to consider by whom and how the project might

be financed. In terms of who might finance it, the following might do so:

• government • local authority/city council • sports bodies • private finance/venture capital • public company • a combination of the above

How it can be financed is by:

• tax revenue/borrowing by government • local tax/borrowing by council/city • loans (secured or unsecured) or mortgages


Page 12

• debentures • equity capital • combinations of the above

One needs to look at the income sources, the outgoings and the end usage to

which facilities might be put. Not just the stadiums but accommodation (the athletes’ village) and new transportation links need to be considered.

Different costs might be financed in different ways. i.e. the infrastructure could be built, used and then transferred to a sports body or company with them putting up the finance (PPI).

Government might build transport links because it suited their long-term

development plans.

A university might like the accommodation and other facilities after the event and so be interested in being a partner in the project.

This is a routine bookwork questions and candidates scored well on it. However (iii) was not as well answered as we would have hoped with few candidates being able to articulate more than a few ways. 11 (i) Assets The house is part owned and may well represent a valuable real asset. Value

will be heavily dependent on desirability of property and also local/national housing market.

Pension provision is partially funded. This may be a defined benefit or

defined amount of money invested on your behalf. The cash savings represent a further asset with future interest a likelihood. Future income is an asset. This could be assumed to be a non-decreasing

stream up until retirement at which point it will probably drop. The insured healthcare is an asset which will demonstrate “piece of mind”

value at all times and actual value in the event of qualifying ill health. Liabilities The outstanding mortgage debt repayment is a liability for the next five years.

Payments may be at a fixed rate or variable. Depending on the contract, final payment may clear the debt or trigger a demand for further loan repayment (perhaps to be settled with cash).

All future living expenses (including pension contributions if required) are a

liability and will be real in different ways.


Page 13

The healthcare premium is a liability although the policy would be likely to be

renewable with the option to cease payment. Store card debt could create additional liability if delayed payment led to

interest being incurred. Tax (income, inheritance) should be factored into the liabilities as appropriate

and any tax relief added on to the assets. (ii) Real income stream can be considered to be some sort of match for real

expenditure stream. Close matching is not possible. Income will move with pay policy of

employer or pension terms in retirement whereas variety of inflationary features impact on expenditure (price inflation, interest rate movements, insurance premium inflation).

The mortgage repayments may well deliver final loan settlement. If further

repayment were required, other assets held (potentially the cash or cash generated by moving house) would need to be used for payment.

(iii) The investor would have to consider their attitude to risk. A low risk investor

might seek to match out liabilities as far as possible (e.g. paying off mortgage as soon as practical and then investing for retirement income).

A more aggressive investor might weigh up the opportunity cost of any money

used now to deflect liabilities and choose to invest instead if the expected return was attractive (e.g. investing in new assets if expected return exceeded mortgage rate).

Regardless of the extent of the liabilities paid off, gearing investment to likely

retirement date (normal or early) would probably be desirable in order to reduce impact of drop in income. A phased move from higher risk/higher expected return assets (e.g. equities) to low risk, lower expected return assets (e.g. bonds) over the period to retirement might be suitable.

Other factors to consider include:

• Tax position (the need to potentially pay inheritance tax/income tax) • The desire to invest in tax efficient investment products • Tax rate may drop by virtue of reduced earnings on retirement • The amount of money available to invest (may preclude direct investment) • The costs associated with investing

This question was well answered and unlike in other questions, solutions were well set out and covered most of the points outlined in the solution. There were additional suggestions to those set out in (ii), some of a more flippant nature, such as blowing it on a world cruise, which received marks provided they were suitably commented upon.


EXAMINATIONS

20 April 2004 (am)

Subject 301 Investment and Asset Management



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.




Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this question paper.

In addition to this paper you should have available Actuarial Tables and your own electronic calculator.

Faculty of Actuaries 301 A2004 Institute of Actuaries

301 A2004 2

1 You are an institutional asset manager domiciled in a developed country.

(i) State with reasons the risk factors you would consider before investing in a Government Bond issued by your country. [6]

(ii) State with reasons what additional risk factors you would consider when investing in emerging market debt. [6]

[Total 12]

2 A portfolio comprises the following assets:

European equities to the value of 750m.

European bonds to the value of 650m.

Cash (including margin account) to the value of 150m.

350 short contracts of Dec 04 UK FTSE100 Index Future currently priced at 4225.

150 long contracts of Dec 04 UK Long Gilt Future currently priced at 106.11.

Calculate the effective fixed income, equity and cash proportions of the fund. [4]

3 You work in the investment team of a life insurer which holds a large portfolio of investments. As part of a diversified property portfolio, you own an industrial unit with office space. The property is occupied by a single corporate tenant.

As part of the rent review process, the tenant has asked for a rent reduction suggesting 80% of the current rent should be paid.

(i) Describe the key features of industrial and office properties. [4]

(ii) Discuss four different options you have, commenting on the financial viability for each of the options. [8]

[Total 12]

4 (i) Describe how the principle of the actuarial control cycle applies to the investment management of a fund. [3]

(ii) Describe the different levels of monitoring you would put in place in order to ensure the arrangements remained appropriate. [3]

[Total 6]

5 (i) Describe what is meant by an Over the Counter (OTC) option. [2]

(ii) Describe the different ways in which a futures exchange could manage its credit exposure. [8]

[Total 10]

301 A2004 3 PLEASE TURN OVER

6 (i) Describe briefly the method by which weighted arithmetic capital indices are constructed. [2]

(ii) Comment on why the current practice of index construction has moved to reflect the level of free float of shares available for purchase. [2]

(iii) Outline two other methods of constructing indices. [4] [Total 8]

7 Outline the issues you would need to consider in developing an investment strategy for each of the following investors:

(a) Contributions to a personal pension plan fund.

(b) The reserves of a general insurance company.

(c) The reserves of a large multi-national pharmaceutical company that has just raised a large sum through a rights issue for future product research and development.

(d) The $70 million investment portfolio of a wealthy family.

(e) A charity. [15]

8 A researcher has compiled a data set showing the annual returns (inclusive of dividends) of the stock market in a developed country for each calendar year starting in 1903 and ending in 2002 (both the calendar years 1903 and 2002 are included in the data set). The range of returns for the overlapping 20-year periods in the data set runs from 4.5% to 15.6%. It has been suggested that you can use this data to forecast future 20-year returns.

(i) Comment on the difference between the numerous overlapping and five non-overlapping periods as forecasts of future returns from the equity market for 20-year periods. [1]

(ii) Comment on using the non-overlapping 20-year periods to test the statement Equities always give a positive return in the long term where 20 years is

regarded as long term . [3]

(iii) Outline the main factors that influence equity returns. [3]

(iv) The researcher has discovered that this market has delivered higher returns with lower volatility than all of the other major developed markets in the world over the period from the start of 1903 to the end of 2002. Discuss the implications of this finding of the researcher for the statement in part (ii) again assuming that 20 years is regarded as the long term . [8]

[Total 15]

301 A2004 4

9 The trustees of a charity whose assets have a market value of £1 billion have directed that 60% of the fund be invested in equities tracking the FTSE Actuaries All Share Index and 40% be invested in bonds tracking the FTSE Actuaries All Stocks Bonds Index (the benchmark indices).

During 2003, the fund manager believed that equities would perform better than debt as growth prospects for the UK economy were improving. Hence at the start of the year he placed £800 million in equities and the balance of £200 million in short bonds. He reinvested dividends and coupons in the respective sector as soon as they were received. New money was invested in the ratio of 80:20 for equities and debt. The following data has been provided.

FUND VALUE Net contribution received from Date Equities Short Bonds charity at the beginning of the quarter

1/1/03 800 200 +200 31/3/03 885 230 +180 30/6/03 1,030 245 100 30/9/03 1,000 230 150 1/1/04 1,150 275

Benchmark Returns (% per quarter) Return Equities Bonds Bonds

(income reinvested) all stocks <5 years

Q1 10.0 9.0 5.0 Q2 2.0 15.0 8.0 Q3 5.7 3.0 +2.0 Q4 3.5 2.0 +6.0

(i) Calculate money weighted and time weighted rates of return for the overall fund in 2003 stating any assumptions that are made. [4]

(ii) For each quarter allocate the difference between the fund s rate of return and the return on the benchmark between:

(a) that which is attributable to stock selection; (b) that which is attributable to asset allocation; and (c) that which is attributable to bond duration selection. [11]

(iii) Give brief comments on the performance of the fund manager. [3] [Total 18]

END OF PAPER


EXAMINATIONS

April 2004


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.

J Curtis Chairman of the Board of Examiners

5 July 2004


Subject 301 (Investment and Asset Management) April 2004

Examiners Report

Page 2

The number of candidates was significantly higher than at previous examinations. This is likely due to the change in syllabus next year. Unfortunately many of the candidates who presented themselves were not well prepared as is evidenced by the high level of FB results at almost one third of the candidates who sat.

The examiners also have to apologise for setting a question that was not fully covered by core reading. Question 2 asked candidates to value a fund that had derivative contracts as part of its investments. Core reading does not cover contract sizes explicitly, this being covered in 401. As a consequence candidates were not able to value the derivatives. To offset this, the pass mark was reduced by 4 marks in effect excluding the question. However candidates who made an attempt at it gained marks for method and these were included in their overall marks. We received comments that the exchange rate had also not been given for £/ . The examiners believe that candidates should have a basic knowledge of current exchange rates for major currencies just as they would know current interest rates.

The solutions supplied should not be viewed as being totally comprehensive. Many questions, especially those involving bookwork, do have additional points for which marks were awarded.

In terms of each question the following comments will hopefully help candidates.

Q1. The examiners are looking for candidates to frame their answers to each part of the question, outlining specific points. Many answers are not well framed and appear to be brain dumps rather than showing to the examiners that the candidate understands the topic.

Q2. This has been commented upon above. Showing method was worth up to 2.5 marks.

Q3. Part (i) was done well. In (ii), whilst the options were listed by many, the financial implications were not so well covered and cost candidates marks.

Q4. This question was in the main well answered. Where marks were lost it was normally for failing to articulate all aspects of monitoring.

Q5 & Q6. Both were well answered.

Q7. Candidates did not do well on this question mainly because they did not apply knowledge. Points were often listed that needed to be considered but solutions were not framed in relation to appropriate strategies for each type of portfolio. Part (d) was one of the best examples where candidates appeared not to believe that a family portfolio of $70 million was large and framed answers in terms of assets and liabilities for a average individual client rather than for one for whom normal liabilities are likely to be a very small consideration. Part (e) was also not well done with protection of capital and income constraints seldom mentioned.

Q8. This question was poorly answered as candidates appeared not to think deeply enough about the issues raised especially for (iv). Part (i) was reasonably straightforward and answers reflected this. In (ii) answers failed to cover the wider implications whilst in (iii) explanations were weak on detail.


Examiners Report

Page 3

Q9. Part (i) was done reasonably well with candidates knowing the formulae and able to apply them. In (ii) candidates produced formulae but failed to explain them appearing to assume that the examiners knew the notation being used. We have discovered that the notation is used in ActEd tutorials and material. However it is not the same as that used in core reading and the examiners do not access ActEd material. We would council candidates to use either formulae that are fully outlined in core reading or preferably even when using such formulae to provide definitions. Answers to (iii) were mixed but those who scored well in (ii) tended to collect good marks for (iii). In marking this question marks were awarded for method as much as correct answers. Thus showing how to calculate the first quarter s analysis earned about 65% of the available marks. Any arithmetic errors were taken into account in subsequent quarter calculations.

1 (i) The factors that should be considered when investing in a Domestic Government Bond are:

Interest rate risk Reinvestment risk Inflation risk Yield curve risk

The interest rate risk and the reinvestment risk relate to changes in interest rates. If interest rates change then bond prices will move in the opposite direction, similarly if interest rates change then the rate on reinvested income will also change.

Inflation risk unexpected inflation will result in the purchasing power of the payments received being reduced, it may also result in interest rates rising thus reducing the value of the bond.

Yield curve risk, if the shape of the yield curve changes then this might result in the price of the bond changing, changes in the shape of yield curve may be brought about by either changes in the supply or demand for bonds at differing maturity dates or by changes in the market s view of future interest rates.

(ii) The additional factors which should be considered when investing in an emerging market Government Bond are:

Credit risk Default risk Spread risk Downgrade risk

Exchange rate risk Liquidity risk Political risk Event risk Inflation risk CPI or RPI benchmark


Examiners Report

Page 4

While the above may also be pertinent to the Domestic Bond market, they are in the main likely to have negligible impact on the decision to invest.

Credit Risk this can be divided into three separate headings:

Default risk this is the risk that the Government in question defaults on its obligations; this has occurred in the past either through economic collapse or a change of Government.

Spread risk this reflects the risk of default of the Government and represents the extra return an investor requires over treasury bonds to compensate them for the extra risk. This spread may change and result in either a profit or loss for the investor.

Downgrade risk if a rating agency such as S&P or Moodys downgrade a country s bonds then the price is likely to fall; these agencies will downgrade if they feel there is an increased chance of default. Equally they may upgrade a country s bonds if they feel that the country s economy has improved.

Exchange risk this is simply the risk that the exchange rate between the investor s domestic currency and that of the emerging market will change thus resulting in a profit or loss on the bonds held.

Liquidity risk this relates to the ability or inability of the investor to convert the bond into a known amount of cash at short notice. This ability may change over time and will depend on the size of the issue and its popularity.

Political risk as mentioned previously there may be a change in Government and the new Government may be unwilling to honour the obligations of the previous Government regardless of its ability to pay.

Event risk there are many events that may cause a country to default on its payments, a devastating earthquake or famine or floods may severely damage a county s economy, a revolution may bring to power a Government who no longer wants to honour its obligations.

Inflation the reliability of the CPI/RPI may create an additional risk over normal inflation risk

2 UK FTSE short has value = 350*10*4225*1.5 = ( 22.2 million) UK Gilt long has value = 150*100,000*1.0611*1.5 = 23.9 million Total value portfolio = 750 + 650 + 150 22.2 + 23.9 = 1,551.7 million Cash = 9.7%, Equities = 46.9% and bonds = 43.4%


Examiners Report

Page 5

3 (i) Offices

Leases are typically long-term, full repairs/insuring and have five year upward only rent reviews.

Wide range of prospective tenants in different industrial sectors and building often multi-let. This serves to control void risk and provides comparability when setting rent.

Location must be convenient for staff and customers but precise location not as important.

Rent will typically be a small proportion of the tenants outgoings. Obsolescence can be a problem if pace of modernisation slips

Industrial

Precise proximity to labour and communications network is important.

Often industry/tenant specific leaving property vulnerable to rental void.

Can be built relatively quickly and cheaply.

Usage can mean more rapid obsolescence/deterioration.

Rent likely to be more significant part of tenants outgoings.

On the whole, offices lowering yielding than industrial

(ii) Sale at reasonable price unlikely to be an option if rental dispute not resolved.

Similarly, redevelopment (given significant costs/further investment) very much a last resort option when other negotiated solutions have failed.

Option to accept the proposal (or a negotiated compromise) on the basis that not to do so could lead to rental void (tenant moves or goes out of business) and subsequent increase in management costs and fees.

Rental reduction could be agreed to alongside space reduction. Although industrial property is unlikely to be immediately useable by a new tenant, the offices could be sub-let.

Different levels of rental income cashflows can be discounted and compared with any potential sale proceeds.

Income should be adjusted for outgoings and management costs and assumptions made about potential future rent increases/decreases.


Examiners Report

Page 6

The discount rate is likely to be set by reference to bond yields adjusted for risk of void.

Potential splitting of tenancy likely to be positive move in terms of controlling risk.

Discussion with tenant on longer term viability of own business model given request for rent reduction is vital. Macro and micro economic analysis should be brought out in these discussions, particularly if new tenant likely to be required.

Local knowledge of property expert (supplemental to in-house team) likely to be helpful when discussing future rental levels and potential sale prices. Local comparisons will be required as well as national examples perhaps drawn from own portfolio.

Redevelopment option would have to be assessed in the first instance by reference to local property developments and/or own in-house resources.

4 (i) The diagram below represents the actuarial control cycle as applied to institutional investment arrangements.

(ii) Monitoring should be focused on the different decision points in the cycle to ensure departures from targeted outcome identified and assessed.

This should incorporate regular assessment of whether objectives remain right for the current and expected future situation.

Specific areas to address include:

Building a structure of the different types of investment

manager that best fits the long term strategic asset allocation

Select suitable and high quality investment

managers to operate the strategy and structure

defined.

Regular monitoring of all arrangements in place relative to the

objectives

Setting clear objectives

Agree a long term strategic asset

allocation


Examiners Report

Page 7

At the investment manager level: quarterly performance and risk monitoring qualitative analysis on investment managers staff capability and house methodologies

At the manager structure level: analysis of suitable manager types (value/growth, large/mid/small cap, active/passive) dialogue/judgement required on whether overall balance still appropriate.

At the strategic level: risk assessment on degree of matching between assets and liabilities and judgement/dialogue on whether still acceptable. Regular pro-active assessment on whether there are new asset classes that should be considered further.

5 (i) An OTC option is a privately negotiated derivative contract offered by dealers directly to end-users.

(ii) The exchange protects its credit exposure to participants in several ways.

Trades can only be cleared by members of the exchange with clearing status. Clearing status involves authorisation, having certain minimum capital and operational standards.

Institutional investors, corporates and individuals who wish to effect futures transactions must have their trades cleared by members of the exchange with clearing status.

Clearing members of the exchange must pass on at least the initial margin requirement and the variation margin calls to their client. They can of course pass on higher margin requirements.

The exchange imposes initial margin requirements on clearing firms (and hence their clients) as part of the procedure of entering into a futures contract.

Typically, the initial margin requirement would provide the exchange with sufficient capital (usually with 99.5% certainty) to weather an adverse price movement in the futures contract in the event of a client/clearing member defaulting.

The credit exposure of the client/clearing member to the exchange varies with the value of the futures contract. E.g. where the client has a short futures contract on the FTSE100 index and the index rises, the client s exposure to the exchange via the clearing member increases.

Variation margin is also required where the initial margin falls below a threshold specific to the contract. This provides collateral movement from the client to the exchange that varies the credit exposure of the client/clearing member to the exchange.


Examiners Report

Page 8

Price movement limits allow the exchange to suspend trading in a contract if its price moves up or down by more than set limits. Such limits allow the exchange to limit its credit exposure to clearing members/clients in the event of sudden moves in the price of the futures contract.

The margin requirements for speculators may be different to those for hedgers as speculators may not have the underlying assets to deliver.

Exchanges usually reserve the right to increase the margin requirements if they deem it fit.

6 (i) The general formula is from Unit 12.

(ii) Not all shares are freely available for purchase with some being held for long term strategic/business reasons.

Including these shares within an index can lead to distortions in the performance analysis, complications for index trackers and other problems.

(iii) Unweighted/ GDP weighted/ geometric would be acceptable. Appropriate formulae required.

7 (a) The investment objective is to create as large a fund as possible on

retirement

although as retirement approaches some defence against the possibility of falling interest rates is also desirable. So likely strategy would involve investment in equities (and possibly bonds as well for diversification), transferring into long-dated gilts as retirement approaches. The key issues should centre around finding the optimum time to begin transferring

and how regularly to transfer

and in what proportions of the fund.

(b) Being able to set competitive premiums can depend on achieving a good investment return on reserves

so the highest return is required

subject to risk of technical insolvency and maintaining adequate liquidity.

Investment strategy will be a diversified investment strategy using asset types permitted by solvency technical regulations. The key issues should centre on producing probabilities of insolvency from various combinations of assets.


Examiners Report

Page 9

(c) The shareholders will not want to see the money that has been raised invested in any risky investments as it has been raised for a clear function for new product R&D

yet the company will want to work the money as hard as possible since

some of it may not be spent for some time

So the strategy is likely to entail investment in safe, short dated cash instruments. The key issues should centre around the probability of capital loss

as more risky investments (e.g. corporate bonds) are considered in order to raise return

(d) This portfolio is likely to have no liabilities, restrictions or objectives to concern itself with

other than to aim for a very well-diversified investment strategy... to deliver the highest possible return

It can consider investing in all asset types. The key issues should centre around correlation between asset types

and the risk/return payoff of those asset types. Absolute returns likely to be preferred.

(e) Charities generally have capital that they wish to maintain

while aiming to pay their costs and do their charitable work from donations and the cash flow generated by the capital. Hence investment in investment grade

bonds suggests itself as a basic strategy The key modelling investigation should centre around the probability of capital loss as proportions of high income non-investment grade bonds and/or high income equities etc are added to the portfolio.

8 (i) The overlapping periods are not independent (whereas non-overlapping periods are independent) and therefore lead to unreliable estimates of the 20-year mean return.

(ii) The sample size (5 non-overlapping periods) is too small to use in the development of reliable estimates of future 20-year returns from equities.

The range of 20-year returns developed from the 5 independent 20-year periods is likely to understate the spread of returns that one might see from this market over 20-year time periods in the future.

It is quite possible that there could be 20-year periods in the future, which produce negative returns.

(iii) expectations of future corporate profitability value of those profits real interest rates and inflation perception of riskiness of equities level of real economic growth


Examiners Report

Page 10

supply and demand taxation attractiveness of alternative investments

(iv) Investors tend to diversify their equity portfolios across a number of major markets to reduce risk through lack of correlation.

20-year returns in other major developed markets were found by the researcher to be lower than in this market

and if the volatility of returns is also higher

then lower returns and higher volatility will increase the chances of negative returns over 20-year periods.

As the chances of positive returns over the long-term (20 years) look less likely in an international portfolio, equity returns look less and less attractive to the long-term (20-year time horizon) investor unless there is a significant reduction in the correlation of returns between the major developed markets in the future.

Investors may therefore wish to lower the equity content of their portfolios and replace equities by assets that have similar long-term returns as equities but which are uncorrelated to the returns of equities. This should reduce the volatility of portfolio returns without sacrificing return.

9 (i) Marks given for each formula and answer. This is straightforward application of Unit 22. MWR =23.6%, TWR = 26.36%

(ii) Q1.

Fund Wt B mark Wt Ind Rtn Fund Rtn Asset Stock

Equities 800 60 10.00 (7.81) 1.52 (14.25) Fixed Inc 200 40 (9.00)

(4.17) 2.28 0.97 Total 1000 100 2.40 (7.08) 3.80 (13.28)

Relative return is (9.48). Due to duration is 0.2*(( 5.0) ( 9.0)) = 0.80 and stock selection for bonds = 0.97 0.80 = 0.17.

(iii) Stock selection main contributor to performance; especially good in Q4 Asset allocation also contributed to the good performance Duration principal contributor to fixed income performance Other comments worth marks if valid

END OF EXAMINERS REPORT


EXAMINATIONS












In addition to this paper you should have available Actuarial Tables and your own electronic calculator.

Faculty of Actuaries 301 S2004 Institute of Actuaries

301 S2004 2

1 You have been given the following information.

Year 1 Year 2

Benchmark asset allocation: Equities Index 60%

30%

Bonds Index 40%

70%

Actual asset allocation of fund:

Equities 50%

50%

Bonds 50%

50%

Investment returns: Average return for similar funds 7.0% 8.0% Equity index return 10.0% 12.0% Bond index return 5.0% 4.0% Equity return in fund 9.0% 14.0% Bond return in fund 6.0% 5.0%

(i) List three methods used to assess portfolio performance, and compare the merits of each method. [6]

(ii) Evaluate the past performance for the fund as a whole over the two year period, using the three different methods. [5]

[Total 11]

2 (i) You are a UK equity analyst and have been asked to prepare a fundamental analysis of one of the companies you cover. List the quantitative factors that you would investigate. [3]

(ii) You are analysing a company which has just completed a major refinancing. List which factors you would spend the most time investigating, explaining why they have been selected. [3]

[Total 6]

3 (i) Explain why margin is levied on exchange-traded futures contracts. Include in your explanation a description of initial margin and variation margin, and the process by which these are determined. [5]

(ii) Your local currency is the Euro and you wish to actively hedge the currency exposure in an actively traded £50m US equity holding. Explaining your reasoning, state whether you would hedge the currency exposure using an exchange-traded future or an over the counter forward contract, assuming that the hedge is adjusted weekly. [3]

[Total 8]

301 S2004 3 PLEASE TURN OVER

4 (i) Outline the factors to be considered before a tactical switch can be made by an institutional investor from their benchmark position. [4]

(ii) Explain what an anomaly switch is, commenting on the risks and the scope for profits in larger bond markets. [2]

(iii) Describe three techniques to identify opportunities for anomaly switches. [3]

(iv) Describe two methods by which an investor could take advantage of an anomaly whilst maintaining no overall market exposure (a market neutral position) to the bond markets. [2]

[Total 11]

5 A developed country is reviewing its market regulations following a number of high profile company bankruptcies. The country currently has a mixed regime backed by rigid codes of practice that it believes have contributed to events.

(i) Describe what is meant by a mixed regime. [2]

(ii) There has been a proposal to weaken the rigid codes of practice and to replace these with codes of principles to be adhered to. Discuss the advantages and disadvantages of this proposal. [4]

[Total 6]

6 (i) List the advantages of investing through an investment trust rather than a unit trust. [2]

(ii) Define the investment trust term discount to net asset value per share . [1]

(iii) Discuss three circumstances under which this discount may become a premium. [3]

[Total 6]

7 You are the consultant to a large defined benefit pension fund that has historically invested significantly in equities. The new finance director is concerned about the volatility of company contributions resulting from the strategy.

(i) Set out the reasons for and against continuing a high equity strategy for the pension fund. [3]

(ii) Discuss the advantages of investing in government bonds as an alternative. [2]

(iii) State the other factors that the trustees should consider in setting investment strategy. [4]

[Total 9]

8 Explain the advantages of overseas investment for an institutional investor. [3]

301 S2004 4

9 An airline which has an average credit rating for its sector needs to issue debt to pay for some new aircraft that it expects to be in service for the next 20 years.

An investment bank has suggested the following three types of debt:

Bond A a 20 year bond with a coupon of 7.0% p.a.

Bond B a 20 year bond with a coupon of 6.5% p.a. for the first 10 years with an option for the airline to redeem at par at that point. If the bond is not redeemed then the coupon increases to 8.0% for the final 10 years.

Bond C a 20 year bond with an initial coupon of 6.5% p.a.. If the company s credit rating improves relative to its initial rating the coupon reduces to 6.0% p.a. and if the credit rating deteriorates from the initial rating the coupon rate increases to 7.5% p.a. Alterations apply immediately for the period of the change in rating.

Compare the three bonds from the risk management perspective of the airline company. [12]

10 (i) Describe four financial risks faced by an institutional investor. [4]

(ii) Describe methods for controlling each of these financial risks. [6] [Total 10]

11 The electricity distribution network of a country enjoys a natural monopoly. The Electricity Market Authority is responsible for ensuring that the price that the network operator charges for distribution is reasonable.

(i) List the key factors, treating the electricity distribution network as a capital project, that affect the long-term cashflow and rates of return of the electricity distribution network. [6]

The government believes that the electricity distribution network is making too much profit.

(ii) Discuss the measures that may be introduced to limit the profits being made. [6]

[Total 12]

12 (i) Give a generalised formula for a total return index suitable for property performance measurement purposes, defining all terms used. [3]

(ii) Outline the problems in constructing such an index for quarterly publication. [3]

[Total 6]

END OF PAPER


EXAMINATIONS

September 2004


EXAMINERS REPORT

Introduction


M Flaherty Chairman of the Board of Examiners

7 December 2004


Subject 301 (Investment and Asset Management) September 2004

Examiners Report

Page 2

Due to the change in the examination system from 2005, we believe that a large number of candidates entered for this examination to try and obtain a pass that would give them more flexibility in determining what elections to make with regard to credits for the new examination system. Consequently there were over 900 entries compared with around 650 in previous years. There was some evidence that candidates were not as well prepared as they might have been and this is reflected in the comments below.

1 (i)

Portfolio relative to:

Published Indices Other Portfolios Benchmark portfolio

Pros Easy to do Data readily available, and accurate

Gives an indication of the cost or benefit of a strategy, relative to those adopted by other funds

Benchmark portfolio can be constructed to reflect fund objectives

Can be helpful in aligning fund manager s interests with liability requirements

Cons Index may be inappropriate for investor s objectives

Comparison may be inappropriate if other funds have very different objectives

General cons All methods look at past performance only, so are not a reliable guide to the future

Assessments do not take account of risks taken by managers

(ii)

Year 1 Year 2 Total Actual-Expected

Actual 7.50% 9.50% 17.71%

Index 7.50% 8.00% 16.10% 1.61% Average 7.00% 8.00% 15.56% 2.15% Benchmark 8.00% 6.40% 14.91% 2.80%

This was answered well in the main for both the bookwork part (i) and the application part (ii).


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2 (i) The purpose is to identify and analyse the key factors affecting the future profitability of a company. This is to determine whether a share is over- or under-valued by the market.

Investigations

Financial accounts and accounting ratios Dividend and earnings cover Profit variability and growth by looking at sources of revenue and expenditure Level of borrowing Level of liquidity Growth in asset values (Both for the company and also for similar companies in this sector and outside the sector)

(ii) As there has been a refinancing, many of the above investigations will no longer be relevant. This particularly affects historical financial information, rather than prospective forecasts.

Care should be taken with the company s own forecasts, which may give an excessively optimistic picture of future prospects.

The key investigations to focus on will be:

sources of revenue and expenditure interest and capital payments on borrowings cash levels, and cash forecasts changes in net asset values quality of management future earnings forecasts

Part (i) was well answered but (ii) was not with few candidates showing the understanding that the refinancing would be likely to distort financial ratios etc.

3 (i) Margin is the collateral which each party to a futures contract must deposit with the clearing house. It acts as a cushion against potential losses which the parties may suffer from future adverse price movements.

In the event of a party to a contract defaulting the clearing house will protect the other party to the contract by ensuring the contract is fulfilled.

Initial margin is deposited with the clearing house when the contract is first struck, by both parties to the contract.

To ensure that the clearing house s exposure to credit risk is controlled, the margin is changed on a daily basis through additional payments/refunds of variation margin.


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If the price of a contract falls, the buyer has to put up additional margin whilst the opposite is true if the price rises.

(ii) State view

Euro/US dollar forwards are more flexible than futures so can have a longer term, whereas futures will need to be rolled over periodically (typically on a quarterly basis.)

A disadvantage is that adjusting the outstanding position weekly will be simpler with futures than with forwards as futures can be bought and sold easily on an exchange, whereas forwards can only be bought and sold from investment banks this may result in an imperfect hedge being maintained at times.

Transaction costs may be an issue Counter-party risk

Both parts reasonably answered.

4 (i) Authority and advice to switch are approvals in place/required Expected extra return to be made relative to additional risk (if any) Are there portfolio/mandate constraints on the changes that can be made Expenses of making the switch that a profit will be made on return to neutral position Problems of switching a large portfolio of assets

(ii) This is a switch between stocks with similar volatility, taking advantage of temporary anomalies in price.

Generally a relatively low risk strategy, but the widespread use of computer based analysis by market participants limits opportunities to profit from significant anomalies in major markets.

(iii) Any 3 of yield differences, price ratios, price models, yield models.

(iv) The investor could:

buy the asset which is believed to be under priced and short sell a similar asset which is correctly priced or overpriced, or

buy the asset which is believed to be under priced and sell a derivative linked to the benchmark bond for the market.

The examiners were disappointed with the answers to this question. Many candidates appeared not to have a full grasp of the bookwork and missed numerous points in (i). Part (iii) was also poorly answered.


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5 (i) In practice many regulatory regimes are not based solely on one system of regulation, but are instead based on a mixture of systems to enhance the strengths and address the weaknesses. A mixed regime is one that includes the following approaches to regulation operating in parallel:

Unregulated markets Voluntary codes of conduct Self-regulation Statutory regulation

(ii) A rigid code of practice is very precise in what exactly is and is not permitted.

A code of principle is a general guide to the fundamentals but not necessarily the detail.

Advantages

Codes of principle are more durable to changing market conditions.

Codes of principle should allow the market to operate more efficiently by allowing product innovation.

Should encourage competition.

Provides greater freedom of action.

There should be less ability to act against the spirit of the regulation.

Disadvantages

Regulation is less precise with more grey areas so market participants will be less sure that they are operating within the rules, leading to transgressions at the periphery going unchecked for longer.

Because the rules are less precise there is greater reliance on the regulator enforcing regulations, investigating suspected breaches and imposing sanctions.

Candidates knew the answers to (i) but were generally weak on (ii).


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6 (i)

The gearing of investment trusts should enable them to outperform unit trusts in bull markets.

Investment trust schemes may be bought at a discount to net asset value and if the discount narrows this should be a source of outperformance relative to unit trusts.

Investment trust management charges are usually lower than for unit trust.

Investment trusts can invest in a wider range of assets than unit trusts.

Investment trusts may have a better tax position than unit trusts.

(ii) The discount to net asset value per share is defined as:

net asset value market price

net asset value

expressed as a %

(iii) This may become a premium because:

(a) the value of assets may be historic and due for re-rating

(b) investors in the trust may be barred from direct entry to the markets in which the trust is invested and they may be prepared to pay a premium in order to gain the exposure they desire

(c) investors in the trust may anticipate the trust management adding value on top of the current market prices of the trust s investments

(d) pay a premium for geared exposure to a rising market

This was well done for parts (i) and (ii) but candidates often had few explanations in (iii).


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7 (i) High equity reasons why

Highest expected return

Historically successful (until 2000)

Not possible to match liabilities by nature or term

Surplus generation used to improve benefits and reduce company contributions

Advance credit can be taken in actuarial valuation through equity risk premium in discount rate

May offer hedge against inflation

May match statutory funding test

May match transfer basis following sale

Common strategy for other schemes (herd instinct)

Reasons why not

Maturity of fund

No match for guaranteed benefits and no surplus

Insufficient income generation

Highest risk and maybe risk is too high for sponsor, especially if scheme large relative to the sponsor

Doesn t match statutory funding test or accounting assessment

Threat of deflation

Availability of alternatives

As the question asks for strategy i.e. long-term benchmark allocation, no credit is available for references to short term under or over value of equity markets.

(ii) Advantages of government bonds

Lowest risk credit, currency and possibly inflation, could improve sponsor credit rating through lower volatility of contributions

Match or immunise to annuity pricing/buyout solvency or statutory funding test bases

Liquidity

Income guarantees

Lower dealing and management costs

(iii) Other issues to consider in setting strategy

Nature and term of liabilities and any changes anticipated

Level of funding and cashflow and any changes anticipated

Statutory funding tests and horizons

Capital market forecasts of returns and risks within asset and liability model

Stochastic modelling of developing assets and liabilities

Sponsor creditworthiness and tolerance of funding and contribution volatility


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Trustees attitude to risk

Market capitalisation or peer group target comparisons

Cost of change and implementation

Good candidates did well on this question but poorer candidates did not give satisfactory answers to (ii) and appeared unaware of the factors to be covered in (iii).

8 Benefits of overseas investing

Diversification of market and currency and creates opportunities for tactical asset allocation

Expands the universe of available opportunities and allows active fund managers to invest in companies giving the best return/risk profiles, wherever the companies are listed

Allows access to best of breed and specialist fund managers in regions

Markets may be more inefficient than domestic market increasing outperformance opportunity

May match real liabilities over the long term

May feature in global market or consensus benchmark

This bookwork question was done reasonably well.

9 In comparing the three bonds one needs to be mindful of issues that will affect the sector and the company. The main issues are: Airlines are cyclical service companies so there will be a greater impact from the economic cycle. Airlines are both capital and labour intensive. Generally subject to tight government regulation and vulnerable to other forms of political risk (e.g. terrorism). The domestic market is the most important but they also have international exposure.

Bond A

The bond has a term of 20 years so corresponds to the period of expected use of the aircraft and there will be a residual value of the aircraft at the end, however, it would recoup the capital cost over the life of the aircraft not at the end. This should not be an issue as the company will have other aircraft and borrowings to meet.

The coupon at 7% p.a. is higher than the other bonds because more credit risk has been transferred to the lender.

The return from the risk transfer is greater certainty over the cost of borrowing.

In a cyclical industry this avoids cost of servicing debt varying and having to refinance in unknown future economic conditions.


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Bond B

Again the bond has a term up to 20 years to match the expected use of the aircraft.

However, this can also be considered as a 10 year bond with the option to extend for a further 10 years.

In the first 10 years the coupon is lower because the credit risk over 10 years is lower than over 20 years, so the initial cost of the debt is lower.

At the end of 10 years the company can choose to refinance the debt and repay this loan or to extend it.

If the borrowing costs are lower for a new issue the company will repay this loan.

If the re-financing costs are more than 8% p.a., for example if the company s credit rating has deteriorated or the general cost of borrowing has increased the company will extend the debt.

The higher coupon after 10 years is the cost of the option to extend the borrowing with a known cost.

The disadvantage of the arrangement is that cost of the borrowing is less certain and may rise during a low in the economic cycle when it can be least afforded.

Bond C

This bond also allows the company to borrow for 20 years.

The initial coupon is 6.5% p.a. and offers the prospect of a lower cost if the company s credit rating improves, . but the penalty is a higher cost if the credit rating deteriorates.

This arrangement retains more credit risk with the company.

If economic conditions are difficult and is the reason for the company s current credit rating then this arrangement may offer the best prospect of a lower borrowing requirement.

However, the arrangement has the highest liquidity risk as it results in less certain borrowing costs and

more variable profitability as the cost of servicing the debt is most likely to increase when profitability is low and to reduce when profitability is high.

Of all the questions this was the one that candidates had most difficulty with and few got more than half marks. Candidates appeared unable to relate the bonds to the business in the context of cash-flow, useful life and options.


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10 (i) Market risk the risk relating to changes in the value of the portfolio due to movements in the market value of the assets held

Credit risk the risk that a counterparty to an agreement will be unable or unwilling to fulfil their obligations, or fails to perform them in a timely fashion

Operational risk the risk of loss due to fraud or mismanagement within the fund management organisation itself

Relative performance risk the risk of underperforming comparable institutional investors

Liquidity risk the risk that though solvent (on a balance sheet basis) either does not have sufficient financial resources available to meet obligations as they fall due or can only secure them at excessive cost

(ii) Controlling Market Risk

To control the risk a measurement is required such as variance of the return on the portfolio over a specified period of time or the maximum loss that could be suffered with say a 95% or 99% probability within the timescales. The returns and losses may be measured in absolute terms or relative to a performance benchmark.

Using the risk exposure measure, a risk control system can be set on the acceptable risk, such as limits on the value at risk.

Controlling Credit Risk

The key factors in managing credit risk are:

Creditworthiness of the counterparties

Total exposure to each counterparty

The credit risk can be controlled by placing limits and monitoring credit ratings and exposures for individual counterparties.

It can also be controlled in derivative transactions by dealing with recognised exchanges with a clearing house which stands as counterparty to all deals.

Credit risk needs to be controlled across the range of types of assets and not just by asset class.

Controlling Operational Risk

Operational risk may not generally be as easy to quantify or measure as credit or market risk.


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Control of operational risk essentially depends on good management practice including having established and documented chains of reporting and responsibility.

Relative Performance Risk

The techniques for monitoring and controlling relative performance risk are essentially the same as those for controlling market risk except that performance is measured relative to the performance of the institution s competitors rather than in absolute terms or relative to the market as a whole.

Liquidity Risk

There are four essential elements to controlling liquidity risk.

Having credit facilities, for example bank overdraft facility or sufficient size to meet immediate cash requirements.

Having readily realisable assets with a low penalty for forced sales so that cash can quickly be accessed with a low cost for forced sales.

Monitoring and projecting cash flow so that the cash requirements and asset realisations can be planned to avoid forced sales.

Having terms of business that control or delay the timing of payments so that the cash flow and asset realisations can be planned.

Whilst (i) was done reasonably, many candidates failed to pick up the marks available in (ii) through being unable to describe how the risks could be controlled.

11 (i) Key Variables

Operating costs including repairs, maintenance, administration, depreciations and the purchase of lost electricity.

Net interest bearing debt possibly separated into long term debt and short term debt to fund working capital.

Capital invested equals balance sheet total adjusted to reflect the technical replacement value of the network together with a number of other small adjustments.

Implied debt/equity ratio.


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Key Features

Permitted total return on capital invested based on weighted average cost of capital formula.

Return on equity calculated using the capital asset pricing model, being based on a riskless return (annualised return from a government bond with an agreed term to maturity) plus a margin reflecting the (low) riskiness of the business.

Revenues received should reimburse actual operating costs.

(ii) The three measures that could be introduced are price controls, tax and competition. A brief description of the nature and effects of each is required

Part (i) was done reasonably although many failed to get all the major points. Part (ii) was not done well with few candidates being able to outline a series of measures.

12 (i) The general formula is:

,

,0( )

i ti

i i

ii

Pw

PI t K

w

where I(t) is the capital index at time t; Pi,t is the price of the ith constituent at time t; Pi,0 is the price of the ith constituent at time 0 the last time at

which there was a capital change; wi is the weight applied to the ith constituent; K is a constant related to the starting value of the index at time 0.

The weights used are the market values of the constituents, usually the market values of the constituents at time 0.

Total return index is calculated from the capital index described above plus a

Rental Yield adjustment.

The income received over the 12 months prior to time t (measured in index points) is

I(t)

yt

where yt is the average rental yield at time t.


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(ii) The production of reliable indices requires knowledge of the market values of the constituents of the indices at frequent intervals. There are a number of problems in obtaining such information for property:

Each property is unique.

The market value of a property is only known for certain when the property changes hands.

Estimation of value is a subjective and expensive process.

Valuations will be carried out at different points in time.

Sales of certain types of investment property are relatively infrequent.

The prices agreed between buyers and sellers of properties are normally treated with a degree of confidentiality.

The heterogeneity of property magnifies the problems of obtaining price data. It is difficult to group properties into usefully homogeneous groups and still obtain sufficient price data for each group e.g. the underlying portfolio of properties will vary in size, regional spread and sector weighting (office, retail etc.).

As the current rental income (the historic yield) is fixed until the next rent review, any response to movements in rental values will be spread over time.

This was done reasonably although many candidates did not score as well as they should have due to poor definitions of terms used.

The solutions included in this report should not be viewed as definitive but as indicative of what was required to score full marks. Where additional points were made these were awarded appropriate marks. In total there were around 110 marks available rather than 100.



EXAMINATION

12 April 2005 (pm)

Subject ST5 Finance and Investment Specialist Technical A








6. Candidates should show calculations where this is appropriate.



In addition to this paper you should have available the 2002 edition of the Formulae and Tables and your own electronic calculator.

Faculty of Actuaries ST5 A2005 Institute of Actuaries

ST5 A2005 2

1 (i) State the taxation factors and influences on these factors that need to be considered when selecting investments which maximise after tax returns. [6]

(ii) Outline the three main systems of corporation tax. [3] [Total 9]

2 You are a fund manager managing a portfolio of international equities. As part of a presentation to trustees you have presented the following table:

Region Fund Return Market Return

US +5.5% +5.1% Japan +9.4% +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]

3 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) State the key objectives of financial regulation. [3]

(ii) Explain why the company might wish to transfer the shares to the policyholders funds. [3]

(iii) (a) Outline the principal factors to be considered in determining an appropriate price.

(b) List the additional information you would consider in setting the price. [3]

(iv) 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]

ST5 A2005 3 PLEASE TURN OVER

4 (i) Describe how to construct a zero coupon yield curve. [5]

(ii) Define the par yield for a bond. [2]

(iii) You have the following information for three conventional gilts:

Gilt 1: coupon 6.75%, maturity 1 year, price 102.01 Gilt 2: coupon 9.50%, maturity 2 years, redemption yield 4.90% Gilt 3: coupon 7.75%, maturity 3 years, price 110.41

Assume that gilts pay annual coupons and that a coupon has just been paid. Calculate the spot yields for the next 3 years. [5]

[Total 12]

5 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 Values (£m)

31/12/04 Values (£m)

Contributions

(£m) Investment

Income (£m)

Equities 600.0 700.0 12.0 15.0 Bonds 350.0 450.0 63.0 25.0 Cash 50.0 50.0 1.0 1.0 Equity Total Return Index 1,000.0 1,115.0 Equity Index Yield 3.00% 3.12% Bond Total Return Index 1,220.0 1,299.3 Bond Index 275.0 280.5 Base Rate 3.50 4.00

(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]

6 In Nestlé 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) Outline how Behavioural Finance challenges this view. [10]

(ii) Give examples of how trustees could make poor manager selection decisions based on these behaviours. [4]

[Total 14]

ST5 A2005 4

7 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


EXAMINATION

April 2005


EXAMINERS REPORT

Introduction


M Flaherty

Chairman of the Board of Examiners

28 June 2005


Subject ST5 (Finance and Investment Specialist Technical A) April 2005

Examiners Report

Page 2

Generally candidates were able to make reasonable attempts at most questions. Whilst there were some incidences of weak knowledge of bookwork, those candidates who failed usually scored poorly on application and or higher level skill aspects of questions. The following comments are written to assist candidates with understanding what the examiners are looking for. The solutions should not be regarded as complete but as a guide to the amount of knowledge and level expected. Other reasonable points and interpretations were awarded appropriate marks.

Q1. This was a bookwork question and well answered. Candidates failed to pick up marks primarily under the influences section of (i). Marks were also lost for incomplete explanations in (ii) especially under classical and split-rate where thye shareholder s position was often ignored.

Q2. Another bookwork question that was done well. Points tended to be lost because of incomplete explanation of points.

Q3. This question was poorly done. Whilst most could attempt (i), the remainder of the question seemed beyond many candidates as they were unable to demonstrate that they understood what the issues were and how they needed to be dealt with.

Q4. This was well done although it was interesting that continuous interest rates were determined rather than yearly rates. Calculation of the price of the 2-year bond required the use of yearly rates given the information supplied. Where an error was made in the calculations this was penalised only once and provided this was carried through marks were awarded for subsequent calculations.

Q5. This type of question gets set on a regular basis and the examiners are always surprised at the spread of answers that they encounter and the failure to use specific pieces of information supplied, particularly in relation to part (ii) of this question. Candidates should realise that all information is there for a purpose usually to assist them in framing their answers in an appropriate manner. The solution shows the answer that is most likely to be encountered in the real world. However no penalties were applied for the more unrealistic assumptions that were often used regarding the timing of contributions and income. The examiners believe that full analysis should be undertaken in a question of this nature as illustrated in the solution.

Candidates are encouraged to set out the formulae that they use as this will ensure that when a mistake is made marks can still be awarded for subsequent calculations.

While many candidates scored well in (i), few candidates were able to attain significant amounts of marks in (ii). Explanations tended to lack the detail necessary to attain the marks on offer.

Q6. This question was done well being predominantly bookwork.

Q7. Of all the questions this was the one that candidates had most difficulty with. Answers in (i) were basically what the examiners view as brain dumps and were not focused on the question as set. Accordingly poor marks were awarded. Very few good answers were seen for (ii) but many managed to collect around half marks in (iii) despite poor attempts at the earlier sections.


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1 The factors to be considered are:

The total rate of tax on an investment.

How the tax is split between different components of the investment return.

The timing of tax payments.

Whether the tax is deducted at source or has to be paid subsequently.

The extent to which tax deducted at source can be reclaimed by the investor.

To what extent losses or gains can be aggregated between different investments or over different time periods for tax purposes.

Influences on these factors are:

tax rates on capital gains

tax rates on income/dividends

exemptions and allowances against tax

rules on particular assets

investor s own status

investor s financial position

investment vehicle s tax efficiency

(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.


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2 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.

3 (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) (a) Any regulatory or recommended limit on the maximum (and minimum discount).

Discounts applying to similar private placements or block trades.

(b) Normal daily volume in the shares and transaction prices.

(iv) Being seen to avoid conflicts of interest (who instigated transaction and why).


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Page 5

Treating customers fairly (suitability of investment; appropriateness of terms) and so satisfy regulator s Principles of Business.

Is the asset manager involved in the transfer and will they be paid for managing the holdings thereafter.

Any lock in period that restricts the shareholders dumping the stock at a later date.

Respective size of the policyholders fund into which the stock is being transferred, its benchmark and mandate, concentration of holdings, nature of underlying investments (direct or commingled funds)

Who are other shareholders how free is float? Volatility of share price and impact on portfolio risk

4 (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 to arrive at the zero coupon yield curve.

(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: 102.01 * (1 + S1) = 100 + 6.75 S1 = 4.65%

No price given for 2 year gilt so need to calculate:

P2: P2 * (1 + 0.049)2 = 9.5 * (1 + 0.049) + 100 + 9.5 P2 = 108.56

Now solve for S2

108.56 * (1 + S2)2 = 9.5 * (1 + 1f1) + 109.5 where 1f1 is the 1 year forward rate starting in 1 years time


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Page 6

(1 + S2)2 = (1 + S1) * (1 + 1f1)

S2 = 4.91%

S3: 110.41 * (1 + S3)3 = 7.75 (1 + 2f1)2 + 7.75 * (1 + 1f2) + 107.75

(1 + 2f1)2 = (1 + S3)3 / (1 + S1) (1 + 1f2) = (1 + S3)3 / (1 + S2)2

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.

5 (i) Contributions occur halfway through the period.

Generalised formula for return (each class):

MV(1) = MV(0)*(1+i) + C*(1+i/2) using the normal approximation for a half year s interest.

[MV(1)-MV(0) - C] / [MV(0) + C/2] = Return (%)

Equity return = (700-600+12)/[600 12/2] = 18.86%

Bond return = (450-350-63)/[350 + 63/2] = 9.70%

Cash return = (50-50+1)/[50 1/2] = 2.02%

Fund total return = (1,200-1000-50)/[1,000 + 50/2] = 14.63%

Bond Index return = 1,299.3/1,220 1 = 6.50%

Equity Index return = 1,115/1,000 1 = 11.50%

Benchmark return = [50 * 1.065 + 50 * 1.1150]/100 1 = 9.0%

In allocating performance the fund weights should be the average weights based on the denominator of the fund returns but initial market values used as weights would not be marked as wrong

Equity Asset Contribution = (594/1,025

0.50) * (11.50

9.0) = 0.20

Bond Asset Contribution = 0.32


Examiners Report

Page 7

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%

Bond Stock Contribution = 381.5/1,025 * (9.70 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.

6 (i) Behavioural Finance looks at the mental biases and decision-making errors that affect financial decisions

The following challenge the view of the judge:

Anchoring past experience adjusted to allow for evident differences to current conditions herd instinct Prospect Theory how decisions are made when faced with risk and uncertainty How questions are framed, especially if of a structured response variety How risk aversion changes as time-frame or number of opportunities increases

Dislike of negative events influences perceived probability of outcome Ease of imagining apparent likelihood increases with detail


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Ease of bringing to mind Overconfidence hindsight bias - confirmation bias mental account count individual gains/losses rather than netting them primary/recency effect first or last option to be presented more influential range of options effect more choice means less decision status quo preference to keep things as they are regret effect don t do anything in order to create no regret ambiguity effect premium for rules

(ii) Suitable examples/conclusions include:

Recent past performance.

The what, not the how, and subject to manipulation.

Size and reputation.

No one was sacked for buying IBM.

Image.

Advertising, familiarity with brand.

Client list.

Assume the others do the due diligence.

7 (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) 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


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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.


EXAMINATION

13 September 2005 (pm)













Faculty of Actuaries ST5 S2005 Institute of Actuaries

ST5 S2005 2

1 Define the role of a custodian, and list the services that they might offer in addition to document safe keeping. [4]

[Total 4]

2 (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) A liability driven investor, investing in bonds to match liabilities of a particular duration.

(b) An unconstrained investor, who is investing in bonds to maximise returns relative to LIBOR.

[2]

(ii) Explain why an analysis of reinvestment rates might mean an investor favours investment in a 10 year bond with a 5% coupon over investing in a 20 year bond with a 10% coupon, when the yield on the longer bond is 0.5% p.a. higher. [2]

(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]

3 (i) Describe the critical difference between a mortgage backed security and a regular fixed income security. [3]

(ii) A collateralised loan obligation (CLO) is backed by a pool of residential mortgages and divided into three investment classes W, X and Y. Scheduled and pre-payment principal repayments are channelled to class W investors until that group of investors has been completely repaid. Thereafter, scheduled and pre-payment principal repayments are channelled to class X investors until that group of investors has been completely repaid. When class W and class X investors have been fully repaid, all remaining principal repayments are directed to class Y investors.

(a) State, with reasons, which class of investor bears the most pre-payment risk.

(b) Rank in order of increasing duration the three investment classes and give a reason for your answer.

(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]

ST5 S2005 3 PLEASE TURN OVER

4 (i) Describe the main aims of the field of Behavioural Finance as applied to investment management. [4]

(ii) Explain how Behavioral Finance arguments might be used by an equity investment manager to explain why they hold a persistently underperforming stock in a portfolio rather than selling out of the position and re-investing in an alternative stock. [5]

(iii) Outline how the irrational actions suggested by Behavioral Finance might be eliminated. [3]

[Total 12]

5 (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]

6 The trustees of a pension fund have appointed an investment manager to invest in global equities and bonds. The investment manager s performance will be compared with a benchmark equally divided between two representative broad market indices. The trustees wish to impose limits on the investment manager s ability to deviate from the 50/50 proportions to which the benchmark will rebalance on a quarterly basis.

(i) 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) Outline appropriate constraints on these factors. [5] [Total 12]

ST5 S2005 4

7 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]

8 (i) Explain why equities are usually analysed in sector or industry groupings. [5]

(ii) (a) Discuss the advantages and disadvantages of this sub division.

(b) Suggest, with reasons, two possible alternative groupings. [5]

(iii) State the features that characterise each of the following economic groups:

General Industries

Consumer Goods

Utilities [6] [Total 16]

9 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.

Fund Returns Index Returns Year 1 Year 2 Year 3 Year 1 Year 2 Year 3

UK Equities 10.1% 2.5% 17.6% 8.5% 5.4% 16.0% Overseas Equities 14.2% 3.2% 13.2% 13.5% 2.1% 1.0% UK Bonds 6.4% 3.1% 4.1% 7.2% 4.5% 5.4% Overseas Bonds 3.2% 1.8% 1.5% 8.1% 2.8% 3.1%

The asset mix of the fund and of the benchmark at the start of year 1 was as follows:

Fund Benchmark

UK Equities 45% 60% Overseas Equities 30% 20% UK Bonds 15% 10% Overseas Bonds 10% 10%

ST5 S2005 5

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) the total return for the fund (b) the benchmark return

(c) the respective contributions from the items in (i) [10]

(iii) Comment on the results of your calculations. [4] [Total 16]

END OF PAPER


EXAMINATION

September 2005


EXAMINERS REPORT


Subject ST5 (Finance and Investment Specialist Technical A) Sept 2005

Examiners Report

Page 2

1 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.

2 (i) (a) Anomaly switches, as these are less likely to alter the duration match of the liabilities.

(b) Policy switches, as these allow the investor the freedom to attempt to maximise return based on the investor s view of future changes in the level and shape of the yield curve.

(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.

3 (i) The borrowers underlying the mortgages in a mortgage backed security have a right to (but are under no obligation to) repay the mortgage to the lender

at any time during the life of the mortgage at its face value.

This introduces pre-payment risk for the holders of mortgage backed securities.


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(ii) (a) The W investment class.

All principal repayments go in the first instance to the class W investors; a rush of prepayments will impact this class of investors the most.

(b) W, X and Y. Class W will be repaid first because of the structure of the CLO and is likely to have the shortest duration followed in order by class X and class Y.

(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.

4 (i) 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) Analysts and investment managers can be unreasonably drawn to a stock based on understanding and belief in the company s business model and/or management. This affection can lead them to persistently discount bad news about the stock.

Investment managers can be highly confident in their own abilities. Over confidence can lead the practice of managers using good news on a stock to reinforce their position whilst putting any bad news down to the ignorance of other market participants.

Managers will be reticent to take responsibility and crystallize a loss having defended the position to date.

(iii) Institute a level of discipline in the investment process to reduce bias without stifling invention and ideas.

Hold periodic peer reviews of the portfolio/decisions.

Create a culture, which actively encourages challenge and debate.

Introduce hard code rules and risk controls to take out some of the human element.


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5 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) Barriers to European integration as per Unit 10, section 9.

6 (i) Aim is to outperform benchmark

To outperform you need to be different

Extent of difference will be controlled to minimise risk of underperformance (and potential termination of mandate)

Justified because:

Markets and asset classes are not perfectly correlated

Asset class and country returns may be predictable because:

Valuations can drift away from fair value

Investors may be slow to incorporate new information

Risk premiums change over time among global markets

Structural barriers exist across global markets

Some market participants (e.g. central banks) may not be motivated by profits

(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 permit only a limited percentage in non-style assets.

Correlations between assets monitor for increases or decreases of a particular magnitude.


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Costs of rebalancing set a limit on management costs.

Rebalancing frequency place a limit on asset allocation shifts other than due to cash flow or income.

Scope to use derivatives limit exposure to derivatives to certain percentage of assets.

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.

7 (i) What market, instrument or other underlying asset drives the performance of the derivative?

What is the formula for the magnitude of the cash flows likely to arise under the derivative contract?

What is the timing of those cash flows?

What is the likelihood of receipt or payment of the cash flows?

What is the liquidity of the contract?

(ii) The factors would be:

return expected what is it going to contribute to overall returns

taxation are there any implications for returns or other aspects of the portfolio

applicable regulatory valuation rules what rules may apply and will they cause complications

accounting treatment of the derivative is it treated as capital or are there income aspects that need to be allowed for

integration with the existing portfolio does it make strategic sense

its effect on risk what does it do to the overall portfolio s position

8 (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.


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Methods of raising finance are often similar within a group.

Experience similar labour problems, costs of raw materials, consumer demand, economy will affect them similarly.

Financial statements are prepared in a similar fashion and will use similar jargon.

No other factor has proven to correlate to shares as closely as industry statistics.

(ii) 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) See Core reading Unit 3 pages 2 & 3.


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9 (i) The overall investment performance of a fund can be divided into:

Sector or asset class selection: the extent to which the fund s proportions in the various sectors will have affected performance.

Stock selection: within any one sector, have the selected stocks performed better or worse than the sector as a whole?

(ii)

Asset Class Stock Total Fund

Benchmark

Fund Ret

Index Ret

Selection Selection

UK Eq 45%

60% 26.24% 19.06% 0.14% 3.23% 3.09% O seas Eq 30%

20% 25.14% 17.04% 0.11% 2.43% 2.32% UK Bond 15%

10% 14.20% 18.07% 0.00% 0.58% 0.58% O seas Bond

10%

10% 6.63% 14.57% 0.00% 0.79% 0.79% Total 100%

100% 22.14% 18.11% 0.25% 4.29% 4.04%

There is a rounding error of 0.01%.

(iii) 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.



EXAMINATION

30 March 2006 (pm)













Faculty of Actuaries ST5 A2006 Institute of Actuaries

ST5 A2006 2

1 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]

2 In relation to portfolio construction:

(a) Define prospective and retrospective tracking errors.

(b) Discuss the use of prospective and retrospective tracking errors as measures of risk.

(c) State why the two measures of risk might differ. [9]

3 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]

4 (i) Outline the key principles underlying the relevant legislation relating to providers of financial services and their clients. [7]

(ii) Describe the points that should be covered by a Statement of Investment Principles . [4]

[Total 11]

5 The following information is provided on a non-UK equity fund.

Asset US Japan Europe Asia Cash Total

Value at 31.12.04 £m. 250

100

100

50

0

500

Value at 31.12.05 £m. 300

140

96

70

5

611

Income in period £m. 5

2

3

4

0

14

Net New Investment in period £m. -10

-5

10

0

5

0

Local Index 31.12.04 100

325

200

210

100

Local Index 31.12.05 120

400

185

296

100

Currency Rate at 31.12.04 v £ 1.90

190

1.40

1.90

1.00

Currency Rate at 31.12.05 v £ 1.75

200

1.50

1.75

1.00

Index Yield at 31.12.05 (%) 2.5

1.0

2.0

3.0

4.0

The benchmark index is weighted 50% U.S., 30% Europe, 15% Japan and 5% Asia.

ST5 A2006 3 PLEASE TURN OVER

(i) Evaluate the performance of the fund through a full attribution analysis by market stating any assumptions that you make. [15]

(ii) (a) Comment on the returns and the results.

(b) Suggest any investigations that you might undertake to better understand the results.

[5] [Total 20]

6 A fund manager operates an OEIC whose investment strategy is to identify pairs of shares in the same industry or market sector one of which is forecast to rise in value while the other is forecast to fall in value over a one-year time period. The manager buys the shares that he forecasts will rise in value. He borrows the shares that he expects will fall in value, sells them in the market hoping to buy them back later at a lower price, and then return the borrowed shares to the lender.

One of the current pairs of shares that the manager has in his portfolio is from the pharmaceutical sector. He expects PharmaUP to rise in value over the next year and he expects PharmaDOWN to fall in value over the next year.

(i) Discuss the risks in this strategy under the following headings:

(a) 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) The costs of implementing the investment strategy. [4]

(d) The impact of the majority of investors redeeming their holdings in the fund on the shareholders who do not wish to redeem their holdings at some point before the one-year investment time horizon has expired.

[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 4

7 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 Credit rating Tranche size

Senior AA £400m Mezzanine BB £50m Equity n/a £50m

(i) Explain why the company might wish to use its asset in such a way. [6]

(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


EXAMINATION

April 2006


EXAMINERS REPORT

Introduction


M Flaherty Chairman of the Board of Examiners

June 2006



Examiners Report

Page 2

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.


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1 Passive management aims to track the performance of a specified benchmark index with no active investment risk.

This approach limits downside risk of poor manager performance.

It also removes scope to benefit from good manager performance.

An under funded scheme may find active management more appealing as a means to catch up some lost capital.

Fees are generally low however this generalised point is not likely to be true for property where transaction and tax costs are significant.

Does a suitable index exist covering the wide range of properties held?

Property indices have numerous problems non homogeneity, timing, frequency and availability of prices.

It may be possible to gain better matching of an index through a derivative instrument, but note that derivatives are often based on an investable index.

Active management aims to provide a return in excess of a specified benchmark by taking investment risk within the portfolio.

It is difficult to correctly identify managers who will consistently outperform.

Fees are generally higher than for passive management.

2 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.


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Retrospective tracking error is defined as the standard deviation of realised past annualised relative performance.

It is also usually expressed in a number of basis points per year.

It seeks to provide an ex post summary measure of investment risk based on the volatility in the monthly (or quarterly) pattern of realised returns.

Prospective and retrospective tracking error will differ because:

Prospective assumes a static and unchanged portfolio and benchmark.

It also relies on many assumptions that are unlikely to be achieved in practice.

Whereas retrospective tracking error is based on the actual portfolio and on the performance of that portfolio against the benchmark

3 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.


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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.

4 (i) The key principles are:

Integrity high standards and fair dealing.

Skill, care and diligence.

Market practice observe proper market conduct.

Information about customers details of circumstances and investment objectives.

Information for customers comprehensive and timely information in all dealings.

Conflicts of interest should be avoided where possible, but otherwise full disclosure to client.

Customer assets proper safeguard, segregation and management of all assets.

Financial resources firm must have sufficient assets to meet its business risks.

Internal organisation properly trained and supervised staff, proper record keeping.

Relations with regulator open and co-operative manner.

(ii) A Statement of Investment Principles should set out:

Who is taking what decisions and why this structure has been selected. Fund s investment objective.

Fund s planned asset allocation strategy, asset class projected returns and how strategy has been arrived at.

What mandates have been given to all advisers and managers. Nature of fees structures for all advisers and managers, reason behind why set of structures selected.


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5 (i) Assumption: net new investment occurs in middle of period. Simplification (1+i/2) allowed. [Whilst candidates were not asked for formulae, it would be good practice to write out what formulae were used as this shows how the table of results is arrived at. Since no marks were being awarded for formulae, the report does not specify them.]

Fund Rtn

Bmark Rtn

Curr Rtn

Alloc

Curr

Stock

Alt Rtn

Stock

US

24.49%

30.29%

8.57%

0.00

0.00

-2.90

0.24

-3.14

Japan

46.15%

16.92%

-5.00%

0.03

-0.35

5.85

0.45

5.62

Europe

-13.33%

-13.67%

-6.67%

2.99

0.86

0.07

-0.14

-0.07

Asia

40.00%

53.03%

8.57%

1.84

0.33

-1.30

0.4

-1.30

Cash

0.00%

0.00%

0.00%

0.00

0.00

0.00

0

0.00

Total

22.81%

16.23%

1.96%

4.86

0.85

1.71

22.20%

1.10

(ii) (a) Fund outperformed by 6.58%/5.97%.

Stock selection added 1.71/1. 1%.

Asset allocation added 4.86%.

Currency added 0.85% of the 4.86%.

Under weight Europe and over weight Asia were positive asset allocation contributions.

Good stock selection for Japan, offset by poor US and Asia stock selection.

(b) Income needs investigating as looks like growth stocks in US but value stocks in rest of world check style.

Check if any currency hedging in place as Japan return very high vis a vis benchmark

6 (i) (a) The manager s valuation model may prove incorrect and if it does investors will lose money on the transaction as the share bought falls in value while the share shorted rises in value.

The manager takes on a very high degree of stock specific risk with this strategy.

In particular, PharmaUP may suffer a significant fall in price due to a factor that is specific to PharmaUP.

For example, an announcement that the Federal Drug Administration in the US is withdrawing its approval for one of the drugs that contributes significantly to PharmaUP s profits as a result of the deaths


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Page 7

of several individuals using the drug while the majority of other pharmaceutical companies may see their share price generally rise.

(b) There is an assumption in the strategy that the manager will be able to borrow the shares for a period of one year and this may not be possible in practice.

If the lender of the shares recalls the loan of the shares the manager may have to unwind his strategy at a point in time when the share bought has fallen in value while the share shorted has risen in value forcing investors to realise a loss

(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) If some investors redeem their shares during the one-year holding period at a point where the value of PharmaUP is less than its value on the date the transaction is initiated or the value of PhamaDOWN is above its value on the date the transaction is initiated this may distort the relationship between the pair of stocks and make the entire trade unprofitable if the price of PharmaDOWN rises unexpectedly on the forced buying in operation and the price of PharmaUP falls unexpected from the forced sale of shares.

(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) The manager could insist on a minimum investment term of one-year so as not to interrupt investment strategies with redemptions.


Examiners Report

Page 8

7 (i) The asset is being used as collateral to back a loan issue.

The asset is intended to provide higher security than an unsecured loan issued by the company.

As the ABS is issued through a SPV, purchasers are protected against other claims made against the company.

These factors will provide lenders (purchasers of the ABS) with more certainty of repayment than purchasers of an unsecured loan stock, reducing the company s cost of capital.

The yield on the ABS will therefore be lower than the yield on an unsecured loan stock of similar term and structure.

Furthermore, it may not be possible for the company to borrow funds in the market at a realistic rate (e.g. the issuer credit rating is weak).

Using the asset in this way would potentially lead to a more efficient balance sheet structure, as the asset is illiquid and not receiving any investment return.

However, this must be offset against the transaction costs of the ABS issue, and the issue may have negative implications for the company s credit

rating as it will reduce asset and income cover for existing unsecured creditors.

(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


Examiners Report

Page 9

some level of company participation in the issue would be needed to avoid moral hazard.

(iii) 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.



EXAMINATION














Faculty of Actuaries ST5 S2006 Institute of Actuaries

ST5 S2006 2

1 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]

2 An equity portfolio has a target beta of 1.2 relative to the market index.

(i) Explain the term beta, and the meaning of a value of 1.2. [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]

3 A futures exchange is considering setting up a new European equity futures contract and there are several existing indices on which the contract could be based.

(i) 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) Describe the types of restrictions that might be made on a European equity mandate, giving suitable examples. [4]

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) 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]

ST5 S2006 3 PLEASE TURN OVER

4 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) Explain which investors may prefer each investment giving reasons. [7] [Total 12]

5 An investment trust provided the following information to shareholders:

Balance Sheet £m £m

Investments 130 Shareholder Funds 110 Cash 10 Debenture 2016 (nominal value) 30 Total 140 Total 140

Income Statement £m £m

Dividends 5.0 Interest Expense 2.4 Interest Income 0.5 Management Expenses 0.9

Other Expenses 0.3 Dividends Paid 1.9

Total 5.5 Total 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) 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]

ST5 S2006 4

6 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) Describe the practical problems of carrying out such a switch by transferring physical stock, in addition to the risk of moving market prices. [10]

(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]

7 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


EXAMINATION

September 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 A Stocker Chairman of the Board of Examiners November 2006


Subject ST5 (Finance and Investment Specialist Technical A) — September 2006 — Examiners’ Report

Page 2

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 today’s 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 A bookwork question which was answered well by most candidates.

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 Candidates answered the bookwork sections of this question well, in particular Part (i). The range of answers in Part iii distinguished the better candidates as they were able to articulate the practical issues when implementing an investment switch. Part iv was generally well answered with candidates showing a good level of knowledge on derivatives.

Q7 Most candidates scored full marks on Part (i). In general Parts (ii) and (iii) were also well answered.


Page 3

1 ALM is an investigation into longer-term issues, involving the projection of assets and liabilities over periods of several years.

The inputs are the future profile of asset proceeds and liability outgo. Assets are largely future tax receipts but include future debt issuance and liabilities

are future government spending including redemptions and interest on existing debt.

Future proceeds and outgo will be heavily influenced by the economic and business cycles together with many politically driven decisions and other government policies. (Or alternative description of input assumptions.)

The ALM can provide a series of annual differences between income and outgo,

under various simulations of the factors noted above.

Debt issuance (repurchase) is the mechanism by which the government makes up any shortfall (excess) in the public finances i.e. the pattern of expected amounts of future issuance is the output of the ALM.

The debt manager will have little or no control over most of the asset or liability items

but can use the ALM study to provide it with information as to the likely pattern of future issuance requirements.

It will be able to influence the profile of redemptions and therefore have some impact

on the future profile of issuance. 2 (i) The Beta of a portfolio is a measure of the portfolio’s volatility relative to

movements in the whole market. It is usually defined as the covariance of the return on the portfolio with the

return on the market, divided by the variance of the market return. A beta of 1.2 means the change in value of the portfolio should be 20% greater

than the change in value of the market. (ii) The performance of the portfolio would be compared to the return on the

index. The portfolio’s target return should recognise the pre specified level of risk. Using an index representative of the market the portfolio is invested in, target returns could be calculated as 1.2x the index return.

(Alternative descriptions using a risk adjusted measure received equivalent credits.)


Page 4

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 portfolio’s 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) The beta of individual stocks can be assessed by calculating the covariance of

the return for an individual investment with the return on the index. If the beta of an individual stock was below 1.2 then the stock could be used

as a diversifier for the portfolio as its inclusion would reduce the overall risk of the portfolio.

3 (i) Popularity — how widely followed is the index by various classes of investors

(e.g. asset managers, investment banks, hedge funds etc.). Benchmarking — is the index used as a benchmark for European equity

mandates? Base currency — what currency should the futures contract use as a base

currency? Currency hedging — should investment returns in the various local currencies

be assumed to be hedged against the base currency? Frequency — how often is the index published?


Page 5

Total return/withholding taxes — would need to be a total return index (preferably net of withholding taxes).

Method of index construction — e.g. based on largest x European stocks by

market capitalisation, or based on a weighted average of underlying country indices?

Frequency of updates to constituents (or any weightings) Capitalisation weighted, or based on some other weighting process (equal

weights, capped weights, economic value, etc.) Whether part of a series of indices (by country, style, sector etc.), so giving

scope for exchange to expand its range of futures contracts in the future if the demand exists.

Suitable indices — FTSE All-World Europe, MSCI Europe, Eurotop, Dow

Jones Eurostoxx. (ii) 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 investor’s 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 6

(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. 4 (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) The equity could be attractive to any investor. It has a reasonable yield. (Or equivalent comment from other investment backgrounds.) The convertible requires a very strong price rise to be attractive to equity

orientated investors. Convertible needs 10.0% to achieve same goal. It might be of interest to a hedge fund wishing to carry out arbitrage

investment. It could be of interest to an absolute return manager if market volatility was

expected to increase. The ZDP is of interest to risk averse investors with minimum return criteria.


Page 7

It might be of interest to structured product providers as collateral. (Other examples of possible investors received equivalent credit.) It could be of interest to hedge funds in conjunction with the ordinary and

convertible to create an absolute/arbitrage return. 5 (a) Yield on investments = 3.85% Yield on year end cash = 5% Net asset value per share = 200p, discount = 15% Interest on debt = 8% Total expense ratio = 0.86% Dividend per share = 3.45p, yield = 2.0% Portfolio has high yield ratio to market Cash return high — need to investigate Gearing = 140/110 = 27% Gearing slightly high for conventional trust (Other relevant ratios plus comment received equivalent credit.) (b) Debt coupon = 8%, current 10 year interest rate = 4.5% (say) Cost of paying off debt = 127.69 * 30m/100 = £38.31m Assets = £101.69m, nav per share = 184.89 Income, assuming cash and prorate reduction = 3.92m Management expense ~ 0.65% = 0.66m, other = 0.3m Available for div = 2.96m = 5.38 pence = 3.2% yield Might suggest reducing yield ratio 6 (i) Selling/purchasing assets in small units Selling/purchasing assets over a period of time (including use of cashflow) Using algorithmic trading techniques Using nominee accounts Using several banks to carry out the trades Using derivative contracts Use cross transactions All of the above methods will mask the trade to other market participants and can be used in combination. Derivatives contracts will be suitable in many cases for changing broad

exposures quickly although the underlying stocks will still need to be sold/purchased in due course unless the asset allocation change is temporary.


Page 8

(ii) These approaches are difficult to implement for unmarketable securities where there is no deep or liquid market.

Assets in this category might include small cap or unquoted equities, certain

high yield bonds or smaller bond issues, and property. (iii) Significant coordination is needed by the UK, US and Japanese equity

managers to ensure that the switch goes smoothly. It may be useful to appoint a transition manager to coordinate the process if

none of the existing asset managers has a specialist team who is able to manage the project.

There may be several asset managers involved in the process. The managers may need some time to decide which stocks to buy and sell, and

this may create further delays as the transition occurs. In practice, it is likely that the sales of UK and US equities will need to be

spread over a period of time, particularly for smaller stocks. Unless borrowing is permitted (unlikely) the Japanese equity manager can

only buy stock after the UK and US equity managers have sold stock… …allowing for settlement periods This will delay the transition. This may have an adverse impact due to market movements …or currency movements However, rushing the sales is likely to impact on the value realised from the

sale. Tax liabilities may be brought forward and crystallised, particularly on stocks

with large gains since purchase. Conversely tax losses may be created where stocks are being sold at a loss,

and it is not known when those losses might be offset against future gains in the UK or USA.

The process will be time intensive and may be expensive in terms of

transaction costs. It is likely that the fund will suffer both buying and selling fees although these might be mitigated if the asset managers are able to “cross”

with transactions for their other clients.


Page 9

The transition programme will need ongoing monitoring in case market movements mean that the target changes in asset allocation are not achieved, or exceeded.

(iv) The UK and US equity managers would sell a number of futures contracts

with exposure equal to the amount of stock to be sold. The Japanese equity manager would buy a number of futures contracts with

exposure equal to the amount of stock to be purchased. As the physical sales and purchases are completed the number of futures

outstanding will need to be reduced to ensure that the correct exposure is maintained.

If the physical sales and purchases are not completed before expiry of the

futures contracts, then any outstanding futures positions will need to be rolled over.

An operational issue with futures is that initial and variation margins will need

to be deposited as the counterparty will want collateral for any outstanding positions.

If the various managers do not have sufficient assets to deposit as collateral

then borrowing may be necessary. Advantages: Switch can be implemented very quickly. Futures markets is very liquid, with little risk of any market impact

(particularly as the futures contracts will be based on market indices). Purchase of futures reduces pressure on asset managers to construct and

execute their buy/sell programs quickly. If the switch needs to be adjusted the positions can be easily and cheaply

reversed without disturbing the underlying stock portfolios.


Page 10

7 (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:

• dependent on the level of investment spending • cyclical • company profits tend to move ahead of the trade cycle • dependent on government spending • volatile profits • high profit margins when conditions are good • low gearing because of volatile profits • possibly exposed to overseas markets and competition

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 non-durable 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 (non-durable) sectors. Other key features are:

• increasingly capital intensive • importance of brand names • increasingly international


Page 11

• moderate to high gearing • low profit margins

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. Non-cyclicals 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:

• they usually require an extensive physical infrastructure. This tends to

make them capital intensive • most utility companies are natural monopolies • they are usually subject to tight government regulation of prices and

vulnerable to other forms of political risk • they generally have low growth prospects; this leads to a high gross

dividend yield • despite their stable demand and large capital requirements, gearing is low • they are largely dependent on the domestic market, although some

companies are diversifying internationally

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:

• banks are highly geared and have volatile profits • general insurers also have volatile profits and virtually no borrowings


Page 12

• life insurers have stable profits and low gearing • labour costs are important for many companies in the group • the domestic market is most important but there is increasing

internationalisation

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) Compare dividend yields, earnings growth and price earnings ratios with the

Index.


Page 13

For example, within each sector for the fund and the index:

• Rank the holdings by increasing yield • Split each sector into an equal number of holdings (e.g. quintiles) • Calculate the weighted average yield of each quintile allowing for the

value of shareholdings as weights

This will help to determine:

• Consistency with the portfolio • Identify any style biases (e.g. growth or value) • How risky the portfolios are relative to 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.

END OF EXAMINERS’ REPORT


EXAMINATION

13 April 2007 (pm)





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. Mark allocations are shown in brackets. 5. Attempt all 9 questions, beginning your answer to each question on a separate sheet. 6. Candidates should show calculations where this is appropriate.




© Faculty of Actuaries ST5 A2007 © Institute of Actuaries

ST5 A2007—2

1 (i) (a) Define risk-free return. (b) List three types of asset that would be expected to provide such a

return. [2] (ii) Write down an equation for the required return on an asset. [1] (iii) Explain why it is necessary to estimate the equity risk premium from historical

data. [2] (iv) Give examples of: (a) the types of distortion that need to be allowed for in any analysis of

historical risk premia. (b) the likely impact of allowing for these adjustments. [6] [Total 11] 2 (i) Describe how the economic cycle can impact companies’ price/earnings ratios. [5] A stock market comprises three securities:

Stock A Stock B

Stock C

Market capitalisation 31/12/2005 $100m $500m $200m Earnings 31/12/2005–31/12/2006 $10m $25m $25m Share price 31/12/2005 $20 $20 $20 Dividend yield 31/12/2005 3% 2.8% 4% Share price 31/12/2006 $24 $25 $16 Dividend yield 31/12/2006 3.2% 2.5% 4.5%

(ii) Describe the characteristics of growth and value stocks. [2] A value investor constructs a portfolio at 31 December 2005 comprising 10% stock A,

30% stock B and 60% stock C. In contrast a growth investor has a portfolio of 20% stock A, 70% stock B and 10% stock C.

(iii) 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. [3] [Total 16]

ST5 A2007—3 PLEASE TURN OVER

3 (i) (a) Explain what is meant by an agency cost. (b) Explain how agency costs can arise. [4] (ii) (a) Explain why conflicts of interest may arise between equity and bond

holders in a company. (b) Give three examples of such conflicts of interest including details of

who gains and who loses from the action. [4] [Total 8] 4 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 consultant’s report examined the fund manager’s 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 manager’s 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] 5 (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) a put option (b) 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 A2007—4

6 (i) Describe three reasons why regulation is considered important in the financial services industry. [3]

(ii) Outline the direct and indirect economic costs of regulation. [6]

[Total 9] 7 (i) Describe the concept of a trust as it arises in trust law. [5] (ii) Suggest the advantages of a debenture trust deed. [3]

[Total 8]

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:

Spread over government bonds

Government bond yield

Sterling issue +125bps 4.50% Domestic issue +175bps 2.00%

You should assume the yield curve is flat across all maturities in both the sterling and

the domestic market. (i) List the main reasons for issuing a bond. [4] (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 A2007—5

9 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


EXAMINATION

April 2007


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 A Stocker Chairman of the Board of Examiners June 2007


Subject ST5 (Finance and Investment Specialist Technical A) — April 2007 — Examiners’ Report

Page 2

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 3

1 (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) Distortions that need to be corrected for in an analysis of historical risk premia

would include: Survivorship bias — allowance needs to be made for the returns achieved on

securities which have been removed from a sample due to defaults or removal from a reference index. Allowing for this factor will typically reduce the measured historical return.

Market valuations/risk preferences — allowance should be made for changed

valuations of securities through changes in investor risk preferences. Investors may be willing to accept a lower/higher risk premium for a given level of volatility, leading to higher/lower prices currently than in the past.

Achieved dividend growth vs expectations — part of the risk premium will

reflect expectations in future dividend growth. If dividends have grown at a faster or slower rate than originally expected by equity investors, this could lead to an inaccurate estimate of the risk premium based on historical return data.


Page 4

2 (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) A: 24/20 × (1 + 3.2%/2 + 3%/2) - 1 = 23.7% B: 28.3% C: -16.6% Value return = 10% × 23.7% + 30% × 28.3% + 60% × -16.6% = 0.9% Growth return = 22.9% (v) Small-cap, large cap, momentum, rotational, contrarian, top-down, bottom-up

(brief description of any three or any other relevant style properly defined)


Page 5

3 (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:

• Equity holders underinvesting in a company to increase profits, whilst reducing long term security for bond holders.

• Equity holders influencing management to take excessive risks, increasing

the default risk of the firm (at the expense of bond holders, but not necessarily for equity holders on an expectation basis).

• Equity holders taking excessive dividends from the company, reducing

asset cover of liabilities (including payments due to bond holders).


Page 6

4 (i) Fees & Expenses 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 FTSE 100 Total Return Index.

Cost of Rebalancing

The FTSE 100 Total Return 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.

Cash Holdings 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 entire 100 constituents in the correct proportions. The manager will therefore have part of the portfolio invested in the constituents of the FTSE 100 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. This can be a significant issue when there are large inflows or outflows from the fund, particularly if asset volatility is higher than typical.

(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 7

5 (i) Marks should be awarded for the following features: Same axes and same scales — one rather than two diagrams; Common strike price 2:1 ratio of premiums (suggested on inspection by eye) General shape of each option’s “hockey stick” diagram. (ii) Marks should be awarded for the following features: Same axes and same scales — one rather than two diagrams; Common strike price of the combined option portfolio; Maximum loss of 3 units (implied by 2:1 ratio of premiums for basic options

in (i)) (suggested on inspection by eye); “V” shape of diagram. (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.

6 (i) Confidence: It is important that there is confidence in the financial system. Systematic Failure: There is a danger of problems in one area spreading to

other parts of the financial system. There is believed to be a significant asymmetry of information, negotiating

strength and expertise in the financial markets especially among retail investors.

(ii) The direct costs of regulation arise in administering the regulation and in

compliance for the regulated firms. Some possible indirect costs include:

• Consumers behaviour is altered which gives rise to a false sense of security and a reduced sense of responsibility.

• A reduction in the consumer protection measures developed by the market

itself. • Product innovation is reduced. • Competition is reduced. • The sense of professional responsibility amongst intermediaries and

advisors is undermined.


Page 8

7 (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) In a debenture trust deed, the individual interests of the usually substantial

number of holders of a debenture are channelled into the trust. The trustee holds and protects the aggregate of the personal rights of all

members of the trust. A debenture trust may be thought of as providing efficient administration. 8 (i) Raising new or refinancing capital — many possible purposes, acquisition,

investment in the business, fund new projects, financing of pension fund… Restructuring the balance sheet — share buy backs, securitising future

cashflows. (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) Assuming the bond doesn’t default Yen 3.75% p.a. £ 3.25% p.a. (4.5% + 1.25% - 4.5% + 2%)


Page 9

The government bond used for comparison has a similar maturity/duration to the “Japanese” bond being considered.

Currency movements reflect the interest rate differentials between the two

countries. (iv) Issue bond in sterling Implement forward currency transactions to neutralise currency mismatch

risks 9 (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:

• Some sensitivity testing of ultimate proceeds and how mortality experience might impact on the ultimate return, most likely using stochastic analysis.

• Need to understand how sensitive the return on the bond is to mortality

experience, as opposed to economic factors. In the longer term it may become important to monitor the sensitivity of the fund to mortality factors, from a risk control point of view.


Page 10

• Investigate size of potential market, from both a supply and a demand point of view.

• 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.

• Specific information on the pool of insured annuitants should be investigated.



EXAMINATION













© Faculty of Actuaries ST5 S2007 © Institute of Actuaries

ST5 S2007—2

1 (i) State the three main aims of regulation. [1] (ii) With any type of regulation there is a cost. (a) Outline the different types of costs involved. (b) How do these costs impact the overall objectives of the regulator. [5] [Total 6] 2 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) Describe the financing options available to the company. [5] (ii) Outline the main contract terms that differentiate between the types of

borrowing available. [4] [Total 9] 3 Three companies are intending to raise finance via the debt market.

• Company A — A government backed company which has a history of strong profits and low levels of debt.

• 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. • Company C — An internet start up company that intends to sell wedding cakes

on-line.

(i) Explain with reasons the credit rating that is likely to be assigned to each of the three bond issues. [2]

(ii) (a) Define the term expected default loss. (b) Explain how this would vary for each of the three companies.

[3] All three companies decide to issue zero coupon bonds. (iii) (a) Assuming the yield on a comparable treasury stock is 4.25% p.a., state

what yields would be appropriate on a zero coupon bond issued by each company.

(b) Calculate the expected default loss for the first year of each bond,

stating any assumptions that you make. [8]

ST5 S2007—3 PLEASE TURN OVER

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] 4 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) Explain the main uses of derivatives. [8] (ii) For a derivative contract traded on an exchange: (a) Explain the term margin. (b) Outline the different types of margin payments that are payable. (c) Explain why a clearing house requires these payments.

[3]

(iii) (a) Explain the difference between a Put and a Call. (b) Explain the term European and American in the context of options.

[2]

The current share price of XYZ is 60p. Your friend has been offered the following options in XYZ.

Strike Price

3 Month 6 Month

Call — 75p 5p 10p Put — 85p 10p 5p

(iv) 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]

ST5 S2007—4

5 (i) Describe the main forms of government policy. [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) Describe how this move is likely to impact: (a) individuals (b) businesses (c) the economy as a whole

[6] [Total 10] 6 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) Outline the main types of hedge fund that the pension fund could

invest in. [2]

(b) Describe the main investment characteristics of a hedge fund. [3] One of the criticisms of hedge funds is the lack of reliable performance data. (ii) Explain why there is a lack of credible performance data. [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] 7 An institutional fund management company listed on the Alternative Investment

Market has sought your advice on how it can better manage the operational risks in its business.

(i) Outline the risks that you would seek to address. [3] (ii) Describe ways in which these risks can be managed. [9] [Total 12]

ST5 S2007—5

8 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) Describe the role of a listings authority. [5] (ii) State the information you would wish to see in order to provide a valuation. [5] [Total 10]

END OF PAPER


EXAMINATION

September 2007


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 A Stocker Chairman of the Board of Examiners December 2007



Page 2

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 3

1 (i) To correct market inefficiencies and to promote orderly markets To protect consumers of financial products To maintain confidence in the financial system (ii) Direct cost

• administering the regulation and compliance of firms Economic cost

• An alternation in the behaviour of consumers, who may be given a false sense of security and a reduced sense of responsibility in their own actions

• Undermining of the sense of professional responsibility amongst intermediaries and advisors

• A reduction in consumer protection mechanisms by the market itself • Reduced product innovation • Reduced competition

2 Money Market Instruments (Unit 5) (i) Term loans Evergreen credit Revolving credit Bridging loans International bank loans Trade credit (ii) Commitment Maturity Rate of interest Security


Page 4

3 Money Market Instruments (Unit 5) (i) Company A, AAA or AA with supporting argument Company B, AA or A with supporting argument Company C, BBB/Junk Bond

(ii) EDL = Value of Treasury Bond – Value of Corporate Bond The expected default loss will go up from A through to C

(iii) (a) The following yields or similar would be expected (different yields

would impact subsequent calculations illustrated).

Company Yield Company A 4.75% Company B 6.00% Company C 8.00% Treasury Bond 4.25%

(b) Assume all trade at par. Treasury Bond = 95.84 Company A = 95.36 loss = £0.48 Company B = 94.18 loss = £1.66 Company C = 92.31 loss = £3.53 (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 sector’s 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 5

This would imply that the spreads for companies A/B/C might increase from 50/175/375 bps to 50–75/200–250/425–500bps, before allowing for company specific factors.

4 Derivatives (Unit 7) (i) The main uses of derivatives are as follows:

• 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 6

• 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 fund’s exposure to an asset category or to change a fund’s exposure within an asset category.

(ii) (a) Margin — definition Unit 7 pg1. (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. (c) The clearing house is removing the credit risk and they need some

form of compensation to cover themselves for this risk.

(iii) (a) Put — the right to sell an underlying asset for a certain price by a certain date.

Call — the right to buy an underlying asset for a certain price by a

certain date. (b) American — exercised at any date to expiry. European can only be

exercised on expiry date.

(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 7

5 Government Policy (Unit 11) (i) Main forms of government policy Monetary Policy Fiscal Policy National debt management policy Exchange rate policy Prices and income policy (ii) Main economic indicators Unemployment Inflation Balance of Payments Economic Growth

(iii) (a) Individuals — reduce variable rate mortgage and debt payments

(making people better off). Consumers likely to increase spending on non-essential services and luxury items. Reduced rate of interest will act as a disincentive for cash savings, although this may be offset by reduced debt payments for some. Imported goods likely to increase in cost due to impact on exchange rates.

(b) Businesses — Capital investment and economic growth likely to

increase due to reduced opportunity cost of committing funds. Increased economic activity likely, offset by lower domestic currency rates which will increase cost of imports.

(c) Economy — increased inflation and growth expectations (from a low

base), possible recovery and increase in inward foreign investment. Longer term concerns about uncontrolled inflation may begin to emerge.


Page 8

6 Hedge Funds (Unit 5) (i) (a) Global Funds Event-driven Funds Market Neutral Funds (b) Describe the main investment characteristics of a Hedge Fund Placing large bets on different asset classes High level of borrowing Mix of investments Willingness to trade in derivatives Illiquid High Fees High risk (ii) Partial market coverage Survivorship bias Selection bias Marking to market bias (iii) Issues for scheme, trustees and sponsors Capital management or financing

Pension management

• Liability cash flow management

− Compensation for inadequacies of bond markets

• 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

Sponsor may be more concerned with volatility of deficit and earnings/corporate activity impacts rather than size of deficit itself

• 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


Page 9

• Market neutral hedge funds plus swaps/bonds equal “Liabilities Plus” fund • Bulk of exposure is through Fund of Funds

Hedge funds have a role as the alpha generator in new products, but could lose

their separate identity

• Not all managers, perhaps even the majority, are skilful • Need a rigorous and different process to identify and invest in persistent

skill 7 (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) The control of operational risk essentially depends on good management

practices. To manage operational risk, the investment manager would need to identify,

assess, put together a series of risk mitigation strategies — one for each non-trivial risk.

Good management practices include: Established and documented chains of reporting and responsibility Separation of duties as between say, front office and back office staff in the

issuing of trading instructions and the confirmation & settlement of such instructions.

Documented and robust procedure for carrying out essential tasks and for

taking on new activities or developing new products Ongoing monitoring of risks and their mitigation techniques


Page 10

8 (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: • The production of relevant business and financial information on the issue

of shares. • The process by which shares are offered to potential shareholders and the

price is set for the issue of shares.

• Continuing production and dissemination of business and financial information on a timely basis on companies with listed securities.

• The continuing conduct of the market in listed securities with a view to

ensuring that the market is fair to all participants, and that the pricing process is fair and reasonable.

• 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.

(ii) The value of the company will be driven by the level and likelihood of future

profits. General factors

• Information about the management and an assessment of their ability to

deliver in a public company. • The type and quality of the products sold • Prospects for market growth • How the company fairs against the competition • Details of operating costs • Details of past retained profits • The history of the company


Page 11

Financial measures

• Financial accounts and accounting ratios • Dividend and earnings cover • Profit variability and growth • Level of borrowing • Level of liquidity • Growth in asset values • Comparative figures for other similar companies



EXAMINATION

16 April 2008 (pm)











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 A2008—2

1 (i) List the types of activity central banks engage in. [3] (ii) Define liquidity risk. [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) Describe ways in which these disadvantages could be mitigated. [2] [Total 14] 2 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

Current Value (£m)

Target Assets

Target Value (£m)

US equities 400 UK equities 300 UK equities 100 UK gilts 400 Emerging market equities 100 Overseas bonds 100 Private equity 150 UK gilts 50 Total 800 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] (iii) Outline the limitations and downsides of the strategies proposed. [4] 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. [2] (v) Describe how the costs identified in (iv) will be affected by the current market

conditions. [3] [Total 15]


3 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 First 3 years £9m p.a., payable annually in advance

Thereafter £9m p.a. plus 5 years’ cumulative inflation, increasing in line with future inflation, payable annually in advance

Ground rent £100 p.a. payable annually in advance

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] 4 (i) Describe the two principal global equity index series. [2] (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. [2]

(iv) 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 A2008—4

5 (i) List the principal aims of financial regulation. [2] (ii) (a) Define a self-regulatory system. (b) Discuss the advantages and disadvantages of self regulation in the

investment management and the securities industries. [6]

[Total 8] 6 A risk averse individual coming up to retirement age has around 1% of their

retirement funds invested in the shares of a highly respected bank. The bank has historically been involved in low risk activities, producing steady returns. Since new management was put in place 3 years ago the bank has been involved in a number of high profile risky investments which have gone wrong. As a result there has been a sharp decline in the share price.

(i) Outline how the change in management has affected the risk and return profile

of the individual’s 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) Discuss whether the investment is suitable for the individual’s circumstances.

[2] 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] The investor decides to use the technique in (iv). (v) Describe the effect on the investor’s exposure to the bank if the bank’s share

price rose by 30%. [2] (vi) Describe the effect on the investor’s exposure to the bank if the bank’s share

price fell by 30%. [2] [Total 15]

ST5 A2008—5

7 (i) List six factors that are important to take into account when valuing a company. [3]

(ii) List six sources of information that an analyst may use when valuing a

company. [3] (iii) Describe how the P/E ratios of the following types of company may change

through an economic cycle: (a) a house builder (b) a tobacco company (c) 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) Discuss the advantages and disadvantages of adopting this methodology. [3] [Total 18]

END OF PAPER



EXAMINERS’ REPORT

April 2008

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


Subject ST5 (Finance & Investment Specialist Technical A) — April 2008 — Examiners’ Report

Page 2

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 3

1 (i) • determining monetary, interest rate and inflation policy • regulation of banks • implementation of government borrowing • ensuring the performance and integrity of financial markets • intervention in currency markets • printing and minting of notes and coins • taxation • lender of last resort

(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 4

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. 2 (i)

• Asset class mismatch between equities and bonds • Country mismatch between overseas assets and UK assets • No private equity holding going forward

(ii)

• Use of futures/derivatives/swaps to make current assets look like the target assets

• Detailed example – e.g.: Short US equity futures by £400m, emerging market £100m, private equity £150m

• Long UK equity £200m, UK gilts £350m, overseas bonds £100m • Ask current managers to restructure their current holdings to replicate asset

classes using physical holdings (iii)

• Futures – might not have suitable futures, especially private equity, • basis risk between active manager and future benchmark, • costs of putting on derivative position, • extra management required to manage future contracts • Physical sell – investment costs (commissions, taxes) of moving to interim

strategy and then extra costs of moving to final strategy once selected. Existing managers might not have capability of managing in other asset classes.


Page 5

(iv) • Taxes, commissions, spread costs, market impact costs, FX costs,

administration and custodian costs

(v) • Taxes, commissions likely to be unchanged • Spreads widen • Market impact costs increased • Custodian costs likely to increase as larger number of split trades due to

poor liquidity • Probably moving to more liquid/tradable currencies within overseas bond

exposures but will need to sell out of emerging positions 3 (i) Reasonable formulae, with consistent assumptions, such as:

( ) ( ) ( ) ⎥⎦

⎤⎢⎣

⎡++⎥

⎦

⎤⎢⎣

⎡+++= ∑∑

=

−

=

−−−

−−

− 29

0

29

1

25.0inf

525.01

25.0inf1 1100£1119£

t

tt

t

tt

tt zzz

InfzmPV

where Inft is the realised inflation index at time t, zt is the zero coupon bond

rate at time t and inf 0.25tz − 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:

( ) ( ) ( ) ⎥⎦

⎤⎢⎣

⎡++⎥

⎦

⎤⎢⎣

⎡+⎟⎟

⎠

⎞⎜⎜⎝

⎛++= ∑∑ ∏

=

−

=

−

=

−

−−

− 29

0

29

1 1

25.0inf

525.01

25.0inf1 1100£1119£

t

tt

t

tt

t

it zzz

InfzmPV

(ii) 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 6

(iv) The key sources of risk are:

Freehold

• Downturn in the economy can lead to a decline in value as occupancy levels fall. The long lease provides a degree of protection provided the bank continues to occupy the building and maintains rental payments.

• Oversupply of new office space leads to a decline in value as occupancy

levels fall. The long lease provides a degree of protection. • 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.

• Building design/specification falls out of favour. Reversion value will

therefore fall (relative to other properties in same 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 sub-let 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).

• Cost of fulfilling covenants or pursuing leaseholder to fulfil

• Void risks. Under either scenario above, there is a risk of void

(incomplete/nil occupancy) which would lead to a loss of rental income. Void risk increases with time and a downturn in the economy

Inflation swap

• Changed/broken/new lease. The inflation swap would need to be cancelled/netted out or run off as the hedge against the inflation linkage in


Page 7

the rental payments would no longer be valid. This would create further costs and possible liquidity issues.

• Default risk (if explained well)

4 (i) FTSE World Indices The FTSE World Indices cover over 80% of the world’s equity markets in

terms of market capitalisation and are broad market indices that aim to cover the vast majority of the free float stocks that are available to overseas investors. Index values are shown for each country, in 5 currencies: Sterling, US Dollar, Japanese Yen, Euro and the local currency. There are also regional groupings of countries (weighted by market cap) and an All-World Index.

Morgan Stanley Capital International Indices This is a series of international equity indices covering both developed and

emerging markets. They are calculated on a market capitalisation weighted arithmetic basis and total returns are published both gross and net of withholding tax, and in US Dollar, Euro and local currencies.

(ii) Replication in tracker portfolio Sampling ETF Buy futures Buy assets (e.g. cash or stocks) and engage in an OTC swap to pay the return

on the assets and receive equity market return (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) The key feature that is needed for an exchange-traded derivative contract is

liquidity. This means that the contract should be based on the most popular local index to maximise demand from users of the derivative.

This is less of an issue for OTC markets, where client preferences will be more important.

Liquidity of the underlying stocks is also important to ensure that the derivative price closely tracks the underlying stocks (as pricing variations can be arbitraged away rapidly).

This leads to a preference for large-cap stocks over small-cap stocks within the underlying index.


Page 8

Using a large-cap index as opposed to a broad-market index also means that the price of the derivative and index value are both available continuously throughout the day, improving liquidity further.

Where the underlying index is not continuously quoted or the index constituents are illiquid, it is likely that pricing of the derivatives will include wider spreads to reflect this illiquidity and uncertainty.

5 (i) The principal aims of regulation are:

• to correct market inefficiencies and to promote efficient and orderly markets

• to protect consumers of financial products • to maintain confidence in the financial system • to help reduce financial crime

(ii) A self-regulatory system is organised and operated by the participants in a

particular market without direct government intervention. Advantages: The system is implemented by the people with greatest market knowledge. System is implemented by people who are incentivised to maximise cost

benefit ratio of regulation and ensure system is non-bureaucratic. Should be more flexible than the alternatives and be able to respond rapidly to

changes in market needs. Cooperation with a self-regulatory organisation may be more forthcoming

than with a government agency (but not necessarily). Disadvantages: Regulator will be perceived to be closer to industry than customers. This can lead to a lack of confidence from consumers and purchasers… …particularly when criticism of industry is high in the wider economy Self-regulatory organisation likely to have fewer powers to fine and punish

industry members than a government agency established under statute. Barriers to entry 6 (i) The bank has become a riskier investment – there may be an additional sector

risk if this bank’s 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) Expect the share price to increase Regret aversion – by maintaining existing arrangements people minimise the

pain associated with feeling of loss Overconfidence in their ability Status Quo bias – like to keep things the same Good diversifier in overall portfolio


Page 9

Could be part of an index tracking portfolio Tax considerations Income may be appreciated (iii) Individual is close to retirement hence would expect to be in less risky

investments where capital more guaranteed. However, depends exactly when investor expects to retire. Small part of overall portfolio so might be suitable if most other holdings are

relatively safe. If majority of investments are equity then probably not suitable. (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) Using example in (iv) to answer (v) and (vi): Will keep premium

Current holdings will increase in value by 30% (vi) Will make loss on put options and Would have to buy additional shares at agreed price Making higher loss and increasing exposure to bank. Existing holdings decrease in value 7 (i) Factors that are important in valuing a company: Management ability Quality of products Prospects for market growth Competition Input costs Retained profits History (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 company’s management Discussions with competitors Stockbrokers’ publications.


Page 10

(iii) (a) A house builder is economically sensitive. The earnings will rise and fall with the economic cycle, they are

volatile. Investors try to anticipate the future earnings profile. When the economy is buoyant earnings will be high however investors

will be discounting an economic slowdown and therefore the p/e will be lower than the average p/e for the company through the cycle.

Similarly when earnings are low the p/e is likely to be high as investors look forward to an upswing in the economy.

(b) Tobacco companies are economically insensitive. Therefore the p/e of the tobacco company is relatively insensitive to

the economic cycle. Investors have no need to anticipate the future earnings profile.

(c) A retail bank is economically sensitive The earnings will rise and fall with the economic cycle, they are

volatile. Investors try to anticipate the future earnings profile. (iv) Discounted cash flow valuations can be very useful in valuing a company. The result of a discounted cash flow number is an absolute number that can be

compared to other DCF valuations. DCF valuations can be used where a company generates no profit and pays no

dividend for instance a start up. It would depend on the sector being analysed, some sectors are more suited to

DCF valuations than others. DCF valuations are more time consuming. DCF valuations can be very sensitive to the assumptions made e.g. the

discount rate and the growth rate. DCF can be difficult to explain to others.



EXAMINATION














ST5 S2008—2

1 (i) Set out a formula for calculating the information ratio for a portfolio that contains two asset classes, defining all terms used. [3]

Asset Class

Annual Return (%)

Tracking Error (%)

Asset Class Correlations

1 2 3

1 10.0 10.0 1.00 2 7.0 5.0 -0.25 1.00 3 5.0 5.0 0.25 0.50 1.00 Risk Free 4.0

(ii) Using the above data, for each pair of asset classes calculate: (a) the proportions of each class that satisfy a minimum variance portfolio (b) the information ratio for each portfolio [8]

(iii) Comment on the results in (ii) (b). [2]

(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. [10] 3 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:

• gaining superior information • processing the information better • eliminating behavioural bias

(i) (a) Explain how outperformance might be generated from each of the

three sources. (b) Comment on whether the target return can be generated by use of these

sources. (c) Comment on whether the 3% p.a. target is reasonable.

[11]

(ii) Discuss the implications the fund launch might have on the structure and management of the investment management department. [7]

[Total 18]


4 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:

Company

Initial Market Cap

(EDUm)

Initial Price(C)

Price at end of first day

(C)

Price at end of second day

(C)

A 500 200 205 205 B 300 150 151 155 C 200 50 50 52 D 700 350 345 348 E 800 400 402 380 F 900 100 102 103 G 1,000 500 505 503

(Initial Market Capitalisation is measured in millions of Equivalent Dollar Units

“EDU” and Prices are in Cents where 100 Cents = 1 EDU) Company E had declared a dividend of 25 and the stock went ex-dividend at the

beginning of the second day.

(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) Outline the practical problems that would be encountered by an overseas

pension fund investment manager in using this index as a basis for index-tracking management. [9]

[Total 17] 5 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) List the uses of equity market indices. [4] (ii) List the main features and characteristics of the main equity indices of UK,

USA, Japan, Germany and France. [5] (iii) State the main uses of exchange-traded options. [2] (iv) Outline the appropriateness of using exchange-traded options for your

company. [4] [Total 15]

ST5 S2008—4

6 A wealthy UK investor is considering buying shares in a luxury car producer based in an emerging country. The unlisted car producer has been running for less than 12 months, but has decided to float its equity on the local stock exchange in 6 weeks time. The investor has been offered shares at a price which is at a 10% discount to the expected flotation price.

(i) 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 investor’s 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] 7 The government of an emerging country is encouraging local companies to set up

pension funds for their employees. Historically the government has provided retirement provision and, therefore, there has been a lack of regulation of institutional investments. You are a financial advisor to the government and have been asked to develop a regulatory framework for the new pension funds.

(i) State why it is important for there to be regulation of institutional investments. [3] (ii) Outline the principles you would recommend adopting under legislation for

institutional investment. [6] [Total 9]

END OF PAPER



EXAMINERS’ REPORT

September 2008

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


30/12/2008


Page 2

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.

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1 (i) IR = [αri + (1 - α)rj – rf]/[α2σi2 + (1 - α)2σj

2 +2α(1 - α)ρijσiσj]½ where α = proportion in asset class i ri, rj = annual return for asset class i, j i = 1, 2 i < j ≤ 3 rf = risk free return σi, σj = tracking error asset class i, j ρij = correlation between asset classes i and j. (ii) To satisfy minimum variance differentiate denominator of IR with respect to α

and set to zero. This gives a solution of α = [σj

2 – ρijσiσj] / [σi2 + σj

2 - 2ρijσiσj]

Asset Pair

α r (%) σ (%) IR

1,2 0.25 3.75 3.95 0.95 1,3 0.125 1.625 4.84 0.34 2,3 0.5 2.00 4.33 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 asset’s 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.

2 The most important consideration is the retailer’s 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?

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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. 3 (i) (a)+(b) Alpha is the difference between a fund’s 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:

• Gaining superior information This should not be confused with inside information. In practice this is probably the most difficult of the three areas to gain a

competitive edge. Information can be gained from a number of sources – the company

itself, their competitors, their customers, their suppliers, the press etc.

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In order to gain superior information an analyst will probably need to spend more time researching the company and its industry.

This has implications for the number of stocks an analyst can cover

and therefore for the total number of analysts required.

• Processing the information better 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.

• Eliminating behavioural bias This is easier said than done. There are a number of behavioural biases. Namely: Anchoring, loss aversion, framing, over confidence and

mental accounting. Elimination of all these sources of bias would take considerable

expertise in the field of behavioural finance. In order to effectively eliminate these biases some form of mechanistic

investment process may be required. If it were possible to eliminate behavioural bias this would not

necessarily lead to the generation of alpha as if other investors were still influenced by behavioural bias these biases could influence asset prices.

Therefore the elimination of behavioural bias may lead to better long

term performance but it may have a detrimental impact on short term performance.

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(c) Given/depending on the arguments advanced in (b) it would seem that the 3% target is challenging, especially allowing for fees of management. It is possible that such a performance is achievable in the short term (and this would be borne out by historic manager return statistics), but may be much harder to sustain a long term competitive advantage, especially as other managers may come to adopt similar styles and so “arbitrage out” the scope for added value. Credit will be given for other reasoned arguments.

(ii) In order to implement such a strategy the department would need:

• A large number of analysts unless the aim was only to cover a limited part of the market.

• A quantitative team.

• Experts in behavioural finance.

• A data entry function to input the large amounts of data.

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. 4 (i) The formula is:

Index level at time 0( / )= i it i

i i

W P Pt KW

∑∑

Where Pit is the price of stock i at time t. Pi0 is the price of stock i at the base date. Wi is the weight applied to stock i.

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K is a constant related to the starting value of the index at the base date.

The weights used are usually the market capitalisations at the base date.

The initial value if the index can be set at any number other than zero,

however it is usually a round number e.g. 1,000. (ii) From the equation above the value of K in this case = 10,000. The index value at end of day 1 = 10,000*(512.5+302+200+690+804+918+1010)/4,400 = 10,082.95 The index value at the end of day 2 =

10,000*(512.5+310+208+696+760+927+1,006)/4,400 = 10,044.32 (iii) In calculating a total return it is usually assumed that dividends are reinvested

back into the index at the ex-dividend date. In this case there was one dividend of 25 and stock E went ex-dividend at the start of day 2.

Total return = ((10082.95+50/0.44)*10044.32/10082.95)/10,000 = 1.01575 i.e. 1.58% (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.

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Needs to reflect situation of non-domestic investor and the ability to replicate or otherwise track individual markets.

There may be limited derivatives available to develop synthetic approaches. 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.

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5 (i) • Measure of short term market movements • Providing a history of market movements • Tool for estimating future movements in market given past trends • Benchmark for assessing portfolio performance • Valuing notional portfolio • Analysing sub-sectors of the market • As a basis for index funds to track a particular market • To provide basis for the creation of derivative instruments

(ii)

• 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

(iii)

• Efficient portfolio or transition management i.e. Asset allocation, equitising cash holdings

• Long term and/or short term risk reduction i.e. Hedging strategic exposures

• Creating structured products with bespoke payoff profiles • Speculation

(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,

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- enforcement of market regulation to ensure fairness and transparency, and

- maintenance of orderly markets, especially during fast trading conditions.

• Basic options are to buy/sell puts/calls (and combinations thereof) depending on investors view of the markets

• As a small life office, ETOs offer low administration/efficient portfolio management and the ability to hedge risks to comply with regulatory or statutory requirements, particularly in volatile markets when fund cashflows are uncertain. Similarly they can be combined with other investments to create more attractive pay-off profiles with minimal counter-party risk.

• However like all standardised contracts, there will be inherent basis risk between the option and the office’s underlying holdings and there may be cashflow or other trading risks if options are exercised.

• Buying options involves paying a premium which may be subsequently proven to have been “wasted” and so impact returns (and potentially competitive positioning).

6 (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) Describe the difficulties.

• Lack of publicly available information to analyse the company. • Lack of company history for profit and cost analysis. • Upfront costs of company setting up be higher than on-going. • Difficult to predict demand for new brand. • Lack of luxury car companies in same period of development for which to

benchmark. (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.

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(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.

7 (i) Describe why it is important.

• To protect the ultimate beneficiaries from gross incompetence or mismanagement by fund managers.

• To encourage confidence in investment schemes and the benefits they secure.

• To promote the accumulation of investible funds. (ii) The principles you would recommend.

• Effective decision making – decisions only taken by people with skill, information etc.

• Clear objectives – Setting investment objectives which represent best judgement on funds liabilities.

• Take account of attitude to risk • Focus on asset allocation – should set strategic asset allocation to be in line

with required risk return characteristics of individual fund circumstances • Expert advice – need for expert advice for actuarial and investment advice • Explicit mandates – Agree fund manager objectives, benchmark, risk

parameters. Understand the manager’s approach in attempting to achieve objective.

• Clear time scales of measurement and evaluation. • Activism – Managers should have explicit strategy on activism • Appropriate Benchmarks – explicit and benchmarks appropriate to assets

being invested in. • Default fund options. • Performance Measurement – Have formal performance measurement

agreements including the period which reviewed. • Transparency – Statement of investment principles on who is taking

decisions, the fund’s investment objective, planned asset allocation, mandates given to managers, fee structures.

• Regular Reporting – members should be sent annual results of monitoring of fund managers.


30/12/2008


EXAMINATION

22 April 2009 (pm)





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.


supervisor. 4. Mark allocations are shown in brackets. 5. Attempt all six questions, beginning your answer to each question on a separate sheet. 6. Candidates should show calculations where this is appropriate.

Graph paper is required for this paper.





ST5 A2009—2

1 (i) Describe the uses of performance measurement for an investment portfolio. [6]

(ii) Discuss the limitations and disadvantages associated with portfolio

performance measurement. [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 fund’s managers. [5] [Total 27] 2 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) (a) Describe what you would expect to see in a high quality piece of

fundamental research of this nature. (b) List the factors that you might expect to see included in the numerical

analysis. [6] (ii) 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]


3 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

Number of days in period Annual Forward Interest Rate

1 183 4.00% 2 181 4.25% 3 182 4.5% 4 182 4.75% 5 181 5.0% 6 183 5.25%

(i) Define the term puttable swap. [1] (ii) Explain why a pension fund may wish to purchase a puttable swap. [2] (iii) State the type of swap that the trustees have purchased. [1] (iv) Using the information above calculate:

(a) Present value of the floating rate payments. (b) The fixed rate of the swap. [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 A2009—4

4 (i) (a) Define the term Warrant. (b) State two differences between a Warrant and an Option.

[2] (ii) (a) Define the terms American call and European call. (b) Explain which one is likely to attract a higher premium.

[2]

(iii) Draw a diagram for each of the following strategies and explain why an investor may wish to undertake such strategies.

(a) Long one call at a strike price of (X – a)

Short two calls at a strike price of X Long one call at a strike price of (X + a) All three have same expiry date

(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 investor’s 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) State the payoff for the investor. [1] (v) Draw the payoff chart for the entire holding. [2] (vi) Calculate the profit or loss to the investor if the price of the share at expiry is: (a) £0.75 (b) £1.50 (c) £2.15

State any assumptions made. [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 A2009—5

5 (i) Define the par yield of a bond. [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 5.50% 2 5.40% 3 5.35% 4 5.30%

[6] (iv) Describe three techniques that can be used to identify bond anomaly switching

opportunities. [6] [Total 15] 6 (i) (a) Describe the primary purpose of an investment manager agreement. (b) List typical restrictions that might be included within an investment

manager agreement for a global bonds portfolio for a charity fund. [3] (ii) Explain why agreements for active managers generally adopt a relatively

prescriptive approach, rather than giving the manager complete discretion in how they achieve the target return. [4]

[Total 7]

END OF PAPER



EXAMINERS’ REPORT

April 2009

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



Page 2

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 non-standard/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 3

1 (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) There are several limitations and disadvantages of portfolio performance measurement. Projection of past results: the fact that a particular result was attained in the past does not mean that it will occur in the future. There is a random element in investment returns and it may be difficult to determine how much a fund manager’s results are due to method and how much to luck. Furthermore a technique that proved successful in a particular set of circumstances may not work so well in changed circumstances in the future. Risk: in the long term we would expect a riskier strategy to produce higher average returns. The measurement of relative performance should therefore take account of the degree of risk taken on by a fund manager. Timescale: determining the frequency of performance measurement calculations requires a delicate balance between assessing performance frequently enough so that problems can be spotted and corrected and avoiding spurious conclusions based on too short a measurement period. Differing fund objectives: different funds may have different objectives and constraints. Comparisons between such funds may not be valid.


Page 4

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 fund’s 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) Index statistics will be influenced by:

• Survivorship bias — unlike in other asset classes, it is difficult to obtain data on hedge fund failures when “backfilling” a history at the time an index is launched by an index provider. This will create an upward bias.

• 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.

• Marking to market bias — where underlying securities are illiquid, funds

may use “stale” prices or mark asset values to a valuation model. Whilst this does not necessarily result in a bias to the return data, it is likely to result in lower volatility figures than would be the case otherwise.

(iv) p

p

R rS

−=

σ

where Rp is the return on the portfolio

r is the risk-free rate of return (usually taken to be 3 month LIBOR) σp is the standard deviation of portfolio returns

(v) The Sharpe ratio is widely understood by investors. The Sharpe ratio can be calculated without reference to the beta of a portfolio... ...making it more practical to compare strategies across different asset classes... ...including asset classes where there may not be an obvious market portfolio that can be used as a reference point. Both the Jensen and the Treynor ratios rely on beta being a proxy for the level of active risk taken by the asset manager. [Credit was awarded for any other reasonable points made]


Page 5

(vi) The key limitations of the Sharpe ratio with regard to hedge fund returns are as follows:

• Mismatch with utility function – the Sharpe ratio falls as downside or

upside volatility increase. In practice, investors will specifically be concerned to avoid downside risks within their utility function.

• Sampling issues – historic calculations will be limited by the length of

available history. With hedge fund strategies, it is possible to employ a strategy that appears low risk for an extended period but has a large tail risk (e.g. selling volatility by writing out-of-the-money put options), and the Sharpe ratio will not capture information about low frequency high severity events.

• Non-normal return distributions – the Sharpe ratio will give a consistent

measure of excess return to risk for normal distributions, however standard deviation is not a useful proxy for risk for all return distributions. This is particularly the case for many hedge fund strategies.

All of these sources of distortion can result in sub-optimal investment decisions.

2 (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) The analysis should include historical statistics and forward-looking

estimates for several of the following factors to enable a picture of the financial position of the companies to be built up:

• Revenues • Operating profit • Pre-tax profit • Earnings per share • Price/earnings ratio • Price/book value • Dividend yield • Outstanding debt


Page 6

Where appropriate, the numerical analysis may need to be supplemented by qualitative commentary to justify the recommendations for each company.

(ii) There should be additional commentary/analysis on the following:

• details of maturities of the company’s existing bonds and loans • trends in the company’s balance sheet over the next 5 years • trends in revenues and operating expenses [P&L alternatively] over the

next 5 years • the likelihood of the existing borrowings being refinanced in the current

climate without other compensating corporate actions • potential corporate actions that may need to be carried out to facilitate a

refinancing (e.g. disposals or rights issues to raise cash) • the likely change in financing costs as a result of the refinancing, based on

analysis of recent loan spreads for the sector and the economy • impact on credit rating • investor appetite for bonds/syndicated loans from this issuer

(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 investor’s

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

• 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).


Page 7

• Alternatively the above may reflect a preference to overweight particular sectors (e.g. mining companies and oil companies tend to employ less leverage than say financial companies) within the portfolio.

• Where one of the two niche funds is being chosen based on beta-based view (whether long-term or short-term), the particular product would only be appropriate if the investor believes that the manager is capable of delivering alpha in the chosen category (otherwise a passive strategy would better suit the investor).

Portfolio construction/style diversification The investor may be working around other equity styles within the existing portfolio, and one of the two niche funds may be more appropriate (e.g. the investor wishes to invest in a style neutral manner but feels that the Lower Leverage fund will better complement an investment in a Global Equity Growth fund offered by another manager). The investor may also have adopted a risk-budgeting approach and one of the two niche funds may be a more suitable addition to the portfolio from the earmarked funds for investment. This would assume that the investor does not have strong alpha and beta views, that would naturally lead to additional adjustments elsewhere in the investor’s portfolio.

(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.

3 (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 8

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) Interest rate swap. (iv)

Period Number of days in period

Annual Forward Interest

1/2 year interest rate

1 183 4.00% 2.03% value 500000002 181 4.25% 2.14% term 33 182 4.50% 2.28% payment semi-annual arrears 4 182 4.75% 2.40% days 3605 181 5.00% 2.51% 6 183 5.25% 2.67%

(a)

PV

Discount

PV of payments

Notional

1 1/[1+(days/360*Interest)] 0.9801 996406 249101602 1/[1+(days/360*Interest) 2 periods] 0.9596 1025205 241224683 etc. 0.9382 1067229 237161974 etc. 0.9162 1100102 231600355 etc. 0.8938 1123398 224679626 etc. 0.8705 1161602 22125746

Total 5.5584 6473942 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 140502569 PV of floating rate 6473942 Theoretical swap rate 4.61%

(v) PV of fixed rate = 4.75 / 4.61 × 6473942 = 6670520

Profit = 6670520 – 6473942 = £196,578 (or the “rounded” equivalent) The fixed rate is higher than the theoretical swap rate so assuming the

payments reflect the assumed then the pension fund will be in the money, i.e. calculation should show a profit, as they have been paid a higher amount from the bank (via fixed) than paid out.


Page 9

(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)

4 (i) (a) An option issued by a company. The holder has the right to purchase

shares at a specified price at specified times in the future. (b) Options can have more flexible exercise dates than warrants. Warrants are new shares issued and therefore dilute share capital,

options are right to buy existing share capital. Warrants are OTC where as options tend to be exchange traded. Warrants have longer expiry than options. (ii) (a) European – right to purchase at set price at set date in future. American – right to purchase at set price at any point before expiry

date. (b) American as it has the added flexibility.

(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.


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(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) O – St +K where St is greater than K, otherwise O. St = price of stock, K = exercise price, O is price of option. (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 11

(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.

5 (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 2

2 1 2 21 1 1 1C zc C zc− −= + + + + (iii)

Term Par Yield V(Bond) V(Bond exc last) ZC Yield 1 5.50% 100.000% 5.500% 2 5.40% 100.000% 94.882% 5.397% 3 5.35% 100.000% 90.114% 5.346% 4 5.30% 100.000% 85.679% 5.290%

(iv) Any three from: Yield differences: in considering possible anomaly switches, yield differences

are widely used to identify individual bonds which seem cheap or dear, in relation to other bonds. However, because of the fact that high coupon bonds are likely to have higher gross yields than low coupons, a high gross yield does not in itself indicate that a bond is cheap. The investor must examine whether the yield difference is greater or less than it has been in the past.

A problem with the evaluation of individual bonds in relation to a fitted yield

curve has been the stability of the method used to fit the curve. It is now more usual to review a computer generated history of yield spreads between pairs of actual bonds.

Price ratios: these can be monitored as well as yield differences. Ideally, a

switch under consideration will look attractive, in relation to both yield and price histories. A practical problem in using price ratios is that they do not allow for the fact that the two bonds may have different coupons; they will have different prices but will both be redeemed at 100. So the ratio of the two prices will display a trend. This history of price ratios may be adjusted by this trend to produce what are often known as “stabilised” price ratios.

Price models: some bond analysts have devised price models which try to

assess the “correct” price for a stock, given the key variables. A stock’s price is considered anomalous if the actual price differs from the price derived from the model.


Page 12

Yield models: rather than compare a bond’s yield with a redemption yield curve it can be compared with one of the alternatives such as a yield surface or par yield curve.

6 (i) (a) The primary purpose of the agreement is to act as a business contract

between the investment manager and the investor/client. As a minimum it would set out the services to be carried out by the manager for the investor and the agreed fees.

(b) Typical restrictions would include:

• limitations on permitted asset classes for manager to invest in • limitations on leverage (explicit and implicit, through derivative

contracts) • maximum and minimum ranges for holdings in particular asset

classes • maximum ranges for holdings in a single company or single

industry sector • prohibitions on particular stocks for ethical/SRI reasons (e.g.

cluster bomb manufacturers) • prohibitions on self-investment in the investor’s own securities

(ii) A fund will often have a number of different managers and mandates

managing its assets. A prescriptive approach within manager agreements allows the asset allocation to be controlled and managed at a global level, whereas if the asset managers had complete discretion in security selection it is unlikely that the actual assets would closely resemble the target asset allocation.

Additionally, many funds will wish to place restrictions on permitted investments and leverage as part of their overall risk controls and wider social responsibilities.

Finally, a relatively prescribed agreement enables the investor to challenge the manager more easily in the event of the assets not being invested in line with the investor’s wishes, or in the event of mismanagement taking place.



EXAMINATION

1 October 2009 (pm)








supervisor. 4. Mark allocations are shown in brackets. 5. Attempt all seven questions, beginning your answer to each question on a separate

sheet. 6. Candidates should show calculations where this is appropriate.





ST5 S2009—2

1 Describe the following terms: (a) split capital investment trust. (b) rights issue. (c) scrip issue. (d) share split. [6] 2 (i) Explain the relationship between forward and futures prices. [5] (ii) (a) Define the term basis risk. (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. [2] (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:

• the current cash bond price is £1269 • the strike price is £1300 • the 10-month risk free interest rate is 2.6% p.a., and • the volatility of the forward bond price in 10 months is 9% p.a.

The bond pays a semi-annual coupon of 6% and coupon payments of £30 are

expected in 3 months and 9 months. Assume that the 3-month and 9-month risk-free interest rates are 2% and 2.5% p.a. respectively. [8]

[Total 22]


3 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:

Pension Fund A

Pension Fund B

Beta of portfolio 0.8 1.2 Holding in Banks 4% underweight to benchmark 10% overweight to benchmark Investment Style Value Growth

(i) (a) Define the term Beta. (b) Describe how the Betas quoted above will have impacted performance

over the period under review. [3]

(ii) (a) Explain what is meant by the terms Value and Growth. (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) State two reasons why the performances might be different. [2] [Total 12] 4 (i) Discuss the key factors to be considered in monitoring and controlling credit

risk. [4] (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 S2009—4

5 (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.

Year (t)

Bond Cashflows

Section A Liabilities

Section B Liabilities

1 10 11 5 2 10 0 10 3 10 5 13 4 10 32 27 5 100 93 85

Assumptions • All payments are made annually in arrears. • Interest rate is 4.75% per annum. • All final calculations are rounded to nearest whole number.

(ii) 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]


6 (i) Describe the key features of a Real Estate Investment Trust (REIT). [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:

2008 2007 Rental income 1,808,925 1,799,581 Fee and asset management 14,373 9,582 Total Revenues 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 Operating Income 567,515 598,176 Net earnings 543,847 421,313

Capital Expenditures 181,948 156,776

(iii) Explain why traditional equity valuation metrics like the earnings-per-share

(EPS) ratio, earnings growth, and the price-to-earnings (P/E) multiple do not apply. [2]

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]

Shareholders’ real estate holdings must be maintained (apartments must be regularly

redecorated, for example), so FFO is not quite the true residual cash flow remaining after all expenses and expenditures.

(v) Calculate an Adjusted FFO (“AFFO”) for each year as a better measure of distributable income. [1]

(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 S2009—6

7 Two investors have the same time horizon to complete the following trades.

• Investor A trading £100m of equities. • Investor B trading £1bn of equities.

(i) (a) List four types of transaction costs. (b) Explain how these will differ between the two investors. [4]

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) Explain the residual risks that remain with each strategy. [4] (iv) Describe the effect adopting each strategy would have on the investor’s

investment performance if the equity markets increased by 5% over the next 12 months. [6]

[Total 20]

END OF PAPER


Faculty of Actuaries

Institute of Actuaries

Subject ST5 — Finance and Investment

Specialist Technical A

September 2009 examinations

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.

Subject ST5 (Finance and Investment Specialist Technical A) — September 2009 — Examiners’

Report

Page 2

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 ½ 2t1t2

where t1 is the time to maturity of the futures contract, t2 is the time to

maturity of the rate underlying the futures contract and is the standard

deviation of the change in the short-term interest rate in one year. (A typical

value for is 1.2%). [Note that the forward and futures rates in this

expression are expressed in continuously compounded form .]

(ii)

a. Basis risk can be defined as ―the residual risk that results when the two

sides of a hedge do not move exactly together‖.


Report

Page 3

b. It may arise if:

• 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 = S / F

where S is the standard deviation of S, the change in spot prices

F is the standard deviation in F, the change in futures price

and is the correlation coefficient between S and F.

(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:

• The behaviour of an individual interest rate is more complicated than

that of a stock price.

• For the valuation of many products, it is necessary to develop a model

describing the behaviour of the entire yield curve.

• The volatilities of different points on the yield curve are different.

• Interest rates are used for discounting as well as for determining

payoffs from the derivative.

(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 (d1) – X (d2)]

where (x) is the standard cumulative Normal distribution function,

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 0.75 0.025 = 59.293

Thus F0 = (1269 – 59.293) e0.8333 0.026 = 1236.203


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Then d1 = (ln (1236.203 / 1300) + 0.092 10/24) / (0.09 (10/12) )

= (– 0.0503197 + 0.003375) / 0.0821583

= – 0.57139

and d2 = (– 0. 0503197 – 0.003375) / 0.0821583

= – 0.65355

Hence, c = e 0.8333 0.026 1236.203 – 0.57139) – 1300 – 0.65355)]

= 0.97857 [(1236.203 0.2839) – (1300 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 Yield

• Sales 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

b. Growth – internet/tech, clean tech

Value – utilities, consumer staples

(iii) Performance over 12 months has been negative

http://moneyterms.co.uk/yield/




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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 creditworthiness of the counterparties with which an institution deals

• the total exposure to each counterparty

Creditworthiness of counterparties can be controlled by placing limits on the

credit ratings (as published by the major rating agencies) with which an

institution may deal. It can be also controlled in derivatives transactions by

dealing on a recognised exchange with a central clearing house which stands

as counterparty to all deals, rather than over-the-counter. The clearing house

will seek to protect itself by requiring the counterparties to deposit ―margin‖

with it. These margin payments are a particular example of the use of

collateral provided by a counterparty as a tool against credit risk.

It is important to monitor and place limits on the credit exposure to any single

counterparty. This will involve aggregating exposures in different areas. For

example a pension fund may hold both equity and debt issued by a bank as

well as having cash on deposit with the same bank and having them as a

counterparty to a derivatives deal. It will also be necessary to be aware of the

particular relationships between different companies within the same group.

Credit risk can be controlled by the use of Credit Default Swaps and other

credit derivatives.

(ii) Ratings agencies will seek to understand the following issues:

• fundamental risks of the company’s industry

• competitive position (relative to peers)


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• downside risk vs. upside potential

• quality of profitability vs. EPS growth

• cash flow generation vs. book profitability

• forward looking analysis

• strategy, management track record and risk appetite

• capital structure and financial flexibility

Specifically:

Purpose

What does the company do and why do they need to borrow? Possible reasons

for seeking finance include:

• organic growth

• acquisition

• investment in an associated company

• capital expenditure

• dividend / share buy-back

Payback

What is the expected source of repayment? Is there a secondary source? Issues

to consider include:

• cash flow / profit profile (over time)

• possible sale of assets and / or businesses

• refinancing

Risks

What risks (quantitative and qualitative) could jeopardise debt servicing in

future? Factors to consider include:

• macro considerations (industry analysis and competitive trends,

regulatory environment, sovereign macro-economic analysis)

• company specific issues (qualitative analysis, financial performance,

market position)

Structure


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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


Report

Page 8

movement of market indices determines the value of the contract in some

way). In order to hedge such liabilities, use is often made of over-the-counter

derivatives purchased from an investment bank, thereby avoiding the

uncertainty (and expense) of ―rolling-over‖ short term exchange traded

derivatives over the lifetime of the underlying contract.

Credit was given for other sensible issues discussed

(ii)

Year (t) Interest rate Bond

1st

condition

2nd

condition 3rd condition

1 1.0475 10 10 10 10

2 10 9 18 36

3 10 9 26 78

4 10 8 33 133

5 100 79 396 1982

115 484 2240

Year (t)

Interest

rate Liability A

1st

condition

2nd

condition

1 1.0475 11 11 11

2 0 0 0

3 5 4 13

4 32 27 106

5 93 74 369

115 499

Year (t)

Interest

rate Liability B

1st

condition

2nd

condition 3rd condition

1 1.0475 5 5 5 5

2 10 9 18 36

3 13 11 34 102

4 27 22 90 359

5 85 67 337 1685

115 484 2187

Liability A fails at the second test of immunisation, Liability B matches all

three conditions.

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.


Report

Page 9

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.

http://www.investopedia.com/terms/n/netincome.asp

http://www.investopedia.com/terms/d/depreciation.asp

http://www.investopedia.com/terms/n/noncashcharge.asp


Report

Page 10

(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:

2008 2007

Net earnings 543847 421313

Plus Depreciation 444339 419039

Gain on Depreciable Property

Sales

(300426) (102614)

Other miscellaneous Depreciation

items and gains

69838 100651

FFO 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 757598 838389

Minus Capital Expenditures (181948) (156776)

AFFO 575650 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 for rent increases

• Prospects to improve/maintain occupancy rates

• A specific plan to upgrade/upscale properties – A popular and successful

tactic is to acquire ―low-end‖ properties and upgrade them to attract a

higher quality tenant. Often a virtuous cycle ensues. Better tenants lead

to higher occupancy rates (fewer evictions) and higher rents.

• External growth prospects – Many REITs favour fostering FFO growth

through acquisition, but it's easier said than done. An REIT must


Report

Page 11

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 sub-

sectors (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 EiP’s 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

http://www.investopedia.com/terms/d/debtequityratio.asp


Report

Page 12

Everything being equal (timing and stocks traded), bid/offer slightly

higher on £1bn trade

Taxes the same (proportionally)

Market impact higher on £1bn trade

Commission – depends but might be lower on larger trade

Opportunity costs will depend on trading time etc. Would be

proportionally equal if traded together

(ii) Sell the equities

Short equity futures

Buy puts set at a level investor is willing to see market value decrease

Use Total Return swaps.

(iii) Sell equities – market risk, if equities rise then miss out on the upside, risks

sell at the wrong time

Short equity futures – investment performance risk, basis risk

Buy puts – investment performance risk, might not be able to buy puts for all

shares in portfolio.

Swaps – investment performance risk.

For all derivative-based strategies, counterparty / default risk is a further issue

when over the counter approaches are used.

(iv) Sell equities – Would be in cash. Mismatch performance between cash and the

equity markets. Lose out on dividends.

Short equity futures – would lose out on market performance would still pick

up alpha from mismatch of futures and underlying portfolio. Could under or

out perform depending on alpha.

Buy puts – depends the levels that they are set at. There would be the negative

drag on paying for puts. However, for some shares in the portfolio that fall in

value then could positively impact overall performance as cap losses on those

securities.

Swaps – Mismatch performance between the equity market and the other side

of the swap.



EXAMINATION

28 April 2010 (pm)








supervisor. 4. Mark allocations are shown in brackets. 5. Attempt all six questions, beginning your answer to each question on a separate sheet. 6. Candidates should show calculations where this is appropriate.





ST5 A2010—2

1 (i) Describe the key characteristics needed in a commodities index before an exchange can use the index as a basis for launching a suite of derivatives contracts. [5]

(ii) Explain, by reference to hedging activity, why it would be reasonable to

expect that derivatives based on a commodities index constructed using a broad range of basic commodities would be more liquid at longer maturities (e.g. over 1 year) than derivatives based on the individual commodities. [4] [Total 9]

2 (i) State six factors that need to be considered when analysing the taxation of

investment returns. [3] A tax authority is considering introducing Capital Gains taxation of unrealised gains. (ii) Discuss the potential advantages and disadvantages of this proposal. [8] [Total 11] 3 The following data has been extracted from the annual report of a UK trading

company.

Income statement £000’s Revenue 5121.5 Cost of sales (3458.5) Gross profit 1663.0 Other expenses (1099.3) Operating profit 563.7 Finance income 16.3 Finance costs (37.9) Net profit before tax 542.1 Tax 185.1 Profit after tax 357.0

Balance sheet

Assets Non current assets 2355.5 Current assets Inventories 364.4 Trade receivables 192.6 Other current assets 13.9 Cash 88.2 659.1 Total assets 3014.6


Equity and liabilities Share capital 673.7 Other reserves 491.2 Retained earnings 757.8 1992.7 Non current liabilities Long term borrowings 348.8 Current liabilities Trade and other payables 548.4

Current tax payable 194.7 743.1

Total liabilities 1091.9 Total equity and liabilities 3014.6

(i) Calculate the main ratios for assessing performance that are likely to be of

interest to shareholders and managers, including ratios on profitability and liquidity. [8]

(ii) Comment on the financial position of the business as demonstrated by these

figures. [7] [Total 15] 4 A wealthy investor’s current asset allocation is 90% equities and 10% cash. The

allocation to equities is mainly invested domestically, with a small allocation overseas. The domestic equity holdings represent about 5% of the total market capitalisation of the newly established exchange. The investor wants to change the allocation to 40% cash, 60% domestic bonds and has approached a transition manager to implement the new strategy.

(i) Suggest reasons why the investor might want to change the current asset

allocation. [3] (ii) Outline the costs the transition manager should highlight prior to executing a

trade on behalf of the investor. [3] (iii) (a) Describe the problems that could be incurred with implementing the

new asset allocation. (b) Suggest potential solutions to the problems identified in (a) and their

limitations. [12] [Total 18]

ST5 A2010—4

5 Following recent economic turmoil in the credit markets, a consortium of governments has proposed launching a new global currency unit, the “GCU”, that will be freely convertible and provide greater security and independence from each government’s fiscal actions than the currencies currently in existence.

(i) Describe the types of investor who will be attracted to GCU-denominated

investments at the time of the launch of the GCU. [5] (ii) Compare the risk-free overnight interest rate that is likely to be available in the

GCU with that for other major currencies such as the Dollar, Euro, Yen and Sterling. [4]

(iii) Explain how you would expect the term structure of the GCU swap curve to

compare to the US Dollar swap curve shortly after the GCU is successfully launched. [9]

(iv) Explain how your answer to (iii) would differ for the Euro swap curve. [2] [Total 20] 6 A charity and an insurance company invest their assets with the same investment

manager. The finance directors of the two institutions, who know each other well, are discussing the performance of the investment manager over dinner. They are surprised that the returns of their respective portfolios have differed considerably over the last year.

(i) Suggest reasons why the performance of the two portfolios might differ. [3] The following portfolio performance and benchmark performance results have been

provided by the insurance company. The strategic asset allocation is 10% domestic equities, 25% overseas equities, 15%

cash and 50% bonds. The portfolio at the start of the year was £2.6m with £1.02m invested in equities in

line with the equity benchmark split. The cash value at start of the year is £410,000.

ST5 A2010—5

Value at the end of Quarter 1 Quarter 2 Quarter 3 Quarter 4 Domestic Equities value 314.7 335.2 266.2 270.2

Benchmark return 7.4% 6.5% –7.0% 2.0% Overseas Equities value 801.5 777.4 612.7 704.6

Benchmark return 10% –4.2% –11.0% 12.0% Cash value 418.2 426.6 439.4 443.8

Benchmark return 1.5% 2.0% 5.0% 1.0% Bonds value 1216.8 1277.6 1366.1 1420.8

Benchmark return 6.0% 7.0% 2.0% 4.0%

(all figures in £000’s) The portfolio is rebalanced at the end of the second quarter back to the strategic

benchmark. (ii) (a) Calculate the quarterly and the yearly total portfolio returns. (b) Calculate the quarterly and yearly benchmark returns. (c) State the under or outperformance of the fund relative to the

benchmark for each quarter and for the year. State any assumptions you make. [8] (iii) Calculate, for each quarter, the returns attribution from:

• Stock performance for each asset class • Stock performance at the total fund level • Asset class performance at the total fund level

showing whether the effect had a positive or negative impact on the performance of the portfolio relative to the benchmark. [8]

(iv) Explain the limitations and disadvantages associated with measuring the

performance of the investment manager. [8] [Total 27]

END OF PAPER


EXAMINERS’ REPORT

April 2010 examinations


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 2010



Page 2

General comments Candidates typically answered Questions 2, 4 and 6 much better than the others, with Question 3 and 5 attracting the worst responses. Question 5 represented the opportunity to demonstrate higher level skills in terms of non-standard/practical application of theory to current issues in investment. Question 3 required the manipulation of accounts and core financial information – arguably a key skill in any exam looking at financial and investment matters. 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 detail or application of knowledge and scored lower accordingly (this was most evident in Questions 1 and 2 where the first parts were well answered, the latter part less so). Candidates are reminded of a bias in the paper towards recognising higher level skills and practical application. 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. 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 12–18 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. Against a background of the credit crisis, new asset classes and ways of structuring investments will themselves generate new types of risk (such as operations, liquidity, credit and counterparty), so the need for new ways of regulation, monitoring and management. Finally the examiners encourage candidates to recognise there are different types of investor beyond purely pension funds and different taxation, time line and cost considerations will apply.


Page 3

1 (i) Interest – the exchange would want to ensure that there was sufficient interest in the index from investors, speculators and hedgers, who are the three main categories of derivatives users.

Measurement frequency – the index would need to be calculated frequently

(e.g. daily) to ensure consistency between the contract values and the underlying assets.

Calculation process – the methodology for construction of the index needs to

be transparent and well understood. This would need to extend to the weightings and replacement of different commodity assets and clear criteria about the quality/purity of the commodities being referenced, their location and delivery dates.

Without the above criteria being satisfied, volumes of contracts will be modest

and the consequential liquidity of the contracts will be relatively low. Whilst a niche contract may be considered worthwhile for an investment bank,

for an exchange it would generally be considered to be a failure if volumes remained weak.

(ii) At short maturities, the individual commodity derivatives may be more liquid

due to hedging activity by producers and customers of the commodity. However, for longer maturities, there is diminishing interest in such hedging activity as producers and customers are less able to predict their production level and input requirement respectively. Also, there may be greater scope to pass on price changes to end-users, reducing the need to hedge.

Therefore at longer maturities, demand is likely to arise from the activities of

investors and speculators. A broad commodities index would appeal to such investors who wish to express a positive or negative view on aggregate levels of demand (based on economic activity). In this scenario, derivative contracts based on an index would be far more liquid than those based on a single asset.

2 (i) Factors that need to be considered are:

• the total rate of tax on an investment including consideration of withholding tax

• how the tax is split between different components of the investment return • the timing of tax payments • whether the tax is deducted at source or has to be paid subsequently • the extent to which tax deducted at source can be reclaimed by the

investor • to what extent losses or gains can be aggregated between different

investments or over different time periods for tax purposes

(ii) • Lack of cash to fund tax bill • Treatment of unlisted assets


Page 4

• Subsequent losses • Practical workloads • Rate of tax? • Impact on dividend policy • Allowances? • Impact on investor behaviour? • International comparisons

(with some words of explanation) 3 (i) Profitability ratios

ROCE Netprofit before tax and interestSharecapital reserves long term debt+ +

= 563.7 16.3 1922.7 348.8

++

= 5802271.5

= 25.5%

or Net profit before tax Sharecapital reserves +

= 542.11922.7

= 28.2%

Asset utilisation ratio

RevenueSharecapital reserves long term debt+ +

= 5121.52271.5

= 225%

Profit margin

Net profit before tax and interestRevenue

= 5805121.5

= 11.3%


Page 5

Gross profit margin

Gross profit Revenue

= 1663.05121.5

= 32.5% Operating profit margin

Operating profitRevenue

= 567.35121.5

= 11.1% Liquidity ratios Current ratio

Current assets Current liabilities

= 659.1743.1

= 0.9 : 1 Quick ratio

Current assets inventoriesCurrent liabilities

−

= 659.1 – 364.4743.1

= 0.4 : 1

Asset gearing

Borrowings Equity

= 348.81922.7

= 18% or

BorrowingsBorrowings Equity+

= 348.8348.8 1922.7+

= 15.4%


Page 6

(ii) High asset utilisation (225%) but relatively low profit margin (11.3%) suggests a “pile ‘em high / sell ‘em cheap” strategy. Gross profit 32.5%, net profit 11% suggests that “Other expenses” are significant. Liquidity ratios look inadequate by conventional standards?

But the company is a retail operation with high levels of stock turnover and

low levels of “Trade receivables” (since most sales are for cash). This is reinforced by the high levels of current liabilities in the form of “Trade payables” since there are typically long delays in paying suppliers for goods. This explains the anomalous liquidity ratios. Clearly, the ratios need to be compared with competitors, sector averages and historic equivalents to assess their adequacy.

The low level of gearing is due to the relatively low fixed assets especially

freehold property). Instead, sale and leaseback is used to generate cash. 4 (i) Their personal circumstances/investment objective have changed Need for liquidity going forward They might be expecting a fall in equity markets They might expect equities to underperform relative to other asset classes over

the short/medium term Tax benefits might have changed Any other sensible suggestion

(ii) Any taxes associated with buying or selling assets Commission costs payable on sales and purchases Bid-offer spreads on both purchases and sales Price impact of selling or purchasing assets in the market Any charges by the transition manager or administration charges. Any foreign exchange costs that might be incurred. Any rebates that might be achieved by using MTFs Potential under / out performance due to the timings of equity sales

(iii) (a) Owning such a large percentage of the equity market mean sales will have an impact on prices.

The potential lack of liquidity due to size of current holdings – i.e. finding buyers (equities) or sellers (bonds).

But some equities might be quoted on other exchanges (which might provide extra liquidity)

Information leakage to the market about what is happening which will hinder ability to sell assets/purchase assets.

The dealing costs involved The time needed to implement the change given the size of the

holdings The possibility of tax, purchase tax or capital gains taxes (b) Potential solutions are to: Sell equity futures and purchase bond futures to change exposure

without physical transaction.


Page 7

Limitations – Suitable futures? Liquidity of futures? Basis risk Spread sales over a period of time Limitations – The investor might be expecting a market fall and

therefore wants to dispose of assets quickly Information leakage if in the market too long or too many times Look for crossing opportunities with other investors to reduce

dealing/spreads costs. Might not be people looking to cross Information leakage Use any cash flows into/out of portfolio to move closer towards the

desired portfolio. Any other sensible suggestion

5 (i) Most liability-focussed investors will typically be interested in receiving an

investment return within a domestic currency. This reflects that they are investing to meet a liability that comprises an obligation in an existing currency. Such investors would include insurance companies and pension funds, and the majority of retail investors who are investing to meet longer term domestic liabilities (e.g. retirement savings, debts etc.).

The GCU will have a strong appeal to investors who are more multinational in

their outlook, and this group would include retail and high net worth investors with savings in excess of their domestic liabilities, and multinational investors such as corporates, sovereign wealth funds, governments, supranational institutions...

...who are currency-neutral for some or all of their assets. (ii) The interest rate is likely to be lower than that in other major currencies as the

risk of devaluation through a weak fiscal policy will be removed. There is still some devaluation risk if weak fiscal policies in several countries

leads to an expansion of credit and asset values rise, however this is a secondary risk factor.

Conversely, if the GCU is less liquid or less widely used than the major

currencies, this will lead to slightly higher interest rates to reflect this illiquidity and higher transaction costs.

(iii) Soon after the GCU is launched, there will not have been many loans issued

that are GCU-denominated. Therefore there will be relative little supply of GCU fixed rates.

Any supply of fixed rates (payers) would arise from assets in other currencies

being swapped to GCU interest rates. This activity would typically arise from the activities of borrowers in other currencies, or investors who wish to take a view on financing costs in the GCU being lower than in other currencies. Such a view might arise from a belief that the GCU will not appreciate relative to other currencies (allowing for the initial difference in swap rates).


Page 8

Demand for fixed GCU rates (receivers) would come from investors who wish to take a view on financing costs in the GCU being higher than in other currencies.

There may also be a degree of hedging activity in either direction from

recipients of relatively certain overseas cashflows who wish to pay fixed GCU rates, or payers of relatively certain overseas cashflows who wish to receive fixed GCU rates. This type of hedge would be more appropriate where the mix of overseas currencies was somewhat unstable, and less appropriate in other cases due to the additional basis risk relative to hedges carried out in currency pairs.

On the assumption that supply and demand are broadly in balance, one would

expect the GCU swap curve to be lower than the US Dollar swap curve, with the GCU-US Dollar curve being downward sloping. This reflects that the expected loss due to currency depreciation will be much lower in the GCU than the US Dollar, due to lower/nil impact of fiscal policy on the currency.

Reasons why the above might not be the case in the short term might be that

the GCU is not as liquid as the US Dollar. This difference in liquidity may itself have a term structure, complicating the comparison.

(iv) The difference between the Euro and GCU swap curves should have a flatter

term structure than the difference between the US Dollar and GCU swap curves. This reflects the weaker impact of a single country’s fiscal policy on the value of the Euro compared to the US Dollar, although there should still be a downward slope as there is a risk of concerted policy actions at times of deflationary pressure.

6 (i) Invested in different strategies, different portfolio manager Invested in different asset classes Different investment restrictions or tracking error limits Frequency of rebalancing might differ Investment fees charged by the manager might differ Cashflows during the year can alter performance Different tax status


Page 9

(ii) Portfolio returns are net of investment manager fees and taxes

Start value 2600 benchmark 100 Domestic Equities 291.4 10 Overseas Equities 728.6 25 Cash 410.0 15 Bonds 1170.0 50 Quarter 1 Quarter 2 Rebalance Quarter 3 Quarter 4Domestic Equities value 314.7 335.2 281.7 266.2 270.2Domestic Equities return 8.0% 6.5% –5.5% 1.5%Benchmark return 7.4% 6.5% –7.0% 2.0%Overseas Equities value 801.5 777.4 704.2 612.7 704.6Overseas Equities return 10% –3% –13% 15%Benchmark return 10% –4.2% –11.0% 12.0%Cash value 418.2 426.6 422.5 439.4 443.8

Cash return 2.0% 2.0% 4.0% 1.0%

Benchmark return 1.5% 2.0% 5.0% 1.0%Bonds value 1216.8 1277.6 1408.4 1366.1 1420.8

Bonds return 4.0% 5.0% –3.0% 4.0%

Benchmark return 6.0% 7.0% 2.0% 4.0%Total portfolio 2751.2 2816.8 2816.8 2684.4 283

9.3 2816.8 Benchmark 2768.1 2862.2 2862.2 2813.5 2964.1

Quarter and Yearly Outperformance answers

Calculate quarterly and total year out performance Q1 Q2 Q3 Q4 Benchmark Fund 5.8% 2.4% –4.7% 5.8% Domestic Equities 0.1 Benchmark 6.5% 3.4% –1.7% 5.4% Overseas Equities 0.25Outperformance –0.7% –1.0% –3.0% 0.4% Cash 0.15 Bonds 0.5 Year Fund 9.2% Benchmark end value 2964Year Benchmark 14.0% Return 14.0%Year outperformance –4.8%


Page 10

(iii) Stock attribution answers Stock attribution Q1 Q2 Q3 Q4 Domestic equity return 8.0% 6.5% –5.5% 1.5% Benchmark 7.4% 6.5% –7.0% 2.0% Stock attribution 0.6% 0.0% 1.5% -0.5% Overseas equity return 10.0% –3.0% –13.0% 15% Benchmark 10.0% –4.2% –11.0% 12% Stock attribution 0.0% 1.2% –2.0% 3.0% Cash return 2.0% 2.0% 4.0% 1.0% Benchmark 1.5% 2.0% 5.0% 1.0% Stock attribution 0.5% 0.0% –1.0% 0.0% Bond return 4.0% 5.0% –3.0% 4.0% Benchmark 6.0% 7.0% 2.0% 4.0% Stock attribution –2.0% –2.0% –5.0% 0.0% Stock attribution total 5.8% 2.4% –4.7% 5.8% Benchmark total 6.6% 2.9% –1.7% 5.1% Overall Stock attribution –0.8% –0.5% –3.0% 0.6%

Asset class attribution answers

Asset class attribution Q1 Q2 Q3 Q4 Fund 6.6% 2.9% –1.7% 5.1% Benchmark 6.5% 3.4% 0.0% –1.7% 5.4% Asset class attribution 0.1% –0.5% 0.0% –0.2%

(iv) Projection of past results – too much reliance on past results which are no

guide to the future performance. Timescale – balancing too frequent, which requires additional administration,

to very infrequent – which limits the possibility of detecting any performance issues. Skill versus luck can be blurred over short-term.

Differing fund objectives – might not have a suitable benchmark or peer group to measure against

Impact on investment manager behaviour – knowledge of how being assessed could influence behaviour of manager to focus too much on measure and not using their skill.

Costs – costs of associated of monitoring and putting together reports etc.



EXAMINATION

8 October 2010 (pm)








supervisor. 4. Mark allocations are shown in brackets. 5. Attempt all nine questions, beginning your answer to each question on a separate






ST5 S2010—2

1 Outline the main stages in an Asset-Liability Modelling exercise. [6] 2 Outline the issues associated with the use of Net Asset Value as a measure of

investment performance. [7] 3 You have recently taken over as the pension manager for a declining manufacturing

company which has had a defined benefit pension scheme for more than 35 years. The fund accounts for the pension scheme for the last two years are set out below.

2009 2010

£000’s Contributions and benefits Contributions received 2,621 2,778 Transfers in 400 408 Benefits payable (11,000) (12,320) Administration expense (385) (400) Return on Investment Investment Income 1,265 1,151 Return on investments 5,500 5,005 Investment fees (300) (330) Balance brought forward 88,655 86,756 Total 86,756 83,048

Comment on what the fund accounts for 2009 and 2010 indicate about the pension

scheme. [4]

4 (i) Define the term Value at Risk. [1] (ii) Calculate the daily Value at Risk with a 95% confidence level for a stock

holding with a current value of £20,000. Assume that log-returns on the stock show a mean of zero and an annualized volatility of 15%. [2]

(iii) Outline the deficiencies associated with using Value at Risk to monitor and

control market risk for a portfolio. [6] [Total 9]


5 The government of a small island population, whose livelihood mainly depends on fishing, has become increasingly concerned at the lack of private provision for retirement. In order to ensure islanders are provided for in retirement the government plans to introduce a compulsory saving scheme. The government has no prior financial experience of such saving schemes.

(i) Discuss the different objectives of the islanders that should be considered

when designing the new scheme. [4] A young adventurous fisherman with no dependents and who earns a below average

salary is considering his investment options for retirement. (ii) Discuss, for each of the objectives identified in (i), which asset type(s) could

be suitable to meet the objectives of the young adventurous fisherman. [7] [Total 11] 6 You are employed as a retail analyst at a well respected investment bank. A very

successful national pizza delivery company is planning to expand into a new overseas market and is looking to raise additional capital. The company has approached your bank for financial assistance. You have been asked to prepare a report for the investment bank on whether they should provide the requested finance.

(i) List the factors that you would consider when evaluating the pizza delivery

company. [3] (ii) Outline the areas you would investigate to form a view on the factors in (i).

[3] (iii) Comment on any potential issues the management of the pizza delivery

company should consider when entering an overseas market. [3] [Total 9]

ST5 S2010—4

7 A washing machine manufacturer, WashCo, is looking to purchase two rival businesses, CleanCo and SpinCo, which are located in two different overseas countries from WashCo. As at the end of the last financial year the three companies posted the following profits:

WashCo CleanCo SpinCo Gross Profits 100m 75m 50m Company Tax 30m 25m 10m Dividend paid 40m 30m 20m Tax rate paid by shareholders on distributed profits 30% 10% 0%

SpinCo pays an extra 10m tax on the dividends paid. In all three countries companies

are required to distribute 40% of gross profits as dividends. (i) (a) Identify the tax system in place for each company. (b) Outline the structure of each tax system in (a).

[3] (ii) (a) Calculate the total tax payable on each company’s profits and

dividends. (b) Calculate the tax payable by each company as a percentage of gross

profits. [3]

(iii) (a) Express the tax payable by each company as a percentage of gross

profits. (b) Comment on the differences between the results in parts (ii)(b) and

(iii)(a). [5]

If WashCo is successful in purchasing its two rivals, the board of directors will locate

the company in one of the three locations of the current companies. The board have asked you, as an independent tax advisor, to help them make the decision.

(iv) Explain which country you would recommend the board moves the company

to. [2] (v) Suggest other taxation factors that the board of directors should consider when

making a final decision. [2] [Total 15]


8 (i) Explain, using the principles of behavioural finance, the types of biases that can affect an investor’s view of the probability of an event occurring that is outside their control, such as an equity market crash. [4]

(ii) Describe the additional forms of bias that are introduced when an active

investor has the discretion to improve an outcome compared with a passive (index) investor. [3]

In a developing country, house prices have been rising rapidly for several years

fuelled by loans of up to 100% of the value of the house. The government has introduced rules that restrict the amount of borrowing to 50% of the value of the house. Following the restriction in lending, house prices have started to fall and are expected to do so for the next couple of years.

(iii) Explain the behaviours exhibited by the following people: (a) An investor who has been successful in the past buying residential

property to profit from capital appreciation, who has decided to continue to buy residential property over the next couple of years.

(b) An economist who has written a recent article commenting that house

prices were always expected to fall. The economist uses historic data to prove this point. All news articles written prior to the borrowing restriction only indicated that prices would continue to rise. [5]

A couple have taken advantage of the falling house prices and purchased a new house.

As part of the move they wish to review their house insurance options. They are deciding whether to stay with their current insurance provider or to move to a new entrant into the market.

Details of the two policies are as follows:

ExistingCo

NewCo

Premium 650 500

Excess payable 100 per claim 80–120 depending on profitability of company

Policy schedule Detailed booklet setting out all terms and conditions

Limited information provided on terms and conditions

The couple have not made a claim in the past and it is unlikely that they will make a

claim over the coming year. The couple decide to take out the policy with ExistingCo.

(iv) Outline, with reasons, three possible behaviours which explain why the couple

have stayed with ExistingCo. [5] [Total 17]

ST5 S2010—6

9 A large investment fund currently has $500 million invested in US equities. As a result of a recent asset allocation meeting, the decision has been taken to invest a further $400 million in US equities by selling the corresponding amount of UK equities. The asset allocation team has emphasised the need for the switch to go ahead as soon as possible.

(i) Describe the practical problems of carrying out such a switch without the use

of derivatives. [6] (ii) Explain how this switching process can be made easier by the use of

derivatives. [4] You decide to buy US equity exposure by buying the S&P500 December futures

contract. You know that you have sufficient cash to cover the margin position. The unit of trading is $500 per index point and you have been quoted a price of $800 for the December contract.

(iii) Calculate the number of contracts you would need to buy to gain the required

US equity exposure. [2] Prior to this additional US equity investment, the fund had no holdings in the

telecommunications sector. Telecommunications stocks constitute 18% of the S&P500 index.

(iv) Calculate the exposure of the fund to telecommunications after the purchase of

the futures. [1] (v) Discuss how you might attempt to eliminate the telecommunications

weighting. [6] The asset allocators of the fund are bullish on US stocks but they are worried about

the level of the dollar, which they think may depreciate in the short-term against sterling. As a result, they would like only one half of the fund exposed to the dollar.

(vi) Explain how you might achieve this reduced exposure, including in your

answer details of the problems that would have to be overcome. [3] [Total 22]

END OF PAPER

INSTITUTE AND FACULTY 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. T J Birse Chairman of the Board of Examiners January 2010

© Institute and Faculty of Actuaries


Page 2

General comments Pleasingly, this diet reversed the trend and was a much better answered paper than previous diets resulting in a higher pass rate even with a higher pass mark. Candidates typically answered Questions 1 and 6 much better than the others (albeit foregoing a lot of marks), with Question 2 and 4 attracting the worst responses, considerably so, with average scores of less than 30% of the available marks and given the fairly basic subject matter, this was something of a surprise. Indeed questions 3 and 9 were little better answered and in question 3, candidates continued to demonstrate difficulties with accounts based questions, a fairly fundamental area of investment analysis. Questions 5 and 8 represented opportunities to demonstrate higher level skills in terms of non-standard/practical application of theory to current or unusual 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 or application of knowledge and scored lower accordingly. 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 including a meeting convened to review a common "test batch". Some candidates believed that parts of Q7 were asking for the same information twice - this was not the intent of the examiners but in order to treat all candidates fairly, the second part was question was discounted, although all relevant points in either section were given credit for and the overall marks scaled up accordingly. 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 in previous reports, 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 12–18 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 and corporate finance 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. Against a background of the credit crisis, new asset classes and ways of structuring investments will themselves generate new types of risk (such as operations, liquidity, credit and counterparty), so the need for new ways of regulation, monitoring and management. Finally the examiners encourage candidates to recognise there are different types of investor beyond purely pension funds and different taxation, time line and cost considerations will apply.


Page 3

1 ALM is increasingly associated with stochastic modelling (although deterministic methodologies can be used). The main stages in an ALM exercise are usually as follows:

1. The key objectives that investment and funding policy should aim to achieve need

to be clarified. These involve objectives such as:

• future on-going funding levels • future solvency levels • future company contribution rates

2. Suitable assumptions to use in the study need to be agreed. 3. Data needs to be collected to carry out the projections. 4. The overall nature of the liabilities is considered – a broad-brush analysis of

current funding level, maturity and cash flow. 5. An analysis would be carried out to identify how the scheme might progress in

the future if different investment strategies were adopted. It would also be appropriate to test the sensitivity of the results to different parameter assumptions.

6. Different asset mixes would then be analysed in more detail to assess the risks

(relative to the liabilities) and the rewards of each alternative under consideration. 7. The results would be summarised and presented.

ALM will often be used in a “control cycle” context that involves monitoring the

experience and revisiting earlier stages of the process.

2 The net asset value of a company, or the net asset value per share, is clearly only one

component of overall value. So, if other things are equal, a share with a higher proportion of its share price represented by net asset value should be cheaper than a share that has less asset backing.

However other things are unlikely to be equal as the market will, in both cases, be attaching a full value to all future cash flow, including that resulting from holding all existing assets and liabilities. The net asset value is, in the end, an accounting number, so it is important to understand how it has arisen and to make appropriate adjustments. For example, property or other non-quoted assets may be difficult to value. For example, a company that has expanded by acquisition will have acquired goodwill on its balance sheet which will form part of its net asset value. A similar company that has only grown organically will appear to have a lower net asset value


Page 4

per share. Generally, goodwill will have to be evaluated for relevance and removed if appropriate in order to make valid comparisons. Some businesses require more assets than do others. For example a manufacturing business will generally require plant, premises and stock whereas a service business will typically require less assets. Comparisons of net asset value between companies in different sectors will inform only about the difference between the sectors. Some assets are more intangible/harder to value. “Human capital” i.e. an asset of service companies is rarely included in NAV. Net assets surplus to those required to run the business may not attract full value. It is usually regarded as inefficient for a company to hold surplus assets, and also it is harder to maintain management discipline when there is a substantial asset cushion. Net Asset Value will not reflect risk Points in favour include the fact that NAV is • readily available • objective • independent • auditable • relevant for break-up

3 The main observation is that the benefits payable are greater than the investments and

other income. All outgoings are increasing, all incomings (except Contributions) are falling. This suggests that either one or more of the following:

• The scheme is very mature and/or the scheme is being run-off/wound down. It

will be necessary to consider the extent of any existing overfunding / surplus and how this is being drawn down.

• The scheme’s assets are underperforming to expectations by a large percentage.

• The scheme is underfunded and liabilities are significantly in excess of the assets. It will be necessary to consider the degree of employer covenant and how the underfunding might be made good.

Credit was given for other appropriate comments.


Page 5

4 (i) Value at Risk is a measure of the maximum loss that might be suffered on a portfolio or a holding in a specified timescale and with a specified probability. As such, it is a measure of Market Risk – the risk relating to changes in the value of a portfolio due to movements in the market value of the assets held.

(ii) Given an annualized volatility of 15%, the daily standard deviation is 0.15/

√250 (assuming 250 trading days in the year). Thus the VaR is given by 20000 × 1.6449 × 0.15/ √250 = £312.10 (Alternatively, if we assume 365 days in the year, the daily standard deviation

is 0.15/ √365 and the VaR is

20000 × 1.6449 × 0.15/ √365 = £258.29

(Credit was given for any sensible number of working days given international variations.)

(iii) VaR calculated using the assumption that stock log returns are distributed

normally is found to be an underestimate in practice. This is because short period stock returns show a more fat-tailed distribution.

The assumption of normality also implies that stock returns are symmetrically

distributed. In practise, return distributions may be skewed. The calculation assumes that the past experience will be maintained, whereas

the future probability distribution may well be different (particularly regarding volatility).

The VaR figure, once calculated, does not say anything about how bad losses

could actually be (and definitely does not specify the worst possible loss). As a risk measure, VaR has poor aggregation qualities. The VaR of a merged

portfolio may exceed the sum of the VaRs of the individual portfolios depending on correlation/(lack of) diversification consideratons.

VaR ignores any problems relating to market liquidity. There is no single optimal choice for the time horizon and confidence level at

which to calculate VaR. VaR is often not well understood and so applied (especially on the retail side). 5 (i) Attitude to risk of the islanders, particularly the investment risk of investing in

different asset classes. Time preference and consumption needs of the islanders. Preferred retirement age.


Page 6

Existing assets of islanders; and disposable income available for savings. Need for diversification

The islanders needs/preferences between the need for income or capital

growth. Inflation / growth protection requirements Tax position of the islanders The level of provision the islanders need/want in retirement Flexibility of contributions.

(ii) The fisherman is adventurous so he is likely to have a higher than normal

acceptance of risk so he is likely to invest in higher risk asset classes such as equities, hedge funds (or any other sensible suggestion)

He is young so has a long way to retirement so is more than likely to be happy

to have assets invested for a long time and therefore can accept risk, again equity type exposure is probably appropriate.

He earns a low salary so is unlikely to have any existing assets. If he wants to

build a level of assets quickly he will invest in higher return seeking assets such as equities. However, if he is concerned that he wants to maintain the minimal assets he has then he is more likely to invest in more stable assets such as bonds or cash.

Tax position – he will want to try and minimise tax and therefore look for

assets that have lower tax implications. The asset class will be dependant on the tax rules for the various asset classes.

If we assume the fisherman wants as much as possible in retirement then he

will opt for higher growth assets such as equities, however if he wants more certainty over the level of benefits in retirement then would invest in less risky assets such as cash and bonds.

Within each asset class, it will be appropriate to diversify the holdings. (Credit was given for other relevant comments)

6 (i)

• Management ability • Management experience in running businesses overseas • Quality of products • Prospects for growth, especially in overseas market • Competition both in domestic and overseas market • Input costs • Retained Profits


Page 7

• History of company • Existing borrowing/capital structure

(ii)

• The financial accounts and accounting ratios • Dividends and the earnings cover • Profit variability and growth • Level of borrowing • Level of Liquidity • Growth in asset values • Market / market potential • Logistics required • Personnel availability (employment levels, etc.) • Competitor analysis i.e. comparative figures for other similar companies

(iii)

• Is there demand for the pizza? • Are there local differences in preferred pizzas • Lack of brand recognition • Language barriers? • Any legal or regulatory constraints? • Logistics including where will ingredients/personnel be sourced from • How will new overseas department be structured • Financial management e.g. currency • Any other sensible suggestions

7 (i) WashCo – Classical tax system where profits are taxed twice – once in the

hands of the company and once in the hands of the investor. CleanCo – Split-Rate tax system where retained and distributed profits are

taxed twice but at a different rate. SpinCo – Imputation tax system where the company has to deduct some of the

tax payable by investors on distributions and pay it direct to the government. (ii) WashCo – £30m in company tax and £12m for dividends = total £42m, 42% CleanCo – £25m in company tax and £3m for dividends = total £28m, 37% SpinCo – £10m in company profits and £10m in dividends = £20m, 40%


Page 8

(iii) WashCo = 30% CleanCo = 33% SpinCo = 40% WashCo profits have the highest overall tax burden but the company burden is

the lowest of the three companies. The highest tax percentage is for WashCo, however the total tax payable is

split at the same rate between the company and shareholders. Spin Co has the lowest rate of company tax but when combined the amount payable on distributed profits the tax is the highest of all three, and as a company the tax payable is the highest of all three.

(iv) The new entity would want to be in the region where they pay the lowest tax

rate. Although WashCo profits have the highest total tax, the burden on the company is the lowest so you would recommend to the board of directors that the new entity remained in the original country. However, if shareholders interests were to predominate, the company should locate where CleanCo is located as the total tax paid on profits and dividends is the lowest.

(v) How stable are the taxation rates, are they likely to change in the future? Are there any tax reliefs available in the countries that would reduce the tax

bill, i.e. carry over previous losses. The timing and frequency of the tax payment, does it all need to be paid at

once? Their own holdings in the company which will effect their tax payments. The tax treatment of “international” transactions i.e. double taxation

agreements or the application of transfer pricing policies 8 (i) Anchoring – this is the term used to refer to the fact that people base their

views of the likelihood of an event on recent experience. Dislike of negative events – the degree to which an outcome is considered

negative or positive has a significant influence on an estimate of its likelihood. In general, people are optimists and overestimate the likelihood of positive events.

Representative heuristics – people find more probable that which they find

easier to imagine. Availability – people are influenced by the ease with which something can be

brought to mind. This can lead to biased judgements when examples of one event are inherently more difficult to imagine than examples of another.


Page 9

(ii) Individuals are typically overconfident about their own skills and insights. Overconfidence arises from:

Hindsight bias – events that happen will be thought of as having been

predictable prior to the event, events that do not happen will be thought of as having been unlikely prior to the event.

Confirmation bias – people will tend to look for evidence that confirms their

point of view (and will tend to dismiss evidence that does not justify it). The discrepancy between confidence and accuracy increases as an individual’s

expert knowledge increases (even where accuracy improves with knowledge, confidence increases by more).

Option issues such as regret aversion may also be relevant. (iii) (a) Anchoring – although the data shows that capital appreciation is

unlikely to continue, the investor is anchored that history will repeat itself and therefore experts opinion is not given due consideration.

Overconfidence – past evidence of the investor's ability to make

money means could have become overconfident in his own abilities. (b) Hindsight bias – Events that happen will be thought of as having been

predictable prior to the event, i.e. re-evaluating past evidence to prove the scenario was always likely to occur.

(iv) Regret aversion – by retaining the existing arrangements, people minimise the

possibility of regret that new policy is not as good as current one. Ambiguity aversion – people pay premium for rules. Here the policy schedule

is unclear for the lower premium and therefore pay premium to receive more detailed rules of existing co.

Status Quo bias – people have a preference to keep things as they are.

Representative heuristics – as the amount of detail increases, its apparent likelihood may increase.

9 (i) Considerable teamwork required by UK and US fund managers to ensure that

the switch goes smoothly. Very time intensive. US fund manager can only buy as much as UK fund manager can sell at any

one time. May take some time for both managers to formulate their buy and sell

programs.


Page 10

May take time for UK to physically sell some of their stocks. Trying to sell stocks aggressively may result in poor prices being obtained.

Similarly aggressive buying by the US manager may well result in poor prices

being obtained. These problems are particularly acute when unmarketable securities are

involved or where the normal market size for deal in the securities is small. Costly – two sets of commissions and two spreads to be paid. No mention if switch is strategic or tactical – if tactical may well have to

reverse position in the near future. The possibility of the crystallisation of capital gains leading to a tax liability. (ii) UK fund manager simply sells a number of futures contracts whose exposure

is equivalent to the amount of stock needed to be sold and US fund manager buys a number of futures whose exposure is equivalent to the amount of stock needed to be bought.

Decision is implemented immediately. Futures markets very liquid – little risk of price drag. Purchase of futures gives fund managers time to construct and execute their

buy/sell programs. As more stock is bought (sold) so the requisite number of futures can be sold (bought back).

If decision is tactical the positions can be more easily and cheaply reversed out

of without harming the underlying stock portfolios. (iii) Value of one contract is 500 * 800 = $400,000 No of contracts 400,000,000 / 400,000 = 1000 (iv) Telecommunications exposure = (500 * 0 + 400 * 18%) / 900 = 8% or $72 million (v) Look at main constituents of S&P500 Telecommunications sector. To

completely negate telecommunications exposure: Sell stocks constituting the sector short (if allowed to) equivalent to the new

exposure of the $900m fund. Buy put options on the stocks in the sector again equivalent to the exposure. Could just do either of the above with a representative group of stocks to

reduce the complexity of the transaction.


Page 11

Sell futures on traded Telecommunications indices – this would introduce some element of mismatching risk.

Enter into an OTC swap transaction to exchange Telecommunications returns

for some other suitable sector. Introduces counterparty risk. (vi) If the investment is via futures, it may be that only the margin is exposed to

the dollar anyway. If have full exposure, then sell forward currency contracts equivalent to half of the fund’s value.

Such contracts are short term and need to be rolled over (though not a problem

here). To precisely keep one half of the fund exposed to the dollar, need to know the

value of the fund on the expiry/sale of the contract. This is unlikely, so some estimate of fund’s future value required.

Hedging small amounts such as dividend receipts will be costly. However,

would have to ensure that exposure to US market is still maintained after reducing telecommunications exposure.



EXAMINATION

20 April 2011 (pm)








supervisor. 4. Mark allocations are shown in brackets. 5. Attempt all eight questions, beginning your answer to each question on a separate





ST5 A2011 © Institute and Faculty of Actuaries

ST5 A2011—2

1 Explain what is meant by stress testing a portfolio. [4] 2 (i) Outline the main use of swaps in portfolio management by a company seeking

to match assets and liabilities. [3] (ii) Discuss the main advantages that interest rate swaps have over conventional

fixed interest securities in portfolio management by a company seeking to match its assets and liabilities. [3]

[Total 6]

3 (i) Outline the different types of infrastructure projects. [1] (ii) Describe the key characteristics of infrastructure investment. [5] (iii) Comment on the differences between infrastructure and private equity

investment. [3] [Total 9] 4 A portfolio consists of £0.5m in asset X and £0.3m in asset Y. Assume that the daily

volatilities of both assets are 0.6%, that the correlation between their returns is 0.4 and that returns on the assets are normally distributed.

(i) Calculate the 10-day 98% Value at Risk of the portfolio. [3] (ii) Calculate the saving in VaR from holding a diversified portfolio rather than

holding two separate assets. [3] (iii) Discuss the practical limitations and difficulties associated with diversifying a

portfolio. [5] [Total 11]


5 A risk-seeking wealthy investor has decided to invest a small portion of his assets with an investment manager for his proposed retirement in five years. The investor is deciding between two investment managers, High Return Investment Company and Strong Growth Investment Company. High Return specialises in equity investment, whereas Strong Growth invests mainly in Government Bonds. Both managers are large international companies with substantial assets under management.

(i) Discuss which investment manager is likely to be most suitable for the

investor. [5] One of the investor’s advisors suggests a different investment manager, FBNX

Investors, a small start up company with five employees investing mainly in futures and credit default swaps.

(ii) List the financial risks faced by an investor investing with an investment

manager. [2] (iii) Discuss how the financial risks are likely to differ between investing with

FBNX Investors and investing with Strong Growth Investment Company. [5] [Total 12]

6 A small listed company specialising in sourcing, processing and supplying restaurants with beef and pork has recently agreed in principle to buy a chain of restaurants. The terms of the agreement are still being finalised.

(i) State with reasons what sort of acquisition the takeover is. [2] (ii) Discuss why the company would be interested in buying the chain of

restaurants. [3] Whilst the takeover is still being finalised a series of market reports are published that

suggest the country is heading for a recession and that the cost of livestock is likely to increase by 30% over the next 12 months.

(iii) Discuss the impact on the business for both the company and the chain of

restaurants of: (a) the recession (b) the predicted increase in livestock costs [6] (iv) Describe the actions regarding the takeover that the company's Board of

Directors might take in the light of the market reports. [5] [Total 16]

ST5 A2011—4

7 A risk averse investor has historically invested her equity portfolio with an index tracking manager, but has recently decided to change to an active equity manager. The investor has four managers to choose from and has been provided with the following information on performance over the last four quarters:

Q1

Q2

Q3

Q4

Covariance with Index

Manager A 3.5% 2.0% 5.0% 8.5% 0.6 Manager B 2.0% 2.0% 3.0% 4.0% 0.2 Manager C 5.0% –2.0% 6.0% 11.0% 0.67 Manager D 4.0% 3.0% 4.0% 6.0% 0.4 Index benchmark return 2.0% 2.0% 3.0% 4.0% Standard deviation of index 0.6 Risk free rate 7% p.a.

(i) (a) Calculate the outperformance of the investment managers relative to

the benchmark. (b) Rank the investment managers from 1 to 4, with 1 being the highest

outperformer. [6] (ii) (a) Calculate the risk adjusted performance of the investment managers

using the Jensen measure. (b) Rank the investment managers from 1 to 4, with 1 being the highest

performer. [6] (iii) Discuss which manager is likely to be the most suitable for the investor. [4] (iv) Outline the circumstances in which standard deviation is a more appropriate

measure of risk for an investor than beta. [2] [Total 18]

ST5 A2011—5

8 A listed supermarket chain (Best Supermarket) based in a small country wishes to expand internationally over a three year period. The Board of Directors is considering the different alternatives for raising capital to implement their growth plans.

(i) Outline the key differences between equity and debt financing. [3] (ii) (a) List the different debt instruments Best Supermarket could issue to

raise the required finance. (b) List the main features that differentiate the types of debt described in

(a). [5] (iii) Discuss how the features listed in (ii) (b) are likely to differ between Best

Supermarket and a large international supermarket chain looking to raise additional finance. [5]

Best Supermarket has produced strong gross profits over the last two years while the

country has been in recession. (iv) Suggest reasons why the company needs to raise finance even though its gross

profits have been strong. [5] (v) Discuss how Best Supermarket’s share price is likely to have performed over

the last two years compared to the price of shares in a chain of luxury handbag stores. [6]

[Total 24]

END OF PAPER


EXAMINERS’ REPORT




Subject ST5 (Finance and Investment Specialist Technical A) — April 201, Examiners’ Report

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General comments Pleasingly, this diet continued the trend from last October and was a much better answered paper than in recent years resulting in a higher pass rate. Candidates typically answered Questions5, 6 and 7 much better than the others (albeit still foregoing 30-40% or more of marks available), with Question 4 attracting the worst responses, considerably so, with average scores of around a quarter of the available marks. Indeed question 1 was little better answered. Questions 1 and 4 go to the heart of modelling and understanding risk and a lack of understanding in these areas has been cited as a key factor in the "Credit Crisis" when risk management models failed. This is an area where actuaries could reasonably feel they could offer relevant skills and knowledge so it is important candidates demonstrate this. Likewise understanding of the theory and practicalities of portfolio diversification are core tenets of investment. Questions 5, 6 and 7 represented opportunities to demonstrate higher level skills in terms of non-standard/practical application of theory to current or unusual 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. The examiners were pleased to see progress in the scores being achieved as well as better data handling. 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 or application of knowledge and scored lower accordingly. 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 alongside the approach outlined below. 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. 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 12–18 months preceding a diet, more so the solutions (and sources of) being debated by the various stakeholders. Hence questions regarding banking and derivative approaches, as well as asset management and insurance solutions, to asset and liability risk management (including model risk) or modern financial theory and commercial applications should be considered likely scope for examination. Against a background of the credit crisis, new asset classes and ways of structuring investments will themselves generate new types of risk (such as operations, liquidity, credit and counterparty), so the need for new ways of regulation, monitoring and management. This paper also looked at the cost of capital, a major


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consideration for clients since capital can no longer be assumed to be freely available or low cost. Finally the examiners encourage candidates to recognise there are different types of investor beyond purely pension funds and different taxation, time line and cost considerations will apply - it would seem that candidates have taken this on board. Whilst the examiners will tolerate bullet point style responses, some candidates’ handwriting was too poor to assess and they will have lost marks. Likewise "text speak" abbreviations will not be accepted.


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1 The risks that are incurred by extreme market events can be identified and investigated by the process of financial stress testing. This involves subjecting a portfolio to extreme market moves by radically changing the underlying portfolio assumptions and characteristics, in order to gain insight into portfolio sensitivities to predefined risk factors. This pertains in particular to asset correlations and volatilities. There are two types of stress test:

• to identify “weak areas” in the portfolio and investigate the effects of localised

stress situations by looking at the effect of different combinations of correlations and volatilities

• to gauge the impact of major market turmoil affecting all model parameters, while ensuring consistency between correlations while they are “stressed”

A major part of establishing a comprehensive stress testing framework should therefore focus on constructing stress test scenarios that apply to the specific portfolio (i.e. a deterministic approach). These scenarios should be tailored to reveal weaknesses in the portfolio structure in terms of risk exposure and sensitivity, and should thus focus on the risk factors that the portfolio is most exposed to. (Candidates who suggest a stochastic approach needed to justify this to be given credit.)

2 (i) A company can use swaps to reduce risk by matching its assets and liabilities.

For example a company which has short term liabilities linked to floating interest rates but long term fixed rate assets can use interest rates swaps to achieve a more matched position. Currency swaps would be used by a company with liabilities in one currency and assets in another.

An inflation swap allows a receiver of inflation-linked payments to pay these

to a counterparty in return for receiving a fixed payment. Typical payers of inflation under inflation swaps will include holders of loans with inflation-linked payments or leaseholders who receive inflation-linked rental income. Institutional investors such as pension funds, with inflation-linked liabilities, can use inflation swaps to receive inflation and thereby hedge the market risk from uncertain future inflation within their liabilities.

(Equivalent marks were awarded for any other example developed in

equivalent detail.) Swaps might be also used as a short-term transition management tool. (ii) Flexibility. IRSs are OTC so can be made to measure for the company’s

portfolio. Dealing costs. With the exception of the most liquid bonds, IRSs can have

lower dealing costs. Complexity. Assuming that the company has the appropriate expertise and

systems, an IRS hedge can be less complex than putting together a portfolio of bonds and attempting immunisation.


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A suitable swaps deal might be quicker to implement than transactions in physical assets.

(Other sensible comments were also awarded marks.) 3 (i) Infrastructure tends to be separated into two broad subsets — economic and

social. Economic infrastructure includes highways, water and sewerage facilities, energy distribution and telecommunication networks whereas social infrastructure encompasses schools, universities, hospitals, public housing and prisons.

(ii) Infrastructure assets are generally characterised by high development costs

(high barriers to entry) and long lives. They are generally managed and financed on a long-term basis. Other features include Large unit size, Illiquid and Inflation hedging properties.

Infrastructure assets display a number of characteristics that distinguish them

from more traditional equity or debt investments. The assets themselves tend to be single purpose in nature, such as gas pipelines, toll roads or hospitals. The private investor’s participation in the asset is often for a finite period. This is generally a function of the agreement the investor has made with the government authority, or a function of the natural useful life of the asset. In either case, infrastructure assets are characterised by their long lives. In fact the capital invested in these projects is often referred to as “patient” capital, in that the initial development involves high upfront capital costs with payback occurring over the asset’s generally lengthy life.

One of the key characteristics of infrastructure assets, and what can make

them particularly attractive as investments, is that they tend to be, or exhibit the characteristics of, natural monopolies. Under a natural monopoly, economies of scale are such that the unit cost of a product will only be minimised if a single firm produces the entire industry output. This environment has the potential to weaken market forces, so there may be a need for tighter regulation, particularly when there are few, if any, alternative suppliers of the infrastructure. In this case, firms operating in a natural monopoly, protected from new competitors by the high barriers to entry, may be able to earn abnormal profits by charging higher prices.

(iii) Infrastructure is generally specific events (i.e. building a new school), private

equity is normal buying or supplying capital for private companies (i.e. buying a pizza restaurant chain).

Private equity tend to have shorter investment durations than infrastructure

projects but this is not always the case and some private equity deals have a long lead time.

Private equity is only privately financed, whereas infrastructure projects can

have an element of public finance. Infrastructure assets and companies can be listed.


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Infrastructure tends to have bond like investment returns, although some infrastructure projects have equity like returns. Private Equity tends to be more equity like returns associated with higher levels of risk.

4 (i) Daily volatilities are: Asset X £3000 ) Asset Y £1800 ) σportfolio = √(30002 + 18002 + 2 × 0.4 × 3000 × 1800) = √(16,560,000) = 4069.398 The 10-day 98% VaR is then √10 × 2.0537 × 4069.398 = £26428.17

(ii) The 10-day 98% VaR’s for the individual assets are:

Asset X √10 × 2.0537 × 3000 = £19483.11 Asset Y √10 × 2.0537 × 1800 [½] = £11689.97 Total: £31172.98

Thus the benefit of diversification is £31172.98 − £26428.17 = £4744.81

(Marks were awarded for suggesting suitable approaches, even if the results were incorrectly evaluated).

(iii) There are significant costs associated with the process of diversification

(dealing, administration, research and the loss of economies of scale). The stability of the parameters ρ and σ may not survive periods of market

stress. “In extreme conditions all correlations tend to 1”. Diversification only guards against specific risk. Systematic risk is still an

issue. There may not be suitable diversifying assets available at an acceptable cost. There may be statutory restrictions or mandate restrictions on the assets

available. The paramount need to match liabilities may restrict the assets available.


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The need to apply diversification to intermediate cash flows (e.g. dividends) is a further practical problem.

5 (i)

• It depends what the investor wants to use the money for: on-going cash requirements or to fund an annuity in retirement.

• If the investor wants it for retirement funds he only has a short time to retirement so is probably concerned with capital preservation on his assets, so would probably favour Strong Growth as the asset class has lower volatility.

• However, the investor is risk seeking which means he might prefer the High Returns Company as equities have higher return.

• The assets are only a small portion of the investor’s total assets. It depends what the investor’s other assets are invested in. If the rest of the assets are in higher risk asset classes then he might prefer Strong Growth to dampen down volatility at the total portfolio level. If the rest of assets are in low returns then he might want a portion of assets in higher return asset classes so would be High Return manager.

• Overall the actual manager chosen will depend on the underlying motivations and other assets held.

• Other issues to consider include currency risk, the tax position of the investor and the level of management charges levied.

(ii)

• Market Risk • Credit Risk • Operational Risk • Liquidity Risk • Relative performance risk

(iii)

• Market risk – Market risk reflects the risk of changes in the value of portfolio due to market movements. Strong Growth is invested in Government bonds which tend to be low volatility. FBNX Investors are invested in futures and CDS which tend to exhibit more volatility and the market risk is likely to be higher with FBNX Investors.

• Credit risk – Risk that a counterparty will be unable to fulfil their obligations. Government bonds tend to be issued directly through the government (or government agency) or via market makers of large institutions. Credit risk tends to be relatively low. FBNX Investors are invested in futures which are exchange traded instruments and carry lower risk than OTC contracts. CDS are OTC instruments and can be issued by a


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wide variety of counterparties with different levels of credit quality. Overall, would expect FBNX to have higher credit risk.

• Operational risk – fraud or mismanagement within the investment manager. Operational risk tends to be higher where there is not appropriate segregation of duties, enough staff or lack of technology which means more human intervention (and potential errors). In a large investment manager that has been established for a long time most operational issues should be addressed. FBNX only has 5 employees which means that employees will complete several different roles (poor segregation of duties). Also, likely that not have the IT budget to have the required infrastructure. FBNX is likely to have higher operational risk than Strong Growth.

• Liquidity risk – is the risk of not having cash needs due to liquidity of portfolio. Government bonds tend to be highly liquid even in times of market distress when there is often a flight to quality, so Strong Return should not suffer too many liquidity issues. Depending on the futures FBNX are invested in, they could be highly liquid or not. CDS tend to have good liquidity in normal market conditions but liquidity can dry up in terms of market distress (as seen following Lehmans collapse). FBNX is likely to suffer higher liquidity risk than Strong Growth.

• Relative performance risk – risk of underperforming relative to peer group. This depends on the quality of investment staff and the investment process. It is impossible to say how this will impact either manager. Past performance can be used but is not a good guide to the future.

6 (i) It is a vertical takeover as the restaurant is part of the overall supply chain the processing company is involved in. It is an upward vertical acquisition.

(ii)

• Diversify returns within the company

• Has money to invest and restaurant offers good rate of return relative to other investments

• The restaurant chain is being offered at a good price which makes it attractive

• Utilisation of unused tax benefits

• Protection against threat of takeover • Enhance EPS – potentially higher margin business

• Low financing costs • Improved co-ordination and administration of the supply chain • Access to complementary resources


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• Response to similar actions by competitors

(iii) Recession Supplier – Likely that some sources of business, e.g. restaurants will reduce

orders as people reduce discretionary spend. Its other sources of business (general public) is likely to be unaffected as people still need to eat and pork and beef are relative affordable meats. If they supply meats to other parties such as hotels these are likely to be impacted by the recession and supplies will be reduced. Overall, the supplier is likely to see business reduce.

Restaurants – During recession people reduce discretionary spend and

restaurants are affected. There is likely to be reduced customers reducing the profits. In recession consumers look to restaurants to have special offers putting further pressure on profits.

Livestock costs Supplier – It is uncertain what the impact is likely to be on the level of supply.

As a supplier they are passing on the product after processing and as long as the purchasers can pass on the cost then profits are likely to be maintained. If the rise changes consumer behaviour and they substitute another product for pork and beef then demand is likely to decrease which will impact costs.

Restaurants – The cost will impact the prices it charges its customers. When

prices rise rapidly over a short period of time, the restaurant is unlikely to pass on the total price rise immediately as people take time to adjust to the new cost. Over time as people accept the new price then price rises can be passed on. Therefore, profits will be affected in short term but unlikely to have an impact over a longer period of time.

(iv)

• Pull out of deal • Look to reduce their offer to reflect market uncertainty • Do nothing • Delay the deal until market conditions become more certain • Look to have the final price contingent on certain targets being hit • Seek an alternative investment strategy

7 Calculations Rb Portfolio returns Manager A 14.41% 20.3% Manager B 9.47% 11.4% Manager C 15.28% 21.1% Manager D 11.94% 18.1% 11.4%

(About half the available marks were awarded for the approach adopted, with the balance for the correct evaluations.)


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(i) Outperformance Rank Manager A 8.8% 2 Manager B 0.0% 4 Manager C 9.6% 1 Manager D 6.6% 3

(ii)

Risk Adjusted Manager A 5.9% 2 Manager B 2.0% 4 Manager C 5.8% 3 Manager D 6.1% 1

(iii) The investor is risk adverse so would prefer a lower risk manager. The

manager with the lowest risk is manager B. However, the investor is looking to add returns from active manager, and manager B looks like it has very index like returns so might prefer one of the other managers, such as manager A. Other issues to consider would include the tax position of the investor, whether the figures quoted are net of management charges and the need to consider more than one year's results.

(Alternate conclusions reached were given equivalent credit if adequately

argued.) (iv) Standard deviation is appropriate where the whole of investor’s wealth is

being considered. If only a subset of assets then beta is the most appropriate method.

8 (i) • Ownership – equity dilutes ownership interest, debt has no impact on

ownership

• Cashflows – equity does not require cashflows but can pay optional dividends. Debt requires regular payments for coupon

• Voting rights – equity often carries voting rights, debt does not

• Priority of payout in default – Debt has higher priority than equity in the event of liquidation of a company

• Impact on financial ratios – Debt and equity have different impact on financial ratios

• Additional security or restrictive covenants may be required for debt financing.

• Tax treatment of the returns on the capital raised


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• Debt securities are usually issued with a specified redemption date. Equities are usually irredeemable.

(ii) (a)

• Corporate Bonds – longer term debt, issued with various coupon rates and maturities

• Commercial paper – Short term issued directly by company

• Term Loans – A loan from a bank for a specific amount that has a specified repayment schedule and a floating interest rate.

• Evergreen Credit – Can borrow up to a specified limit with no fixed maturity

• Revolving Credit – Like evergreen but with fixed maturity, normally up to three years

• Bridging loans – advances to be repaid from specified income

• International bank loans

(b) • Commitment • Maturity • Rate of interest • Security

(iii)

• Commitment – This is where the borrower pays a fee to have advanced funds where required. It depends on the cashflow requirements of the two organisations so impossible to say how these are likely to differ.

• Maturity – It is likely that a large international chain will be given longer terms than Best Supermarket as the lenders are likely to have greater confidence the established supermarket can pay back loans over a period of time.

• Rate of interest – lenders charge higher rates of interest to higher risk borrowers. Therefore, Best Supermarket is likely to pay a higher rate of interest as it will be seen as higher risk.

• Security – Again as Best Supermarket will not be seen as good a credit risk as the established supermarket it is likely to be asked for greater security in return for the loan.

(Appropriate credit was given for discussion of alternative classification of the

features in part (ii) (b).)


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(iv) • Short term cashflow issues and therefore loan will assist paying short term

debts.

• Gross profits might not have been retained and therefore has no additional capital to expand. This might be due to the purchase of fixed assets or the level of dividends paid.

• Potentially high taxes meant net profits were low.

• The expansion plans cost more than the retained profits.

• Predicting lower gross profits in their core market due to recession which will reduce self finance.

(v) Best Supermarket sells essential goods and demand is relative inelastic. It is a

non-cyclical (defensive) business. On the other hand luxury handbag market has elastic demand and in time of recession, people have less money, discretionary spend is reduced and therefore, a reduced number of handbags are being sold. It is a cyclical business.

As the country entered recession the luxury handbag share price would have

reduced in value to a greater extent than Best Supermarket. Following the initial falls and during the recession the two share prices are likely to have performed similarly. As the country starts to leave recession and confidence return the luxury handbag share is likely to outperform Best Supermarket.

However, the actual performance of the handbag store will depend on the

demand for their product relative to other handbag companies. Best Supermarket will probably lag the market as the country leaves the recession which is typical for a defensive stock.



EXAMINATION









supervisor. 4. Mark allocations are shown in brackets. 5. Attempt all nine questions, beginning your answer to each question on a separate





ST5 S2011 © Institute and Faculty of Actuaries

ST5 S2011—2

1 (i) Outline the principal characteristics of credit default swaps. [3] (ii) Outline the characteristics of structured products. [8] [Total 11] 2 (i) Describe the process used for pricing forward currency deals. [2] The two year zero coupon interest rates in Countries A and B are currently 2% and

3% respectively. The spot exchange rate between the currencies is 1.15 units of Country A’s currency for one unit of Country B’s currency.

(ii) Calculate the two-year forward exchange rate. [2] (iii) State how forward currency rates are usually presented. [1] [Total 5] 3 (i) Describe the differences between Exchange Traded Funds and Index Funds. [3] (ii) Outline why an Exchange Traded Fund will not exactly replicate an index

benchmark. [3] [Total 6] 4 (i) State the assumptions about investor behaviour that underpin mean-variance

portfolio theory. [2] (ii) Determine the minimum variance portfolio made up of two assets A and B,

given the following asset characteristics: Asset Expected return Standard deviation of return A 5% 5% B 9% 8% The correlation between the two assets (ρAB) is +0.3. [3] (iii) Determine the expected return and the standard deviation of return of the

minimum variance portfolio. [2] [Total 7]


5 A UK pension fund has assets in excess of £4bn, managed across multiple asset classes using a number of investment managers. Following the disposal by the sponsoring company of one of its subsidiaries, the pension fund is required to pay a bulk transfer of approximately £200m to another pension fund in six weeks’ time. The amount to be paid will be determined as at the date of sale and then adjusted to the date of payment by the total return for the FTSE All Share Index. Under the terms of the sale agreement, the pension fund is obliged to settle the payment by transferring stock representing a reasonable cross-section of the fund.

(i) Explain the investment risk for the pension fund which is introduced by the

liability for this payment, illustrating your answer with a simple example. [3] (ii) (a) Explain how derivatives may be used to mitigate this risk. (b) List the problems that may occur.

[5] [Total 8] 6 (i) Outline the principal characteristics of fundamental share analysis. [2] A private equity firm that specialises in turning around failing firms has recently

raised $500m. One potential investment is a bed manufacturer (HotSleep) whose main market is supplying independent hotel chains in its local country. HotSleep is a family owned partnership which has been running for over 100 years. The company has not made a profit for the last three years.

(ii) List the financial and qualitative factors the private equity firm will have

considered to establish the valuation of HotSleep. [5] (iii) Discuss what changes the private equity firm could make to improve the

financial position of HotSleep. [5] [Total 12] 7 (i) Discuss the advantages and disadvantages of the four main methods used by

passive fund managers to match the investment performance of a benchmark. [7]

(ii) Suggest reasons why investors might prefer a passive rather than an active

approach to bond fund management. [6] [Total 13]

ST5 S2011—4

8 A portfolio manager who worked at Only Investment Management had a successful track record over a number of years. A highly successful rival, QTRM Investment Managers, persuaded the portfolio manager to work for them instead two years ago. Since moving employment, the portfolio manager has underperformed the benchmark index by 3% each year.

(i) Suggest reasons for the portfolio manager underperforming in the last two

years. [4] QTRM are interested in understanding more about what drives performance in their

portfolios and hire a specialist firm to look at each portfolio manager’s track record. The specialist firm finds the following:

(1) On average, portfolio managers hold onto underperforming stocks for six

months longer than they should. (2) Portfolio managers often ignore investment analysts’ reports when

choosing which stocks to buy and sell. (3) The underlying stock analysis is often changed by portfolio managers to

justify holding onto stocks. (4) Some portfolio managers sell stocks as soon as any bad news on the

stock is published in the market. (5) When given a choice of several stock recommendations, portfolio

managers tend to choose the first recommendation on the list.

(ii) Explain the type of behaviour exhibited by the portfolio managers for each of the five points above. [7]

(iii) Suggest actions that could be taken to stop some of the behaviours identified

in (ii). [5] [Total 16]


9 You are the investment advisor to the trustees of a pension scheme. The trustees terminated the mandate of one of the scheme’s equity investment managers (Super Return Inc) and replaced them with a new equity investment manager (Thinking Portfolio Managers) over the course of the year. At the end of the year the trustees review the scheme’s performance and have questioned the actual scheme return relative to the benchmark. The trustees have asked you to produce a report on the performance.

Period 1 Period 2 Transition Period

Period 4 Period 5

Domestic Equities value 3,500,000 3,000,000 Domestic Equities return 9.0% 8.0% 7.0% 6.0% 8.0%Benchmark return 11.0% 7.0% 7.0% 6.0% 5.0%Overseas Equities value 4,000,000 3,000,000 Overseas Equities return 4.0% 7.0% 6.0% 5.0% 7.0%Benchmark return 5.0% 7.0% 5.0% 5.0% 8.0%Small Cap Equities 2,000,000 1,000,000 Small Cap Equities return 3.0% 6.0% 6.0% 4.0% 5.0%Benchmark return 3.0% 6.0% 8.0% 4.0% 3.0%Cash 500,000 3,000,000 Cash return 1.0% 1.5% 2.0% 1.0% 3.0%Benchmark return 1.0% 1.0% 2.0% 1.0% 2.0%

The values in the table above represent the values at the start of the period. The

trustees adjusted the allocation to equities and cash to $10 million at the start of the transition as shown in the table above.

Both managers were measured against the same benchmark:

• Domestic Equities 50% • Overseas Equities 30% • Small Cap Equities 15% • Cash 5%

Assets are rebalanced at the discretion of the investment manager. Following the

transition, Thinking Portfolio Managers’ asset allocation was in line with the benchmark. No other rebalancing took place apart from during the transition period.

(i) Calculate the benchmark return and the portfolio return for the following: (a) Super Return Inc (Periods 1 and 2 separately) (b) Assets during transition (Period 3) (c) Thinking Portfolio Managers (Periods 4 and 5 separately) [7] (ii) Calculate: (a) The cash value taken out of the scheme at the start of the transition

period. (b) Total scheme portfolio return and benchmark return over the entire

period. [3]

ST5 S2011—6

(iii) Calculate for each period the returns attribution from:

• Stock performance for each asset class • Stock performance at the total fund level • Sector performance at the total fund level

showing whether the effect had a positive or negative impact on the

performance of the portfolio relative to the benchmark. [8] (iv) Discuss how transition management could have been used during the portfolio

switch to improve performance. [4] [Total 22]

END OF PAPER


EXAMINERS’ REPORT



Purpose of Examiners’ Reports The Examiners’ Report is written by the Principal Examiner with the aim of helping candidates, both those who are sitting the examination for the first time and who are using past papers as a revision aid, and also those who have previously failed the subject. The Examiners are charged by Council with examining the published syllabus. Although Examiners have access to the Core Reading, which is designed to interpret the syllabus, the Examiners are not required to examine the content of Core Reading. Notwithstanding that, the questions set, and the following comments, will generally be based on Core Reading. For numerical questions the Examiners’ preferred approach to the solution is reproduced in this report. Other valid approaches are always given appropriate credit; where there is a commonly used alternative approach, this is also noted in the report. For essay-style questions, and particularly the open-ended questions in the later subjects, this report contains all the points for which the Examiners awarded marks. This is much more than a model solution – it would be impossible to write down all the points in the report in the time allowed for the question. T J Birse Chairman of the Board of Examiners December 2011


Subject ST5 (Finance and Investment Specialist Technical A) — Examiners’ Report, September 2011

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General comments 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. 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 12–18 months preceding a diet, more so the solutions (and sources of) being debated by the various stakeholders. Hence questions regarding banking and derivative approaches, as well as active and passive asset management and insurance solutions, to asset and liability risk management (including model risk) or modern financial theory and commercial applications should be considered likely scope for examination. Against a background of the credit crisis, new asset classes and ways of structuring investments will themselves generate new types of risk (such as operations, liquidity, credit and counterparty), so the need for new ways of regulation, monitoring and management. Finally the examiners encourage candidates to recognise there are different types of investor beyond purely pension funds and different taxation, time line and cost considerations will apply – it would seem that candidates have taken this on board. Whilst the examiners will tolerate bullet point style responses, some candidates’ handwriting was too poor to assess and they will have lost marks. Likewise “text speak” abbreviations will not be accepted. Specific comments on September 2011 paper This paper had a similar pass mark to the April diet which resulted in a lower pass rate, albeit comparable with previous years. Candidates typically answered Questions 4 and 6 much better than the others (albeit still foregoing 30–40% or more of marks available), with Questions 2 and 9 attracting the worst responses, considerably so, with average scores of around a third of the available marks. These latter two questions were two of the calculation biased ones and, notwithstanding the performances in questions 4, it is disappointing to see a lack of skill demonstrated in this area given recent improvements in data handling in previous exams. Question 1 dealt with some of the core products cited as a key factor in the “Credit Crisis” when risk management failed. Actuaries could reasonably feel they could offer relevant skills and knowledge in this area, so it is important candidates demonstrate understanding. Questions 3, 5 and 7 focussed on the practical aspects of investment as distinct from theory. Question 8 took this further in looking at behavioural aspects – markets and funds are susceptible to such biases and it is important for candidates to be able to recognise and identify such distortions; although one of the better answered questions, a lot of marks were missed and candidates should expect further examination in this area. Many questions represented opportunities to demonstrate higher level skills in terms of non-standard/practical application of theory to current or unusual issues in investment – hence


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candidates who wish to progress to SA6 will need to improve their understanding of and approach to such questions. 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 or application of knowledge and scored lower accordingly. 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 alongside the approach outlined below.


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1 (i) A credit default swap is a contract that provides a payment if a particular event occurs. The party that buys the protection pays a fee to the party that sells the protection. If the credit event occurs within the term of the contract a payment is made from the seller to the buyer. If the credit event does not occur within the term of the contract, the buyer receives no monetary payment but has benefited from the protection during the tenure of the contract. There are two ways to settle a claim under a credit default swap:

• A pure cash payment, representing the fall in the market price of the

defaulted security. However, the market value may be difficult to determine.

• The exchange of both cash and a security (physical settlement). The protection seller pays the buyer the full notional amount and receives, in return, the defaulted security.

(ii) A structured product is a pre-packaged investment strategy in the form of a

single investment. A typical structured product will consist of two components:

• A Note – essentially a zero-coupon debt security that provides capital protection, i.e. guarantees a return of all or part of the initial investment at maturity

• A derivative component that provides exposure to one or several underlying assets such as equities, commodities, FX or interest rates.

Returns from the derivative can be paid out in the form of coupons during the lifetime of the product, or added to proceeds at maturity.

In some, more complex, structured products, the amount invest in the zero-

coupon debt security can vary dynamically over time depending on a pre-determined view. And in others, the capital protection may itself be dependent on the performance of the underlying assets.

Structured products are also typically provided in a packaged format that provides advantages to investors over investing directly in the underlying derivatives – for example: • Practical – investors may be unable to invest themselves in the underlying

derivatives. The structured product also provides a pre-packaged investment strategy that does not require active intervention by the investor.


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• Legal – the format may be designed to satisfy legal or regulatory requirements as to accessible investments for retail or institutional investors.

• Tax – the tax treatment from the structured product may be more favourable than direct investment.

• Accounting – for example, the product may be structured so as to avoid income statement volatility from the underlying derivatives.

Structured products may lack transparency, making them hard for the investor to assess. There may be cost advantages to the investor (compared to using the underlying instruments. Alternatively, the structured product may cost more.

2 (i) The forward rate is the guaranteed price agreed today at which the buyer will take delivery of the currency on a specific future date. Pricing of forward contracts is known as “Covered interest parity” (CIP) and involves the spot rate and money market interest rates in the two countries. If rd and rf are the interest rates in the domestic and foreign markets and F and S are the forward and spot rates, then

F = S × (1 + rd) / (1 + rf) [½] for a one year contract. (ii) Forward rate = Spot rate × (1 + rA)2 / (1 + rB)2 = 1.15 × (1.02)2 / (1.03)2 = 1.1278 (or Forward rate = Spot rate × exp 2(rA − rB) = 1.15 e−0.02 = 1.1272 )

(iii) In practice, outright forward rates do not usually appear on a dealer’s screens.

Instead, “forward points” are quoted where forward points = F − S. Thus the “outright” forward rate is the spot rate plus forward points.

3 (i)

• Index Fund is open ended fund, exchange traded fund is closed ended.

• Index fund redeem at NAV (sometimes with spread). Exchange traded funds not always priced at NAV

• Index Fund tend to replicate main indices, exchange traded funds can be much more focussed on a sector


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(ii) • Tracking error – not holding all securities in benchmark • Management fees • Expenses • Handling of dividends • Treatment of tax taken at source

4 (i) Mean-variance portfolio theory relies on some strong and limiting

assumptions about investor behaviour. It is assumed that:

• (i) investors select their portfolios on the basis of the expected return and the variance of that return over a single time horizon.

• (ii) investors are never satiated. At given level of risk, they will always

prefer a portfolio with a higher return to one with a lower return.

• (iii) investors dislike risk. For a given level of return they will always prefer a portfolio with lower variance to one with higher variance.

(ii) The covariance for the two assets CAB is given by ρABσAσB = .0012 Minimum variance occurs when the proportion of asset A(xA)

= 2

B AB

A AB B

V CV C V

−− +

= 0.0064 0.00120.0025 0.0024 0.0064

−− +

= 0.00520.0065

= 0.8

xB = (1 − xA) = 0.2

(iii) E = xAEA + xBEB = 0.8 × 5% + 0.2 × 9% = 5.8% V = xA

2VA + xB2VB + 2xAxB CAB

= .00224 So standard deviation = 4.7%


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5 (i) The amount of the bulk transfer is linked solely to the level of the market for UK equities.

The fund is invested across a range of asset classes in accordance with a set benchmark distribution.

Unless the proportion of the benchmark allocated to UK equities explicitly allows for this bulk transfer, part of the bulk transfer liability is effectively mismatched by asset class.

If, for example, the portfolio is 50% invested in UK equities and 50% in

overseas equities, bonds, properties etc., then circa £100m of the bulk transfer is matched by asset class. However, there is still a circa £100m liability linked to UK equities which will be settled by transferring securities to the requisite value from the overseas equities, bonds, properties etc. classes i.e. this £100m is mismatched by asset class.

(ii) You may be able to reduce your exposure to these other asset classes and

increase your exposure to UK equities by using financial futures. In total, you need to change your exposure for approx. £100m i.e. sell £100m

worth of futures on these other asset classes and buy £100m worth of UK equity futures.

A variety of futures would be sold related to the markets in the other asset classes and in proportion to the distribution of the assets amongst these markets.

At the time of payment the futures position would be unwound. The principal problem is that there may not be appropriate derivative contracts

for some of these other asset classes e.g. property, venture capital etc. Other main problems are: • The basis risk associated with futures contacts • The need to take account of foreign exchange hedging in relation to

overseas asset classes • The trustees may be restricted in their use of derivatives • Margin payments may need to be funded • The investment managers may lack the requisite expertise, which may result in additional costs

6 (i) Fundamental analysts use a variety of techniques to try to determine whether a

share is over- or under-valued by the market. Most methods involve an attempt to obtain a better estimate of future earnings or dividends, either by the use of a superior model or by the use of information which hasn’t been taken into account by the market. The process can be considered as consisting of two stages. The first is the construction of a model of the company which


Page 8

allows future cash flows and earnings to be estimated. The second involves the use of the output from the first stage to determine whether the company’s securities are over- or under-valued by the market. In practice, a wide range of techniques is used and the degree of sophistication employed varies greatly.

(ii)

• The analyst will consider the following:

− Management ability − Quality of products − Prospects for market growth − Competition − Input costs − Retained profits − History

• In order to consider the above they will undertake the following analysis:

− Financial accounts and accounting ratios − Dividend and earnings cover − Profit variability and growth − Level of borrowing − Level of liquidity − Growth in asset value − Expenditure − Performance relative to other similar companies

(iii) Reduce Costs

• Reduce expenses – this could be done by: − Reducing size of work force

− Reduce salaries of firm or cut benefits

− Reduce costs of manufacturing by sourcing cheaper materials

− Improving efficiency of current process or outsourcing

activities/processes to cheaper location

− Reduce/eliminate non-essential expenses

− If firm has debt, maybe able to restructure debt to lower borrowing costs

− Move headquarters to more tax beneficial location


Page 9

Increase Revenues

• Increase prices of beds • Expand product range available to market • Expand beyond hotel market and offer to public as well • Expand into overseas markets • Stop producing any loss making products

7 (i) A discussion of the four main methods is provided below. Full replication involves holding every stock in the chosen index in the index

proportions. Thus the index is fully matched. This can be an expensive approach to matching the investment performance of

the index if there were a lot of stocks in the index. Imagine the dealing costs involved in full replication of the FTSE All Share

Index as stocks move in and out of the index and dividend income is reinvested in the correct proportions across the index.

The need to be a “forced” buyer or seller as index constituents change may

result in trades being made at unattractive prices. Stratified sampling entails purchasing a sample of the stocks in the index so

that the proportions of the fund in the specified industry categories matches that of the index. Some mismatching is inevitable.

Fewer stocks are required compared with full replication and this should lower transactions costs.

The method requires a significant statistical analysis to find the sample that best matches the performance of the index.

There will be less 'forced' buying and selling involved. Optimisation entails constructing a portfolio that matches the index in certain

specified fundamental factors (e.g. price earnings ratio, capitalisation, and beta) that are known to affect performance.

Choosing the fundamental factors in the first place is a problem that requires

high level analytical skills − choosing appropriate stocks thereafter is yet another problem. This approach requires ongoing analysis and computing power to carry out the optimisation.

Again the method has the advantage of requiring less stocks than full

replication and hence lower transaction costs. However some mismatching is inevitable.


Page 10

Synthetic funds are constructed using derivatives on the underlying assets rather than holding the assets themselves.

For example, a passive fund manager could hold cash (perhaps in the form of

T-bills) and futures on the index. Provided suitable derivatives exist/are used, the index is fully matched, at least in capital terms.

If futures are underpriced relative to fair value the manager may outperform an

index fund that holds stocks directly and vice versa. The necessity to roll over the index futures every few months can give rise to

basis risk [½] which may cause the fund to outperform/under perform a portfolio holding the stocks directly.

The costs associated with constructing the synthetic fund may be significant. (ii) Matching an index may be problematical due to the lack of fungibility i.e. you

can only buy what bonds others want to sell. Hence matching an index may be quite easy in gilts but very hard in corporate space. Moreover a single issuer can have multiple stocks available with different terms and features, some rated some not, so you could get a yield pick up for the same underlying credit risk simply because, say, there is less demand for unrated issues.

Where the index being matched is a very broad market index, indexation

exposes the investor to market risk whereas active management which aims to beat the performance of the index exposes the investor to both market and stock specific risk.

Index portfolio managers tend to deliver a narrower range of returns compared

to active managers targeting the same benchmark. This has led some observers to argue that the average active manager provides a poor risk-return trade-off relative to the average index manager targeting the same benchmark index.

Index funds tend to beat the average active manager which aims to beat the same benchmark index.

Markets are relatively efficient – information is disseminated quickly and

simultaneously to all major market participants who take the correct action, which is quickly reflected in stock prices – and any outperformance by generated by an active manager may not justify the extra dealing and fund management costs.

The problem with active management is that while some active managers do indeed produce returns well in excess of the benchmark the question is can they be identified in advance and can they consistently outperform the index.

Where a bond fund is subject to taxation, active fund management means an earlier incidence of capital gains tax. Index funds have a very low level of


Page 11

turnover, so until all or a part of the fund is disposed of it (and ultimately the investor) pays minimal capital gains tax.

The need to match liabilities may make the use of passive management

preferable. 8 (i)

• Portfolio manager picked underperforming securities (i.e was “unlucky”)

• Portfolio manager might have been given a different brief (asset class) to manage than they are use to managing before

• Portfolio restrictions might be too restrictive limiting ability to add value

• Portfolio manager’s style might be out of favour (i.e. growth manager and market conditions have been value markets)

• Quality of analyst recommendations have been poor • The skill of the supporting team or systems may be less developed

(ii)

• 1 – regret aversion – retaining current arrangements minimise possibility of regret. Also, anchoring and adjustment to keep convincing themselves the new price is correct

• 2 – Overconfidence in own abilities and believes own judgement is best

• 3 – Overconfidence – confirmation bias, looks to change views to suit their own views

• 4 – Dislike of negative events - influence of the 'valence' of the outcome

• 5 – Primary effect – like to pick first option on list (iii)

• Have strong sell rules (stop losses) to stop portfolio managers holding onto underperforming securities too long

• Have all sell decisions reviewed by second person to stop securities being sold too quickly

• Have a model portfolio which is decided by a group of portfolio managers rather than stock selection influenced by a single manager

• Remunerate portfolio managers on their stock selection could increase focus on performance


Page 12

• Introduce rules that all stock selection must have an analyst recommendation

• Change way stock recommendations are presented to stop stock at the top of list being selected

9 Start value 10000000 Benchmark 1 Domestic Equities 3500000 50% Overseas Equities 4000000 30% Small Cap Equities 2000000 15% Cash 500000 5%

Period 1 Period 2 Transition Period

Period 4 Period 5

Domestic Equities value 3500000 3815000 3000000 5255000 5570300

Domestic Equities return 9.0% 8.0% 7.0% 6.0% 8.0%

Benchmark return 11.0% 7.0% 7.0% 6.0% 5.0%

Overseas Equities value 4000000 4160000 3000000 3153000 3310650

Overseas Equities return 4.0% 7.0% 6.0% 5.0% 7.0%


Small Cap Equities 2000000 2060000 1000000 1576500 1639560

Small Cap Equities return 3.0% 6.0% 6.0% 4.0% 5.0%


Cash 500000 505000 3000000 525500 530755

Cash return 1.0% 1.5% 2.0% 1.0% 3.0%


Total portfolio 10000000.0 10540000.0 10000000.0 10510000.0 11051265.0 10540000.0 10510000.0 Benchmark 7.5% 6.6% 6.3% 5.1% 5.5% Answers

(i) Domestic Overseas Small Cap Cash Total return (a) Super Return 4120200 4451200 2183600 512575 12.7% Benchmark Return 14.5% (b) Transition Period 3210000 3180000 1060000 3060000 5.1% Benchmark Return 6.3% (c) Think Return 6015924 3542396 1721538 546678 12.5% Benchmark Return 10.9%


Page 13

(ii) (a) Cash taken out 1267575 (b) Total scheme 33.3% Total benchmark 35.0% (iii) Stock attribution Period 1 Period 2 Transition

Period Period 4 Period 5

Domestic equity return 9.00% 8.00% 7.00% 6.00% 8.00% Benchmark 11.00% 7.00% 7.00% 6.00% 5.00% Stock attribution –2.00% 1.00% 0.00% 0.00% 3.00% Overseas equity return 4.00% 7.00% 6.00% 5.00% 7.00% Benchmark 5.00% 7.00% 5.00% 5.00% 8.00% Stock attribution –1.00% 0.00% 1.00% 0.00% –1.00% Small Cap Equity 3.00% 6.00% 6.00% 4.00% 5.00% Benchmark 3.00% 6.00% 8.00% 4.00% 3.00% Stock attribution 0.00% 0.00% –2.00% 0.00% 2.00% Cash Benchmark 1.00% 1.50% 2.00% 1.00% 3.00% Benchmark 1.00% 1.00% 2.00% 1.00% 2.00% Stock attribution 0.00% 0.50% 0.00% 0.00% 1.00% Actual alloc, benchmark

perf 6.50% 6.52% 5.00% 5.15% 5.46%

Actual / actual 5.40% 6.90% 5.10% 5.15% 7.02% Overall Stock attribution –1.10% 0.39% 0.10% 0.00% 1.56% Sector attribution answers Sector attribution Q1 Q2 Q3 Q4 Actual alloc, benchmark

perf 6.50% 6.52% 5.00% 5.15% 5.46%

Benchmark / benchmark 7.50% 6.55% 6.30% 5.15% 5.45% Sector attribution –1.00% –0.03% –1.30% 0.00% 0.01% Alternative approach

Benchmark alloc, actual perf

6.20% 7.08% 6.30% 5.15% 7.00%

Actual / actual 5.40% 6.90% 5.10% 5.15% 7.02% Overall Stock attribution –0.80% –0.17% –1.20% 0.00% 0.02% Sector attribution answers Sector attribution Benchmark alloc, actual

perf 6.20% 7.08% 6.30% 5.15% 7.00%

Benchmark / benchmark 7.50% 6.55% 6.30% 5.15% 5.45% Sector attribution –1.30% 0.52% 0.00% 0.00% 1.55%


Page 14

(iv) • Transition managers have performance benchmark, so assets would have

been managed to the target asset allocation which would have improved performance

• Transition manager could have used derivatives to manage against target benchmark whilst underlying securities are bought/sold

• Transition manager has skills in trading securities which might be beneficial compared with the investment manager trading the portfolio



EXAMINATION

25 April 2012 (pm)

Subject ST5 – Finance and Investment Specialist Technical A













ST5 A2012–2

1 (i) Outline the characteristics of debentures. [3] (ii) Explain the attraction of debentures for: (a) issuers (b) investors [7] [Total 10] 2 (i) State the differences between forward and future interest rate contracts. [2] (ii) State the formula for converting a futures rate to a forward rate, defining any

terms that you use. [2] A Eurodollar futures quote is for a three-month contract and is expressed with

quarterly compounding. (iii) Calculate the forward rate consistent with a six-year Eurodollar futures price

quote of 96, where the volatility of short-term interest rates is 1% p.a. [3] (iv) State the procedure for valuing a swap using forward rate agreements. [3] [Total 10] 3 (i) List the key industrial classification features of banks. [2] (ii) Describe how domestic bank shares are expected to perform relative to

consumer non-durable goods shares during: (a) low economic growth (b) high economic growth [4] A retired professional is deciding whether to invest part of his portfolio in a number

of domestic bank shares. His requirement is for capital growth over a short horizon of one to two years.

Over the past year bank shares have fallen in value by an average of 60% due to

concerns about global economic growth. The current forecast is for an economic recovery in three to four years’ time.

(iii) Explain why the proposed investment might not be suitable for the individual.

[5] (iv) List other ways in which this investor could gain exposure to banks without

investing directly in the underlying shares. [2] [Total 13] 4 Explain why declines in property prices may create losses in other parts of the

economy. [14]

ST5 A2012–3 PLEASE TURN OVER

5 (i) Outline three ways of minimising an investor's capital gains tax liability. [3] A wealthy investor with multi-residency status is deciding which country to

declare her personal wealth in to minimise taxes payable. Currently the investor’s portfolio consists of:

(All values in 000’s) Asset Start

Year 1 End

Year 1 End

Year 2 End

Year 3

Property – Main residence 2,000 2,000 2,500 2,500 Property – Investment portfolio

3,750 4,000 5,000 4,500

Share portfolio 2,800 3,000 6,000 5,000 Income from shares - 300 500 500 Automobile collection 1,000 1,000 1,200 1,500 Art collection 150 250 300 0*

* The art collection was sold at the end of Year 2.

The investor is choosing between the tax regimes in two countries as set out

below: Tax Country A

Country B

Income tax 50%

10%

Capital gains tax

30%, payable each year based on appreciation of asset value during the year

15%, payable only once every 3 years based on value of assets at end of 3rd year. Assets disposed of before 3 year period not subject to tax

Allowances Main residence is exempt from tax

Depreciating assets (includes automobiles) can offset 25% of value from any tax payable

Capital loss 20%, claim back tax on depreciation of asset value during the year

No allowance made for capital losses

(ii) Calculate the total tax that would be payable in each of the three years and in

total, in each country, split between income and capital tax. State any assumptions you make. [7]

(iii) Describe two ways the investor might be able to lower her future total tax

burden, assuming the above tax regimes remain unchanged. [2] (iv) Suggest reasons why an investor might decide to declare residency in a

country where the capital gains tax rates are higher than in another country. [2] [Total 14]

ST5 A2012–4

6 (i) Describe absolute and relative approaches to pricing assets. [4] (ii) Explain the function of beta in the Capital Asset Pricing Model (CAPM). [3] In a market where the CAPM holds, the following parameters are known: Risk-free rate of interest = 5% p.a. Expected market rate of return = 9% p.a. Standard deviation of an efficient portfolio’s returns = 0.10 Standard deviation of market returns = 0.2 (iii) Calculate the expected return on the portfolio. [2] (iv) Outline reasons why the CAPM may not hold true. [5] [Total 14] 7 (i) State how the MSCI style indices distinguish between value and growth

stocks. [2] (ii) List factors which identify: (a) growth stocks (b) value stocks [4] (iii) Describe other equity investment styles an investor might use. [3]

(iv) Assess whether the following stocks would be classified as value or growth stocks.

Company

Products/Services

Big Bang Theory Ltd Develops computer software for mobile / cell phones

Power2u Provides electricity to the northern region of a country

Classic Wooden Furniture Ltd

Has produced chairs and tables for schools for the last 100 years

Superfluid An energy drinks company which has recently expanded into countries where energy drinks are new to the market

In the sticks A regional supermarket with plans to introduce stores nationally

GiveMeSomeCredit.com A bank with a stable client base [6]

ST5 A2012–5

All these stocks have been included in an equally weighted portfolio (with no rebalancing).

You have been given the following investment performance results:

Company

Year 1 Year 2 Year 3

Big Bang Theory Ltd 12% 5% 2% Power2u 7% 8% 8% Classic Wooden Furniture Ltd 4% 7% 9% Superfluid 21% 2% −6% In the sticks 5% 11% 1% GiveMeSomeCredit.com 9% 8% 9% Total Benchmark return 11% 5% 4% Growth Benchmark return 14% 5% −1% Value Benchmark return 7% 7% 8%

(v) Calculate the following: (a) Return of the total portfolio compared with the total benchmark return (b) Return of the growth portfolio compared with the growth benchmark

return and total benchmark return. (c) Return of the value portfolio compared with the value benchmark

return and total benchmark return. [8] (vi) Assess whether the returns in (v) indicate that the economy was growing or

contracting during the period calculated. (You may assume that the portfolio is representative of the entire economy.) [2]

[Total 25]

END OF PAPER


EXAMINERS’ REPORT



Purpose of Examiners’ Reports The Examiners’ Report is written by the Principal Examiner with the aim of helping candidates, both those who are sitting the examination for the first time and who are using past papers as a revision aid, and also those who have previously failed the subject. The Examiners are charged by Council with examining the published syllabus. Although Examiners have access to the Core Reading, which is designed to interpret the syllabus, the Examiners are not required to examine the content of Core Reading. Notwithstanding that, the questions set, and the following comments, will generally be based on Core Reading. For numerical questions the Examiners’ preferred approach to the solution is reproduced in this report. Other valid approaches are always given appropriate credit; where there is a commonly used alternative approach, this is also noted in the report. For essay-style questions, and particularly the open-ended questions in the later subjects, this report contains all the points for which the Examiners awarded marks. This is much more than a model solution – it would be impossible to write down all the points in the report in the time allowed for the question. T J Birse Chairman of the Board of Examiners July 2012


Subject ST5 (Finance and Investment Specialist Technical A) – Examiners’ Report – April 2012

Page 2

General comments 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 or application of knowledge and scored lower accordingly. Whilst some candidates are too narrow in their responses, a greater number 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 alongside the approach outlined below. 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. Given the greater volatility in recent years and globalisation/integration of markets and economies, delivering an acceptable return from a long term strategy against an increasing short term focus and political/regulatory backdrop has become increasing challenging for investors. 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 12–18 months preceding a diet, more so the solutions (and sources of) being debated by the various stakeholders. Hence questions regarding banking and derivative approaches, as well as active and passive asset management and insurance solutions, to asset and liability risk management (including model risk) or modern financial theory and commercial applications should be considered likely scope for examination. Against a background of the credit crisis, new asset classes and ways of structuring investments will themselves generate new types of risk (such as operations, liquidity, credit and counterparty), so the need for new ways of regulation, monitoring and management. Finally the examiners encourage candidates to recognise there are different types of investor beyond solely pension funds, and that different taxation, time line and cost considerations will apply to each type of investor – it would seem that candidates have taken this on board. Whilst the examiners will tolerate bullet point style responses, some candidates’ handwriting was too poor to assess and they will have lost marks. "Text speak" abbreviations will not be accepted.


Page 3

Specific comments on April 2012 paper This paper had a similar pass mark to the September diet and resulted in a higher pass rate, which was a pleasing result. Candidates typically answered Question 7 much better than the others (albeit still foregoing a third of marks available), with Questions 4 and 1 attracting the worst responses, considerably so, with average scores of between a quarter and a third of the available marks. Question 1 was predominantly bookwork knowledge so the scores are disappointing. Conversely, Questions 5 and 7 were two of the more calculation biased ones and it was pleasing to see more skill demonstrated in this area. Question 2 focussed on different derivative contracts and pricing, an increasing area of focus for actuaries generally as liability driven investment grows in popularity. Questions 3 and 5 focussed on the practical aspects of investment as distinct from theory, highlighting that the client could more likely be an individual than a institution requiring different considerations. Many questions represented opportunities to demonstrate higher level skills in terms of non-standard/practical application of theory to current or unusual issues in investment – hence candidates who wish to progress to SA6 will need to improve their understanding of and approach to such questions.


Page 4

1 (i) A debenture is a loan made to a company which is secured against the assets of the company. Debentures usually have a “floating” charge over the assets of the company, so that debenture holders rank above other creditors should the company be wound up. Alternatively, mortgage debentures have “fixed” charges − they are secured against specific assets set out in the legal documentation.

(ii) Issuers Issuers are likely to be able to obtain funding via the debt capital markets at

lower borrowing spreads if they issue debentures than if they borrow on an unsecured basis.

Funding may be available at longer maturities, or in larger size, than if

borrowing on an unsecured basis. At times of market stress it is desirable to have multiple sources of funding to

maximise the likelihood of being able to source new funds, therefore issuers often want to ensure they have a presence in the debenture markets.

Financial institutions often have significant illiquid assets (e.g. mortgages) that

are available for use as collateral cover, therefore it is efficient to use them in this way to reduce funding costs.

Debentures are issued with a fixed redemption date and carry a fixed rate of

interest, so the issuer has a known debt servicing commitment. Interest payments are tax deductible. Debenture holders have no right to interfere with the running of the company. Investors Investors may be willing to invest in debentures to a greater extent than

unsecured bonds with some issuers due to concerns about credit risk. Debentures are likely to have a higher credit rating than unsecured bonds, so

may fit elsewhere in a portfolio for a given issuer. Due to the different credit characteristics, a debenture will provide some

diversification compared to an unsecured bond, as it is exposed to different risk premia (both the issuer’s credit risk, and that of the collateral assets).

For a hold to maturity investor, debentures have very low risk as they are

likely to offer very high recovery rates due to the collateral pool.

Credit will be given for relevant points from part (ii) that were included in part (i)


Page 5

2 (i) Forwards are over the counter instruments. Futures are exchange-traded. Forwards are bespoke contracts. Futures are standardised. For a forward, there is no cash flow until the maturity. For a future, there is

daily marking-to-market and settlement of margin requirements.

(ii) To convert futures to forward interest rates, a convexity adjustment is applied: Forward rate = Futures rate − ½σ2t1t2 where t1 is the time to maturity of the futures contract t2 is the time to maturity

of the rate underlying the futures contract and σ is the standard deviation of the change in the short-term interest rate in one year.

(iii) t1 = 6, t2 = 6.25, σ = 0.01 so the convexity adjustment is .001875 (or 0.1875%) The (nominal) futures rate i(4) is 4%, so the equivalent annual rate is 4.0604%. Thus the forward rate is 4.0604 − 0.1875 = 3.8729% Using a continuous compounding then the alternative answer in 3.8655%

which will be given similar credit. (iv) The procedure is: 1. Calculate forward rates for each of the floating rates that will

determine swap cash flows. 2. Calculate swap cash flows on the assumption that the floating rates

will equal the forward rates.

3. Set the swap value equal to the present value of these cash flows. 3 (i) Capital intensive Highly geared Volatile profits Labour costs important Domestic market is most important Highly regulated

(ii) In low economic growth a consumer non-durable stock is less affected by the

economy than an organisation with volatile profits (banks) which are expected to decrease. Conversely in high economic growth you would expect banks to make higher profits. Therefore, in low economic growth you would expect the durables to outperform the bank stock, whereas in higher growth bank stocks are expected to outperform the consumer durables.


Page 6

Variations in demand for the shares will exacerbate these effects. (iii) Because the individual is retired it is likely they are concerned with capital

preservation and equities being volatile are not usually suitable for risk averse individuals.

On this occasion the individual wants capital growth so equities might be

suitable. However, given their retired status their time horizon might be shorter than economic recovery period when bank stocks are expected to underperform.

Also, the economy might make it difficult for banks to produce profits and the

bank stocks are not at the bottom of their valuation cycle. The investor might wish to diversify away from one sector. (iv)

• A pooled fund holding bank stocks • An ETF invested in bank stocks • Derivatives • Bond holdings

4 Property losses can rapidly result in losses being “transmitted” to other parts

of the economy as property assets are often purchased using borrowed funds, rather than purchased on an outright basis.

This means that if a property falls in value, the owner (borrower) will see an

increase in their loan to value (LTV), and hence represent a greater credit risk for the lender. If the funds have been borrowed from a regulated financial institution (e.g. a bank) then they will need to hold more capital against the loan, creating balance sheet strains, and potentially the bank may need to sell long-term assets such as loans to restore capital levels.

If a number of lenders are impacted simultaneously, as would often happen if

property prices fall, then they will all face capital strains. This will reduce their ability to advance funds to new borrowers, and create shareholder losses. They will also become less creditworthy themselves, resulting in funding strains or higher borrowing costs.

Householders would experience problems when selling properties in the

depressed market. As the property value was now lower than their mortgage borrowing, they would experience “negative” equity. This would in turn limit their ability to fund a new property purchase and thus cause the property market to stagnate. Where the move was needed due to a planned change in employment, this would then influence the labour market. A regional differential in property price movements, so that prices were falling in some parts of the country but remaining stable elsewhere, could exacerbate this problem.


Page 7

Where property loans had been used as collateral in asset-backed securitisations such as mortgage-backed securities or collateralised debt obligations, the fall in property prices would reduce the demand for such assets by investors. Equally, lenders would find that short-term funding, e.g. on the interbank market, would become more expensive (or might even become unavailable). This problem would be particularly acute if the lender's activity concentrated on property loans.

The fall in property values and transactions might reduce government tax

revenues. Business supporting the property market, such as estate agents and conveyancing solicitors, would also be adversely affected. Conversely, there might be increased demand for property refurbishments or improvements from homeowners unable to move. However the availability of “second” mortgages and further loans would be limited due to the reduced collateral available and exacerbated by additional caution from lenders.

Similar effects would be experienced in the commercial property sector if real

estate prices fell. The use of property values to support debenture loans or “sale and leaseback” transactions could be affected. The property development sector (builders, architects, material suppliers, etc.) would also be adversely affected, particularly if the decline in prices was expected to persist for a substantial period.

The fall in capital values will be reflected in an increase in rental yields.

Indeed the lack of turnover in the property market and the increase in required LTVs may generate excess demand for rental property leading to a further increase in rents. This will effect an income transfer from tenants to landlords and the resulting change in disposable income may have wider economic impacts and consequent changes in asset capital values according to relative consumption patterns.

5 (i) Capital gains tax is usually payable on disposal of an asset. This can lead to

investors attempting to defer tax liabilities by avoiding the crystallisation of a capital gain.

Using capital losses to offset capital gains in the same year. Derivatives can be used to reduce exposure to an asset rather than selling the

asset itself. The existence of an annual tax-free allowance can also lead to investors selling

and repurchasing assets to crystallise a gain in order to take advantage of their annual allowance.


Page 8

(ii)

Country A Year 1 Year 2 Year 3 Total Income tax 150000 250000 250000 650000 Capital gains tax 165000 1275000 −210000 1230000 Total 315000 1525000 40000 1880000 Country B Year 1 Year 2 Year 3 Total Income tax 30000 50000 50000 130000 Capital gains tax 1968750 1968750 Total 2018750 2098750

(iii) Declare income tax in Country B and capital gains in Country A. Have main residence in Country A. Sell all assets in Country B every 3 years to exempt from capital gains tax. (iv) Overall tax paid in country of residence might be lower (i.e. lower income

tax). Might not have any assets which are subject to capital gains. Has some capital losses which are more advantageous to be written off in

country of residence. If tax is only paid on capital gains (compared to a country where rates are

lower but tax is on the value of the assets). Non-financial reasons as described. 6 (i) Absolute pricing prices assets by reference to exposure to fundamental sources

of macroeconomic risk. The consumption-based and general equilibrium models (such as CAPM) are examples of this approach, which can be used to predict how prices might change if policy or economic structures change.

Relative pricing, as exemplified by Black-Scholes option pricing and

Arbitrage Pricing Theory, considers the value of an asset given the price of some other assets. Here we use as little information about fundamental risk factors as possible, and we do not ask where the prices of the other assets came from.

(ii) Beta is a measure of a stock’s volatility relative to movements in the whole

market. 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. It is a measure of the stock’s exposure to non-diversifiable systematic risk.

Beta is useful because it allows the expected return of any security to be expressed as a linear function of the security’s covariance with the market as a whole.


Page 9

(iii) Expected return = 5% + (0.1 / 0.2) (9 − 5) = 7% (iv) Empirical evidence suggests that the line relating return to beta has been too

“flat” in recent years, and that while return has not risen with beta it has been related to other measures such as market capitalisation or book-to-market ratio. CAPM predicts that beta is the only reason that expected returns differ

The “risk free” rate is not truly attainable, due to factors such as default,

inflation and currency risk. CAPM assumes that investors can borrow money at the same rate of interest

as at which they can lend. In practice, borrowing rates are higher than lending rates.

Markets are not “perfect” (with information freely and instantly available to

all investors). Similarly, investors will not share the same estimates of expected returns, standard deviations and covariances of securities.

7 (i) The MSCI style indices take the universe of a standard index and ranks the

securities according to Price-to-Book values. The top half – stocks with low Price-to-Book values – is associated with the Value style and the bottom half – stocks with high Price-to-Book values – is associated with the Growth style.

(ii) Five Growth factors are:

• Sales Growth • Earnings Growth • Forecast Earnings Growth • Return on Equity • Earnings Revisions

and five Value factors:

• Book to Price • Dividend Yield • Earnings Yield • Cash Flow Yield • Sales to Price

(iii) Other equity investment styles include:

• Momentum – purchasing (selling) those stocks which have recently risen (fallen) significantly in price on the belief that they will continue to rise (fall) owing to an upward (downward) shift in their demand curves.

• Contrarian – doing just the opposite to what most other investors are

doing in the market in the belief that investors tend to overreact to news.


Page 10

• Rotational – moving between Value and Growth depending on which style is believed to be attractive at any particular point in time.

(iv) Big Bang – Tech stock in market which is expanding – growth stock Power 2u – Utility which is non-cyclical stock – classic value stock Classic Wooden Furniture – mature, stable market – value Superfluid – Expansion into markets that are growing – growth In the sticks– expansion plans – growth GiveMeSomeCredit.com – stable client base, seems to be value (v)

Company Year 1 Year 2 Year 3 Total return

Big Bang Theory Ltd 12% 5% 2% 19.95% Growth Power2u 7% 8% 8% 24.80% Value Classic Wooden Furniture Ltd 4% 7% 9% 21.30% Value Superfluid 21% 2% −6% 16.01% Growth In the sticks 5% 11% 1% 17.72% Growth GiveMeSomeCredit.com 9% 8% 9% 28.31% Value Total Benchmark return 11% 5% 4% 21.21% Growth Benchmark return 14% 5% −1% 18.50% Value Benchmark return 7% 7% 8% 23.65% Total portfolio return 9.7% 6.7% 3.7% 21.35% Growth portfolio return 12.7% 5.8% −1.1% 17.89% Value portfolio return 6.7% 7.7% 8.7% 24.80% Workings

Company Year 1 Year 2 Year 3 Total Return Big Bang Theory Ltd £100.00 12.0% £112.00 5.0% £117.60 2% £119.952 Power2u £100.00 7.0% £107.00 8.0% £115.56 8% £124.805 Classic Wooden Furniture Ltd

£100.00 4.0% £104.00 7.0% £111.28 9% £121.295

Superfluid £100.00 21.0% £121.00 2.0% £123.42 −6% £116.015 In the sticks £100.00 5.0% £105.00 11.0% £116.55 1% £117.715 GiveMeSomeCredit.com £100.00 9.0% £109.00 8.0% £117.72 9% £128.315 Portfolio return £600.00 9.7% £658.00 6.7% £702.13 3.7% 21.35% Growth portfolio return £300.00 12.7% £338.00 5.8% £357.57 −1.1% 17.89% Value portfolio return £300.00 6.7% £320.00 7.7% £344.56 8.7% 24.80%


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Answer

Calc Answer Total portfolio return 21.35% Total benchmark return 21.21% 0.14% Total Growth portolio return 17.89% Growth benchmark return 18.50% −0.61% Total benchmark return 21.21% −3.32% Value portfolio return 24.80% Value benchmark return 23.65% 1.16% Total benchmark return 21.21% 3.59%

(vi) From the calculations it shows that value stocks have outperformed growth

stocks. When an economy is contracting, value stocks tend to outperform so it is likely the economy was contracting.



EXAMINATION

2 October 2012 (pm)














ST5 S2012–2

1 Outline the process of asset / liability mismatch reserving. [6]

2 (i) Define “arbitrage”. [1] (ii) Explain how the concept of arbitrage can be applied to derive the price of a

forward contract. [4] (iii) Explain why, in practice, it would not be possible to generate unlimited profits

from a legitimate arbitrage opportunity. [3] [Total 8] 3 (i) Define “behavioural finance”. [2] (ii) Describe the behaviours exhibited in each of the following scenarios: (a) A pension scheme is looking to award a new global equity mandate.

The trustees of the scheme have invited five investment managers to each present their proposed strategy, with the intention of selecting one of them. The investment manager who has been asked to present third during the day has subsequently requested to present last.

(b) A risk averse individual has sold their portfolio of Government bonds

and invested the proceeds in tulip (a flower) futures. Tulip futures have been the best performing asset class over two years and are increasing in value each month. Many financial commentators predict they will continue to rise in value.

(c) A holiday company, which ran a competition for a free holiday, has

sent the 10 winners a brochure with 300 different choices of holiday all worth the same amount. Seven of the 10 winners pick the first holiday in the brochure.

(d) A pension fund manager is having operational problems with the

pension fund’s custodian. The custodian has recently received a lot of negative publicity and service standards have been slipping. The fund’s investment consultant recommends a search for a new custodian is undertaken, but the pension manager is very resistant to the idea.

[8] [Total 10]

ST5 S2012–3 PLEASE TURN OVER

4 A government has decided to introduce regulations to strengthen the capital position of domestic companies. The additional capital required by a company will depend on the historic volatility of profits for that company's sector.

(i) Describe the impact the capital requirements will have on: (a) Utility companies (b) Consumer goods (c) Industrials (d) Banks [8] (ii) Outline the reasons why the government would want to introduce the new

regulations. [3] (iii) Suggest possible negative effects of the introduction of the regulations. [5] [Total 16] 5 (i) Outline the main financial risks faced by institutional investors. [4] (ii) For each of the following scenarios, describe the financial risks present: (a) An options trader who is responsible for valuing and settling his own

trades has recently been found to have incorrectly represented a number of trades over the last year. This has resulted in a large loss for an investment bank.

(b) In a small country the standard asset allocation for a pension scheme is

a balanced mandate based on the allocation of the average pension scheme. One of the larger pension schemes has now decided to change to a scheme specific benchmark, which has resulted in a higher allocation to equities.

(c) A large bank which specialises in uncollateralized derivatives has

recently gone bankrupt. This has caused banks in other countries to restrict their lending in the affected market.

(d) An island with very few regulatory rules has been successful in

attracting hedge funds to be registered in their country. Due to a shortage of financial professionals, each professional is responsible for about 200 funds on average.

[8] (iii) Suggest possible actions to reduce the risks identified in (ii). [5] [Total 17]

ST5 S2012–4

6 (i) Outline the process of liability hedging. [4] (ii) Discuss the difficulties that may arise in constructing an investible portfolio of

hedge assets. [6] (iii) Outline the Liability Driven Investment approach to setting investment

strategy. [7] [Total 17] 7 (i) Describe what is meant by the terms: (a) active management (b) passive management (c) core and satellite portfolios [7] A small pension fund has recently decided to invest in US large capitalisation equities

and an emerging markets equity portfolio. As their investment consultant you have been asked to comment on whether the US large capitalisation equities strategy should be managed on an active or passive basis.

(ii) Set out, with reasons, what you would advise the trustees. [4] For the emerging markets equity portfolio, the trustees have decided to follow an

active investment strategy with a manager called Emergaine Capital Markets. One of the trustees recently met a friend who operates a company, Commertoze, which manages emerging market equity portfolios on a passive basis. As a result of the conversation the trustee is suggesting that part of the emerging markets equity portfolio is managed on a passive basis.

(iii) Comment on the financial reasons why the trustee has put forward the

proposed structure. [2] The trustees have decided to investigate whether a proportion of the emerging markets

equity portfolio should be managed on a passive basis. They have been presented with the following information:

Manager Year 1 Year 2 Year 3

Emergaine Capital Markets 33% 18% −7% Commertoze 14% 9% 15% Benchmark 14% 9% 13%

Emergaine Capital Markets applies an annual management fee of 0.75% applied to

the gross end of year value. In addition it applies a fee of 10% of the gross outperformance of the benchmark each year.

Commertoze applies a fee of 0.15% of the average asset value during the year. All charges are deducted at the end of each year.

ST5 S2012–5

(iv) Calculate: (a) The gross of fees returns for both investment managers and the

benchmark for the entire three year period. (b) The net (of fees) value of both the Emergaine and Commertoze

portfolios at the end of each of the three years, assuming an initial investment of 10 million dollars in each.

(c) The net of fees returns for both investment managers at the end of

three years. [10] (v) Comment on the trustees' decision to invest in an active strategy rather than a

passive strategy based on the results in (iv). [2] (vi) Suggest how the trustees might be able to achieve a better net of fee return

with the active manager. [1] [Total 26]

END OF PAPER


EXAMINERS’ REPORT



Introduction The Examiners’ Report is written by the Principal Examiner with the aim of helping candidates, both those who are sitting the examination for the first time and using past papers as a revision aid and also those who have previously failed the subject. The Examiners are charged by Council with examining the published syllabus. The Examiners have access to the Core Reading, which is designed to interpret the syllabus, and will generally base questions around it but are not required to examine the content of Core Reading specifically or exclusively. For numerical questions the Examiners’ preferred approach to the solution is reproduced in this report; other valid approaches are given appropriate credit. For essay-style questions, particularly the open-ended questions in the later subjects, the report may contain more points than the Examiners will expect from a solution that scores full marks. D C Bowie Chairman of the Board of Examiners December 2012


Subject ST5 (Finance and Investment Specialist Technical A) – Examiners’ Report – September 2012

Page 2

General comments Investment is a 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. 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. Candidates are reminded to avoid being too narrow in their responses to questions, but ensure that responses remain relevant and do not labour minor points. Candidates will not be explicitly penalised for this last activity, but it gives an impression of a lack of understanding and, more importantly, wastes limited time. The examiners have used their discretion as to whether or not to recognise valid points for one part of a question made in another. Likewise the examiners share and agree alternative possible solutions to questions alongside the approach outlined below. Investment is a fast evolving subject driven by the greater volatility and globalisation/ integration of markets and economies alongside the challenges of delivering an acceptable return for a long term strategy in the context of a focus and political/regulatory backdrop that is increasingly short term. 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 12–18 months preceding a diet, more so the solutions (and sources thereof) being debated by the various stakeholders. Hence questions regarding banking and derivative approaches, as well as active and passive asset management and insurance solutions, to asset and liability risk management (including model risk) or modern financial theory and commercial applications should be considered likely scope for examination. Against a background of the credit crisis, new asset classes and ways of structuring investments will themselves generate new types of risk (such as operations, liquidity, credit and counterparty) and so the need for new ways of regulation, monitoring and management. Finally the examiners encourage candidates to recognise there are different types of investor beyond purely pension funds so that different taxation, time line and cost considerations will apply - it would seem that candidates have taken this on board. Whilst the examiners will tolerate bullet point style responses, some candidates’ handwriting made assessment difficult and they may have lost marks. Likewise "text speak" abbreviations will not be accepted.


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Specific comments on September 2012 paper This paper resulted in a relatively high pass rate. It was of a comparable standard to previous exams and so the examiners were pleased to note candidates were generally better prepared, providing better content in quality and not just quantity. The examiners are hopeful that this trend will continue. Candidates typically answered Question 5 much better than the others (albeit still foregoing a third of marks available), with Questions 1 and 6 attracting the worst responses, considerably so, with average scores of around a third of the available marks. Question 1 was predominantly bookwork knowledge so the scores are disappointing. Question 6 focuses on Liability Driven Investing, one of the most topical issues facing many institutional investors today and so candidates might reasonably have been expected to be aware of the key issues. Candidates generally scored very well on the risk and management aspects of Question 5 and 2. Questions 4 and 7 focussed on the practical aspects of investment as distinct from theory, right down to stock level and candidates generally gave a good account of the detailed considerations required. Many questions represented opportunities to demonstrate higher level skills in terms of non-standard/practical application of theory to current or unusual issues in investment – candidates who wish to progress to SA6 will need to improve their understanding of, and approach to, such questions.


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1 Asset / liability mismatch reserving is an example of the use of modelling in actuarial work. The emerging asset and liability position is projected under a range of possible conditions (economic, environmental, etc.) in order to establish the extent to which assets and liabilities are mismatched. Appropriate supplementary reserves can then be set up to cover the possible levels of shortfall identified.

The modelling can, as usual, be carried out using either deterministic or stochastic

methodologies. In a deterministic framework, it is up to the modeller to decide the nature and extent of the scenarios to be tested for the purpose of setting the reserves. At its simplest, the investigation may be restricted to the current portfolio of assets and liabilities only, and consider the impact of an immediate change in conditions, rather than involve projections of the emerging state of the fund. Such an approach is often referred to as resilience testing. However, with modern computer modelling power readily available, more dynamic approaches are typically adopted.

These would include the use of stochastic techniques, where multiple projections

would be made in order to generate many possible future scenarios. Most often, the stochastic element of the projections would apply to the asset portfolio and investment returns, in order to assess exposure to systematic risk. Given that a finite number of projections must be performed, assessment of the results is often carried out in the form of ruin probability, that is, the outcomes are ranked in terms of a target measure (such as the shortfall of assets relative to liabilities at a specified future date). Additional reserves are then set up at a level sufficient to cover all but a specified proportion of such shortfalls.

2 (i) The simultaneous buying and selling of two economically equivalent but

differentially priced portfolios so as to make a risk free profit.

(ii) We can apply the concept of arbitrage to derive the price, F0, of a forward contract in terms of the spot price S0. No arbitrage requires that F0 = S0erT where T is the time when the forward contract matures and r is the risk-free rate of interest (for an investment maturing at time T). If this equality did not hold, arbitrage possibilities would exist. If F0 < S0erT the investor can sell the asset short at the current spot price S0, invest the sale proceeds risk-free (to accumulate a sum S0erT), and, at the same time, enter into a long forward contract to buy the asset at time T at price F0. This will generate a risk-free profit of S0erT − F0 for no initial outlay.

Similarly, if F0 > S0erT unlimited profit can be made from a strategy of

borrowing S0 now to buy the asset and entering into a short forward contract to sell the asset at time T for F0. At that time the loan and accumulated interest of S0erT will be repayable, leaving the investor with a risk-free profit of F0 − S0erT . The only price for the forward, F0, that eliminates the arbitrage opportunities is S0erT.


Page 5

(iii) Cannot get access to unlimited borrowing. Arbitrage opportunities only exist for a finite time frame before other investors

recognise the arbitrage and the opportunity is closed. The use of modern technology increasingly limits such arbitrage opportunities.

Frictional / transaction costs, taxes, etc. The loan interest rate may be higher

than the risk free rate. Operational and credit risk may be involved. “Basis” risk e.g. the funds borrowed are recalled before the investment period

expires. Limits on the use of short-selling. 3 (i) The field of behavioural finance looks at how a variety of mental biases and

decision-making errors affect financial decisions. It relates to the psychology that underlies and drives financial decision-making behaviour.

(ii) (a) Recency effect – in some instances the final option (presentation) is

preferred. (b) Anchoring and adjustment – people base future perceptions based on

past experience and expert opinion. The valuation is then amended for the scenario to fit the assumptions.

Could also mention myopic loss aversion – investors less risk averse

when faced with a multiple period of gambles. (c) Primary effect – people are more likely to choose the first option

presented. Effect of options – a greater range of options tends to discourage

decision making. (d) Status Quo bias – people like to keep things the way they are. Regret aversion – by retaining the existing arrangements people

minimise the possibility of regret.

Other behaviours cited were given credit if fully described so that their applicability to the scenario was clearly demonstrated.


Page 6

4 (i) Utility – stable profits so likely to have little additional capital requirements. Consumer goods – durables tend to have volatile profits so will have

additional requirements. Non-durables have more stable profits so capital requirements will tend to be lower.

Industrials – In general volatile profits which means that industrials are likely

to be hit hard by capital requirements. Banks have volatile profits and therefore banks are likely to be hit hard by the

introduction of the regulations. If banks are required to hold extra capital then this is likely to impact how

cash is invested as capital reserves tend to be held in low risk assets. As a result the bank profits are likely to be lower which will negatively impact the share price.

(ii) To lower the risk of firms becoming insolvent in times of poor economic

climate. To increase investor/consumer confidence in the market and protect

consumers. To bring them in line with regulations in other countries. To restrict new entrants to well funded organisations.

(iii) Lower profits as capital being used to meet reserves plus the cost of monitoring. Companies may respond by charging higher prices or reducing the workforce.

Higher barriers to entry as new companies might not have enough capital to meet the requirements.

Companies that don’t have enough capital might be forced into bankruptcy.

Could make companies less competitive relative to international peers.

Capital requirements will mean less cash to spend on growing business and product development. Hence lower international competitiveness.

Companies might restructure to get into a less volatile sector.

Companies might relocate to other countries.

Tax revenues might be reduced.


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5 (i) Market risk – the risk relating to changes in the value of the portfolio due to movements in the market value of the assets held.

Credit risk – the risk that a counterparty to an agreement will be unable or

unwilling to fulfil their obligations. Operational risk – the risk of loss due to fraud or mismanagement within the

fund management organisation itself. Liquidity risk – the risk of not having sufficient cash to meet operational needs

at all times. Relative performance risk – the risk of underperforming comparable

institutional investors. (ii) (a) Operational risk – The trader has the opportunity to influence the price

of the trades he makes and therefore the risk of fraud is increased. Liquidity risk – the loss might have caused the bank to have liquidity

problems due to loss. Credit risk – risk that other banks might not lend to affected bank as

perceived higher credit risk. (b) Market risk – Equities can be volatile so this could result in capital

losses and therefore the risk that portfolio value decreases. Relative performance risk – if the pension scheme is holding a

different asset allocation compared to other schemes then there is the risk that the allocation underperforms relative to the other schemes. This can be exaggerated by holding greater allocation to equities which can be volatile.

(c) Credit risk – restricted lending as fear that other banks in country with

bankrupt bank could be affected and therefore other countries reduce credit risk exposure.

Also liquidity risk. (d) Operational risk – the professionals have too many funds to look after

and regulation is light which increases the risk of fraud and errors due to lack of oversight.

(iii) (a) Risk could be reduced by separating trading function from the

operations department so that a trader cannot settle own trades, and someone in operations is responsible for settling trades. This is referred to as segregation of duties.

(b) Return asset allocation to the peer group to reduce relative

performance risk.


Page 8

The pension fund could look to offset increased volatility in the equity portfolio by investing remaining assets in less volatile assets (such as cash) to reduce risk of portfolio declining in value.

(c) The banks lending could insist on derivative deals being completed on

a collateralised basis. Banks could ask for Government guarantee if the banks in the country

fail. This will allow lending to take place again. (d) Limit the number of funds that a professional could represent. Increase regulation. 6 (i) Liability hedging is where the assets are chosen in such a way as to perform in

the same way as the liabilities (that is to change in value by the same proportion). A specific example of this is the concept of immunisation, where assets are matched to liabilities by term in order to reduce interest rate sensitivity (to parallel movements in the yield curve). Other 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 be for an investor to hold a portfolio of

government bonds (in the appropriate currency) until maturity to meet a pre-specified stream of future fixed payments. Provided the future payments do not change in amount or timing, the coupon and principal proceeds from the bond portfolio can be used to meet the obligation to make the payments.

(ii) Difficulties with this approach arise for the following reasons:

• Such an approach requires a bond asset to be held that is equal in present value to the future payments discounted at bond yields (using the full yield curve). Therefore, only a partial hedge is only possible if asset cover is less than 100%.

• If the latter payments are payable after the principal payment of the longest available government bond then it will not be possible to hedge these payments at present (until longer maturity bonds become available, i.e. creating reinvestment risk).

• Due to “gaps” between bond maturities (particularly at longer durations), there may be a need to reinvest or disinvest bonds prior to maturity, and the hedge may therefore be imperfect.

• The use of government bonds gives risk to a (small) degree of credit risk that may not necessarily be reflected in the liability. If other bonds are used, they are more risky.


Page 9

• If the tax status of the government bonds worsens, this will mean the assets are likely to be insufficient to meet the liability payments.

• Due to the above factors, there may be some mark to market risks between the asset value of the bond portfolio and the present value of the liability payments discounted using the bond yield curve. In some cases this may be a material risk factor, but in other cases this will be much smaller than uncertainties in the liability payments themselves or other portfolio risks.

(iii) Liability Driven Investment (LDI) is the terminology used to describe an

investment decision where the asset allocation is determined in whole or in part to a specific set of liabilities.

LDI is not a strategy or a type of product available in the market but an

approach to setting investment strategy that controls asset-liability mismatches. Thus, while liability hedging seeks to address specific features of the liability structure, LDI is a more holistic approach to developing an investment strategy.

An LDI approach would typically aim to achieve a close match of the

following liability features:

• The interest rate sensitivity (duration) of the liabilities. Investments that are used to match the duration of liabilities include fixed rate bonds and interest rate swaps.

• The inflation-linkage of the liabilities. Investments used to match the

inflation exposure of liabilities include inflation linked bonds and inflation swaps.

The shape of the liabilities. The shape of the liabilities will depend on when the cashflows are expected to be paid. Although it is possible to construct a bond portfolio where bond payments match the projected liability payments for a pension fund it is often more difficult to match longer duration payments (40–50 years) due to the limited issuance or non-availability of bonds. This presents particular challenges for long-dated liabilities, especially inflation linked liabilities. In order to purchase assets that match the shape of cashflows at longer durations, investors rely on using swaps to hedge both interest rate and inflation risks. However, non-investment risks such as longevity tend to remain, although products are being developed to manage non-investment risks and are gaining in popularity.

Examples relating to asset classes other than bonds were given equivalent credit.


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7 (i) (a) Active investment managers apply various types of judgement to the selection of portfolios with the objective of outperforming a benchmark. Active management offers the prospect of large returns (in excess of fees paid) and the limitation of “peer group” risk. However, successful selection of active investment managers is hard to achieve and timing the changes to the line-up of active managers is also very difficult.

(b) Passive investment managers are, typically, index-trackers. They

manage assets without taking active investment decisions. Instead, their objective is to track closely the performance of a specified index. This offers the advantages of lower cost and volatility, but with the loss of upside potential and the implicit restriction to markets and asset classes where a suitable benchmark exists.

(c) An increasingly popular fund management structure is to manage the

majority of the fund (the “core” portfolio) on a passive, low-cost basis. Specialist satellite managers are then employed to provide increased performance (in excess of fees paid) in respect of the balance of the fund. This may extend to employing a number of competing managers in respect of the specialist asset classes, if the size of the overall fund warrants this. Increasingly, the satellite managers will include hedge fund and private equity specialists.

(ii) The trustees have to decide how much return will be derived from beta

(exposure to systematic risk) and how much from alpha (asset selection to exploit market inefficiencies). For the alpha allocation (manager outperformance) the trustees need to decide which is the most efficient way to generate the alpha.

The alpha can be generated from either the emerging markets portfolio or the

US equities portfolio. US large cap is a highly efficient market and therefore difficult to generate alpha. Emerging markets is less efficient and should be easier to generate alpha. Based on the choices recommend to invest US equities on passive basis.

(iii) To reduce the risk of underperforming the benchmark by applying a core and

satellite approach to the emerging market portfolio. Has concerns that Emergaine are not the most suitable manager and therefore,

wants to decrease allocation. Trustee wants to spend alpha budget on another bit of the portfolio rather than

the emerging markets. To cut costs.


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(iv) Gross of Fees

Manager Value 1 Return 1 Value 2 Return 2 Value 3 Return 3 Value 4 Total Return

Emergaine Capital Markets 10000000 33% 13300000 18% 15694000 −7% 14595420 46.0% Commertoze 10000000 14% 11400000 9% 12426000 15% 14289900 42.9% Benchmark 10000000 14% 11400000 9% 12426000 13% 14041380 40.4% Net of Fees

Manager Value 1 Return 1 Value 2(net) Return 2 Value 3 Value 3 (net) Return 3 Value 4

Value 4 (net)

Total Return (net)

Emergaine Capital Markets 10000000 33% 13010250 18% 15352095 15119862 −7% 14061471 13956010 39.6% Commertoze 10000000 14% 11383950 9% 12408506 12390661 15% 14249260 14229280 42.3% Benchmark 10000000 14% 11400000 9% 12426000 13% 14041380 40.4%

Note: Candidates may choose to apply the returns obtained to the year-end fund values in calculating the performance fee for Emergaine. Credit should be given for this alternative approach – the appropriate figures are:

Value 1 Return 1 Value 2 (net) Return 2 Value 3 Value 3 (net) Return 4 Value 4

Value 4 (net)

Total Return (net)

Emergaine Capital Markets 10000000 33% 12947550 18% 15278109 15026020 −7% 13974199 13869392 38.7%


Page 12

(v) Based on results there is very little to choose between active and passive managers on a net of fees basis. The passive manager has slightly outperformed which suggests that up to all the portfolio could be invested on a passive basis. However, past performance is no guarantee for future and active manager might offer outperformance in the future.

(vi) Negotiate lower management fees with the active manager. Have a high watermark applied to performance fee to reduce performance fee

payable. Increase risk that manager is allowed to take.



EXAMINATION

17 April 2013 (am)














ST5 A2013–2

1 (i) Outline the two key investment objectives for a fund holding assets below 100% of its liabilities, and the conflict between them. [5] (ii) Describe two measures of the risk of the portfolio in (i) relative to its

benchmark, including details of the data used and any assumptions made. [6] (iii) Suggest how the two measures in (ii) can be adapted to measure asset risks

relative to liabilities. [3] [Total 14] 2 An investment manager who previously managed property funds has decided to offer

a guaranteed capital return type product which will offer the client the higher of the following returns each quarter:

1. fixed 4% per quarter 2. the rate of increase/decrease in the average value of football players in a certain

Football league (Footy) (i) Discuss the difficulties of calculating the Footy index return. [5] (ii) Describe changes that could be made to the Footy index to reduce some of the

difficulties highlighted. [4] You have been given the following information in respect of the Footy index.

End of quarter 1 2 3 4 5 6 7 8 Footy value 105 108 106 112 117 119 124 127

The start value was 100. At the beginning of period 4, one player valued at 4 was removed and one valued at 6 was added.

(iii) Calculate the overall return for the 2 year period: (a) of the Footy (b) of the fund

[4] [Total 13]


3 M-Loans is a specialist firm offering finance to small companies. Prior to any funding being agreed the company must undergo a rating agency assessment.

(i) List the areas a rating agency would focus on in its analysis. [4] (ii) Discuss the potential problems M-Loans may face during a recessionary

period. [4] (iii) Suggest how these problems could be mitigated. [3] [Total 11]

4 (i) Describe the key characteristics of each of six bond-like assets which could be used as alternatives to government bonds. [8] (ii) Describe the circumstances in which these asset classes might exhibit different returns to government bonds. [5] [Total 13] 5 (i) Define what is meant by a “contango” market. [2] (ii) Explain what is likely to happen to prices of the following commodities during

a global recession: (a) crude oil (b) gold (c) pork bellies [6] (iii) Explain the principal benefits of investing in alternative asset classes such as commodities. [3] (iv) State the ways in which an investor could invest in commodities. [3] (v) Outline the benefits and disadvantages of each method in (iv). [6] [Total 20] 6 (i) State the formula for calculating a total return index, defining all the terms used. [3] (ii) Given the following data, calculate the value of the total return index for Day 2. [2]

Day

Capital index Total return index XD adjustment

1 5857.52 4080.63 168.82 2 5774.20 170.85

(iii) Calculate the dividend yield over the day. [1] [Total 6]

ST5 A2013–4

7 You are a new provider of an individual defined contribution pensions savings product with a simplified investment approach sold via the internet. The product charges a total management fee of 50bps p.a. (all assets are directly managed) and there are only two fund choices:

• a growth fund, and

• an inflation-linked annuity matching fund (at retirement it is mandatory to use

pension savings to buy an inflation-linked annuity) The growth fund invests in a diversified range of asset classes with a benchmark asset allocation of:

40% equity; 20% alternative asset classes (property, private equity, infrastructure); 20% investment grade bonds; 20% high yield bonds and asset backed credit. Individual contributors can either select their chosen mix of growth fund and annuity

fund units, or opt for a lifestyling approach that phases from the growth fund into the annuity fund based on the chosen retirement date. Individuals are permitted to transfer to another provider with no penalty.

You are confident that the low fee scale, the simplified approach and the attractions of

diversified investment strategies will permit the rapid growth of market share and assets under management.

(i) Describe the advantages and disadvantages of such an approach from the investor’s perspective. [8] (ii) Describe the specific challenges for the provider in managing the underlying investments as assets under management grow. [8] [Total 16] 8 (i) State the formula for calculating a forward interest rate, defining all terms

used. [3]

Assume that the 3-month Libor rate is 5% p.a. and the six-month rate is 5.5% p.a. (with continuous compounding). A forward rate agreement has been set up where we will receive a rate of 7% p.a., measured with quarterly compounding, on a principal of $1m, between the end of months 3 and 6.

(ii) Calculate the value of the forward rate agreement. [4] [Total 7]

END OF PAPER


EXAMINERS’ REPORT



Introduction The Examiners’ Report is written by the Principal Examiner with the aim of helping candidates, both those who are sitting the examination for the first time and using past papers as a revision aid and also those who have previously failed the subject. The Examiners are charged by Council with examining the published syllabus. The Examiners have access to the Core Reading, which is designed to interpret the syllabus, and will generally base questions around it but are not required to examine the content of Core Reading specifically or exclusively. For numerical questions the Examiners’ preferred approach to the solution is reproduced in this report; other valid approaches are given appropriate credit. For essay-style questions, particularly the open-ended questions in the later subjects, the report may contain more points than the Examiners will expect from a solution that scores full marks. The report is written based on the legislative and regulatory context pertaining to the date that the examination was set. Candidates should take into account the possibility that circumstances may have changed if using these reports for revision. D C Bowie Chairman of the Board of Examiners July 2013


Subject ST5 (Finance and Investment Specialist Technical A) – April 2013 – Examiners’ Report

Page 2

General comments on Subject ST5 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. Given the greater volatility in recent years and globalisation/integration of markets and economies, delivering an acceptable return from a long term strategy against an increasingly short term focus, disclosure regime and political/regulatory backdrop has become increasingly challenging for investors. However, the challenge can be viewed as just a more complex variant of the traditional risk/reward trade-off where the “return-free risk” is becoming increasingly and unfortunately common. Investors generally only have assets because they have liabilities and it is the latter that will drive strategy. 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 12–18 months preceding a diet. This particularly includes the solutions being debated by the various stakeholders. Hence questions regarding banking and derivative approaches, as well as active and passive asset management and insurance solutions, to asset and liability risk management or modern financial theory should be considered likely scope for examination. Against a background of the credit crisis, new asset classes and ways of structuring investments will themselves generate new types of risk (such as benchmark, model, operations, liquidity, credit and counterparty) and also the need for new ways of regulation, monitoring and management. Finally the examiners encourage candidates to recognise there are different types of investor and stakeholders beyond purely pension funds where different taxation, time line and cost considerations will apply – it would seem that candidates have taken this on board. Whilst the examiners will tolerate bullet point style responses, some candidates’ handwriting was too poor to assess and they will have lost marks. Likewise “text speak” abbreviations will not be accepted. Comments on the April 2013 paper This paper had a lower pass mark than the previous diet although perhaps more consistent with prior years given the pass rate. The examiners believed that the paper was of a comparable standard to previous exams but the examiners are looking for candidates to be better prepared, providing better content in quality and not just quantity so that both an increase in pass mark and rate is witnessed. Candidates typically answered Question 5 and 6 much better than the others (albeit still foregoing 25–40% of the marks available), with Question 1 attracting the worst responses, considerably so, with average scores of around a third of the available marks. That said, some candidates did achieve nearly full marks on this question (and some achieved full marks on questions 6 and 8). Question 1 highlights a real challenge facing many institutions today and the need for pragmatism as well as theory so the average scores are disappointing.


Page 3

Question 2 also looked at benchmarks and construction issues – benchmark risk, data management and the unintentional consequences they may have for successful investing is a challenge that investors are only really starting to appreciate properly. Question 3 looks at a particularly topical issue given the public scrutiny on lending to businesses and the role of credit agencies in the financial crisis and now, likewise Question 4 as many investors “search for yield”. Questions 5 and 7 required a good knowledge of bookwork and its application, and so probably were the questions to differentiate candidates, whereas Questions 6 and 8 were fairly standard numerical calculations and high scores were to be expected. Many questions represented opportunities to demonstrate higher level skills in terms of non-standard/practical application of theory to current or unusual issues in investment – candidates who wish to progress to SA6 will need to improve their understanding of and approach to such questions. 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 or application of knowledge and scored lower accordingly. Whilst some candidates are too narrow in their responses, a greater number 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 alongside the approach outlined below.


Page 4

1 (i) Ensure security by maintaining solvency coverage (in some cases allowing for planned future contributions to the fund) Aim to generate long-term investment returns above the risk-free

rate so as to reduce the size of required future contributions

The first of these objectives will encourage hedging of liabilities and holding low risk assets, whereas the second of these objectives will encourage holding more risky assets in pursuit of excess returns (and reducing hedging activity where there is a cost to hedging).

(ii) Retrospective tracking error – annualised standard deviation of portfolio return relative to benchmark return. This is based on historic / observed returns

It is often useful to differentiate between downward and upward semi-standard

deviation (by separating returns above and below the benchmark respectively). Prospective tracking error – a forward looking measure of the risk of the

portfolio relative to the benchmark based on a quantitative model which assumes that the current structure remains unaltered and makes assumptions about the volatility of stocks or asset classes and correlations between them . Different models will have different levels of granularity.

Other measures that might be used include the Jensen and “pre-specified

standard deviation” risk-adjusted performance measures. The information ratio also makes use of the retrospective tracking error.

(iii) Instead of using an asset-based benchmark, the benchmark can be set to be the

total return on a pool of assets that are a close match for the liabilities, i.e. a liability proxy.

Then the retrospective tracking error would measure the magnitude of overall

asset liability mismatches on a historic basis, and the prospective tracking error would measure the same on a forward looking (model) basis.

2 (i) Each football player is unique so no defined price The market value of a footballer is only known when a trade takes place Estimation of player value is very subjective Valuations will be carried out at different points in time The price at which the price is agreed between buyer and seller is often

confidential. Large number of players to assess


Page 5

(ii) Use a subset of players to reduce the amount of calculation required Use valuation points where most transfers take place to get better idea of price

inflation Use a proxy increase rate where values are not known, such as inflation Devise a pricing methodology based on some factors such as division play in,

age etc. (iii)

Footy return 1.050 1.029 0.981 1.037 1.045 1.017 1.042 1.024 24.6% Fund return 1.050 1.04 1.04 1.04 1.045 1.04 1.042 1.04 39.1%

3 (i) The fundamentals of the rating agencies’ approach to rating companies will focus on:

• fundamental risks of the company’s industry • competitive position (relative to peers) • downside risk vs. upside potential • quality of profitability vs. EPS growth • cash flow generation vs. book profitability • forward looking analysis • strategy, management track record and risk appetite • capital structure and financial flexibility

(ii) Increase in defaults from companies taking loans Likely to be poorer quality companies looking for funding Maybe fewer loans being taken as companies decide to exit business or not

finance expansion like previously Quality of data from rating agency. In fast changing credit situation then

ratings could be behind cycle. (iii) Ask for additional security in event of default Only lend to sectors that expect to do well or not decline significantly during

recession. Thus diversification would be sensible. Use different analysis to rate clients rather than using credit rating agency May need to offer more competitive rates to take higher proportion of a

smaller market. Use credit derivatives to mitigate risk. Securitise the loans (to transfer risk to other investors).


Page 6

4 (i) Alternative bond-like assets include:

• Agency bonds – bonds issued by government–sponsored agencies e.g. nationalised industries and local authorities (in the UK) or Federal Mortgage Associations, states and counties and school boards (in the US).

• Investment Grade Corporate bonds, preference shares and debentures – bonds rated at least Baa (by Moody’s) or BBB (by Standard and Poor’s)

• High Yield bonds – bonds rated below investment grade

• Convertible bonds – bonds that may be converted into equity at a later date

• Distressed debt – securities of companies or government entities that are either already in default, under bankruptcy protection or in distress and heading for bankruptcy

• Event linked bonds – bonds with coupons and redemption payments conditional on the non–occurrence of a defined event (such as an earthquake)

• Interest rate and inflation swaps – swapping fixed payments on a notional principal for payments linked to market interest rates such as LIBOR or an inflation index

• Credit default swaps – contracts that provide a payment if a specified credit event occurs

• Mortgage Backed Securities (MBS) and Asset Backed Securities (ABS) (“Securitisations”) – bonds that are serviced and repaid exclusively out of a defined element of future cash flow from a bundle of assets owned by the issuer

• Infrastructure assets – debt serviced from the cash flow generated by an infrastructure project

(ii) The above assets could exhibit gains or losses relative to government bonds due to one of the following factors:

• Divergent yields between low risk assets (e.g. high quality government bonds) and risky assets (e.g. credit, equities), e.g. “flight to quality” or a risk assets rally

• Asset class specific factors (e.g. general rerating of a single asset class)

• Issuer or security level factors (e.g. the downgrade or default of an issuer) Particular risk factors for the above asset classes include:


Page 7

• Prepayment risk – MBS, ABS, Agency bonds have incentives for borrowers to bring forward payments on the underlying loans (e.g. falling interest rates and ability to refinance at a lower rate)

• Changing views on probability of default – can impact at an issuer, sector or asset class level

• Changing views on recovery after default (or loss given default) – can impact at an issuer, sector or asset class level

• Illiquidity risk (if the terms of the bonds are different to government bonds)

5 (i) A contango market is a commodity futures market where the futures price normally exceeds the spot price. This is usually because the cost of carry (the financing cost of holding the underlying commodity, plus storage costs ) is positive and future price = spot price + cost of carry.

(ii) Crude oil – in recession there is less demand for oil which reduces output. Reduced output and weakened demand have negative impact on price therefore, decreasing cost of commodity

Gold – during a recession gold is often regarded as a safe haven for investors.

Therefore, the demand for gold usually increases, resulting in the value of gold commodities to rise.

Pork bellies – during a recession then people start to switch from expensive

foods to cheaper foods. Pork bellies are a cheaper meat and it is likely that people will switch from more expensive meats therefore, leading to a moderate rise in pork belly prices

(iii) The principal benefits of alternative investments are:

• Potential for higher returns, possibly from increased beta, market inefficiencies, pricing anomalies or the skill in selection / management of the investor.

• Diversification due to a lack of correlation with existing assets or by exposure to underlying risks that are uncorrelated so reducing the overall portfolio risk.

(iv) Should an investor wish to gain exposure to commodity price movements it

can do so in three ways:

• Invest in the underlying commodity (or basket of commodities) • Commodity derivatives (on either single commodities or an index) which

are widely traded on major exchanges such as Euronext.liffe and the Chicago Mercantile Exchange.


Page 8

• Invest in companies whose share price is influenced by commodity prices (such as oil and mining companies).

• Invest in a commodity fund offered by an investment manager.

(v) Comment on management costs and skills, minimum bargain size, scope for

diversification, basis risk with derivatives, volatility, liquidity and physical settlement / storage / shipping / transportation.

Holding individual contracts introduces risk of being delivered against . Disadvantages if companies are used as a proxy for commodity investment:

• It is unlikely that there will be exposure to just one commodity.

• The company’s management may alter the exposure via acquisitions or disposals or by hedging its position .

• The company’s share price may be influenced by other factors.

• The company will incur various operating expenses which will dilute overall return.

• Use of commodity shares (mining, exploration companies) gives less diversification from equity market than physical would.

Investment management commodity fund Advantage: access to specialist management, liquid, small universe, etc. Disadvantage: High management fee, excessive sector concentration. 6 (i) The formula to obtain a total return index at time t is:

( )( ) ( 1)( 1) [ ( ) ( 1)]

I tTRI t TRI tI t XD t XD t

= −− − − −

where TRI(t) is the total return index, I(t) is the capital index at time t, XD(t) is the value of the accumulated XD adjustment at time t. (ii) TRI (Day 2) = 4080.63 × 5774.20 / (5857.52 − [170.85 − 168.82]) = 4023.98 (iii) Dividend yield = (170.85 – 168.82) / 5857.52 = 0.0347% per day, or 13.5% p.a.


Page 9

7 (i) Advantages:

The simplified approach reduces the likelihood of contributors making poor savings choices. This is particularly the case for less sophisticated contributors, who might be overwhelmed by the large ranges of funds offered by competitors. There are significant cost savings under such an approach, due to low distribution costs and by eliminating third party asset management (e.g. specialist funds, ETFs, hedge funds etc.). The transparent charging structure is likely to be attractive as is the absence of any penalty if funds are subsequently transferred to another provider. It is likely that investors will need less advice to manage their pension plan. The diversified growth fund permits access to expert investors who can allocate to new asset classes, apply tactical asset allocation skills and stock / sector selection skills. Not all of these asset classes may be available on competitors’ platforms.

Disadvantages: Some potential customers will prefer to invest with a more traditional provider who operates a number of different investment funds that they can choose to invest in. There is a high level of trust required that the provider will invest assets appropriately, and have strong investment capability in all asset classes, and be able to add value through access to expert investment views (TAA, alpha, new investment strategies, etc.), since it is not possible to select an alternative asset allocation. The provider has no track record for these funds in their current form.

The customer will need to be confident that the low fee scale will be maintained over time and that other expenses and costs will be managed appropriately. Customers will need to be confident that the provider’s approach will scale, otherwise active returns may weaken as assets under management grow.

(ii) So long as the provider has a good understanding of liquidity requirements,

inflows and outflows, a diversified approach is straightforward to manage.

Significant outflows can cause particular difficulties due to 40% of the assets being highly illiquid, with corporate bonds having poorer liquidity than equities.


Page 10

In the event of significant disinvestments this is likely to lead to the asset allocation moving above its desired allocation to illiquid assets. A further complication is that with customers able to invest and disinvest according to their own choice, it may be difficult to fairly allocate returns on long-dated investments (e.g. private equity and infrastructure) to customers. Sudden inflows may mean that assets are held in cash pending identification of suitable investment opportunities. This is unlikely for equities and investment grade corporate bonds but is a possibility for alternative assets, high yield and asset backed credit. Finally, the provider will need to ensure that its investment process scales appropriates as assets under management grow. This is particularly the case with regards to identification of alpha opportunities, new asset classes and tactical asset allocation shifts.

8 (i) If R1 and R2 are the zero-coupon rates for maturities T1 and T2

respectively, and RF is the forward interest rate for the period between T1 and T2, then

RF = 2 2 1 1

2 1

R T R TT T

−−

(ii) δ1 = 0.05, δ2 = 0.055, T1 = 0.25, T2 = 0.5 RF = 0.06 The quarterly- compounded rate is then given by 4[e0.06 × 0.25 −1] = 0.06045 The value, V, of a FRA where it is specified that an interest rate RK will be earned for the period of time between T1 and T2 on a specified principal of

L can be evaluated as: V = L(RK − RF) (T2 − T1) 2 2R Te − So V = 1,000,000 × (0.07 − 0.06045) × 0.25 × e−0.055 × 0.5

= $ 2322.74



EXAMINATION












Hand in BOTH your answer booklet, with any additional booklets firmly attached, and this question paper.



ST5 S2013–2

11 (i) Outline the characteristics of the following asset classes: (a) Bond repo (b) RPI swap (c) Currency Coupon swap (d) Dividend swap (e) Volatility swap

[8]

(ii) Discuss the risks that arise from investing in RPI swaps and how these can be mitigated. [5]

[Total 13] 12 (i) State the principal aims of financial regulation. [2] Following a financial crisis in Actuaria, a significant proportion of the blame for the

crisis was attributed to “overfriendly” regulation by the Financial Regulator. In response to this the regulatory regime has been made significantly stricter and less “friendly”.

(ii) Discuss the possible implications of this change in regime for the financial

markets in Actuaria. [10] [Total 12] 13 (i) Compare the relative advantages and disadvantages of “top down” and “bottom up” management techniques. [6] A wealthy individual has decided to set up an investment management company –

BigDosh Management. The company will try to attract investors seeking alternative sources of return.

You have been employed as a strategic advisor to BigDosh. As part of your role you

have been asked to advise on the following investment strategies:

(a) fund focused on mining stocks (b) fund investing in classic cars (c) fund exploiting anomalies in exchange rates (d) fund investing in fitness centre shares

(ii) Discuss which of the management techniques outlined in part (i) would be most suited to each investment strategy. [12] [Total 18]


14 (i) Describe the role and functions of a custodian. [5] (ii) Outline the advantages of a Central Securities Depository. [3] (iii) Describe some of the issues that might be encountered in moving from an environment where the use of a regulated custodian is voluntary to one where it is mandatory for all collective investments. [4] [Total 12] 15 The authorities of an emerging country are to allow its citizens to invest in non-cash

assets for the first time. However, the authorities are concerned by the lack of investment knowledge amongst its citizens and therefore want to impose restrictions on the type of investments that can be held.

Suggest the type of restrictions the authorities might impose. [6] 16 (i) State the formula for calculating the total return on a gilt index for an investor

subject to income tax, defining all the symbols used. [3] You have been given the following data:

Day

Capital index

Total return index

XD adjustment Accrued interest

1 172.52 2797.01 168.82 1.892 2 171.86 170.85 1.904

(ii) Calculate the value of the total return index for Day 2. Assume that the rate of

tax is 20%. [2] [Total 5]

ST5 S2013–4

17 (i) Explain the difference between a “clean” and a “dirty” bond price. [2]

You have been given the following data in respect of a bond:

Coupon rate p.a. 5% No. of coupon payments p.a. 2 Redemption date 31 December 2014 Redemption value 102 Settlement date 30 October 2013 Net redemption yield 6% p.a. nominal

(ii) Calculate the dirty price of the bond for a taxpayer subject to 30% tax on

income. [6]

The same issuer has another bond with similar liquidity and the same maturity date, but where the issuer has the option 1 month before 31 December 2014 to extend the term of the bond by a further 5 years at the same coupon rate.

(iii) Explain how the price of this second bond would differ from the price of the

first bond. [2] (iv) Set out the circumstances in which the price of the second bond will be

volatile relative to the price of the first bond near to expiry. [4] [Total 14] 18 (i) State the reasons for performance measurement. [3] A pension fund has employed a single investment manager, WLM, to manage assets on their behalf. WLM have split the portfolio between two portfolio managers.

One portfolio manager is focused on generating returns from sector decisions, the other portfolio manager maintains sector neutrality, and generates returns through stock selection.

WLM is assessed against the following benchmark, which is rebalanced at the end of

each period: Industrials 35% Utilities 25% Financials 40%

ST5 S2013–5

Sector

Manager Start

Period 1

Stock Manager (Value

$m)

Return Period 1

Sector Manager

Start Period 2

Return Period 2

Industrials 25% 30% Stock A $15 10% 10% Stock B $20 15% 20% Sector benchmark

12% 15%

Utilities 25% 30% Stock C $10 12% 10% Stock D $15 6% 15% Sector benchmark

10% 10%

Financials 50% 40% Stock E $20 20% 2% Stock F $20 2% 2% Sector benchmark 15% 2%

Assumptions

• The sector manager achieves the benchmark return in each sector. • The stock selection manager invests in line with the sector allocation benchmark

and rebalancing takes place at the start of each period. • Both managers are given $100 million to invest at the start of the period.

(ii) Calculate and show outperformance or underperformance for the following: (a) total portfolio return compared to total benchmark return, for period 1,

period 2 and the two periods combined (b) portfolio return compared to benchmark return for period 1 only:

• Industrials sector • Utilities sector • Financials sector

(c) attribution from stock performance at the total fund level for period 1, period 2 and the two periods combined

(d) attribution from sector performance at the total fund level for period 1,

period 2 and the two periods combined (Show all workings.) [15] (iii) Comment on the relative performance of the two strategies. [2]

[Total 20]

END OF PAPER


EXAMINERS’ REPORT



Introduction The Examiners’ Report is written by the Principal Examiner with the aim of helping candidates, both those who are sitting the examination for the first time and using past papers as a revision aid and also those who have previously failed the subject. The Examiners are charged by Council with examining the published syllabus. The Examiners have access to the Core Reading, which is designed to interpret the syllabus, and will generally base questions around it but are not required to examine the content of Core Reading specifically or exclusively. For numerical questions the Examiners’ preferred approach to the solution is reproduced in this report; other valid approaches are given appropriate credit. For essay-style questions, particularly the open-ended questions in the later subjects, the report may contain more points than the Examiners will expect from a solution that scores full marks. The report is written based on the legislative and regulatory context pertaining to the date that the examination was set. Candidates should take into account the possibility that circumstances may have changed if using these reports for revision. D C Bowie Chairman of the Board of Examiners January 2014

Institute and Faculty of Actuaries

Subject ST5 (Finance and Investment Specialist Technical A) – Examiners’ Report, September 2013

Page 2

General comments on Subject ST5 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. Whilst the examiners will tolerate bullet point style responses, handwriting that is too poor to assess will lose marks. Likewise “text speak” abbreviations will not be accepted. Comments on the September 2013 paper This paper showed a welcome improvement in the quality of answers, with a corresponding higher success rate than in recent diets. It is hoped that this will continue in the future. Comments on individual questions are incorporated in the solutions below. Many questions represented opportunities to demonstrate higher level skills in terms of non-standard/practical application of theory to current or unusual issues in investment. 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 or application of knowledge and scored lower accordingly. Thus, weaker candidates found difficulties with the later parts of Questions 11, 12, 13, 14 and 17. Whilst some candidates are too narrow in their responses, a greater number 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 alongside the approach outlined below.


Page 3

11 (i) (a) A repo (or repurchase agreement) is a form of secured lending whereby an investor buys stock from a dealer who, in turn, agrees to buy the stock back again at a later date at an agreed price. Such deals are of a short-term nature. The repo market is very liquid.

(b) RPI swaps (swapping fixed rate for “index” return).

(c) Currency coupon swaps. (Exchanging a fixed interest rate in one

currency for a floating interest rate in another currency. This is a combination of an interest-rate swap and a currency swap.)

(d) Dividend swaps (exchanging the dividends received on a reference pool of equities in return for a fixed rate).

(e) Volatility swaps (exchanging a fixed rate in return for the experienced volatility of price changes of a reference asset).

General characteristics of swaps were also credited (once) under (b)–(e): illiquid principal not exchanged OTC deals that introduce counterparty risk

While most candidates demonstrated a reasonable knowledge of these asset classes, many did not recognise that one leg of the swap contracts provides a fixed return. (ii) Risks Losses due to the counterparty defaulting Liquidity risks when trying to disinvest Rapid changes in interest rates leaving investors out of the money and unable

to make collateral call Cross-hedging risk Basis risk Risk of changes to the (external) index used as the basis for the swap Mitigation Only deal with high quality counterparties Regular credit review of counterparty exposure Diversification of counterparties Regular collateral call to make sure that cover any in-the-money amounts Invest only in more liquid end of RPI swaps curve Ensure adequate modelling carried out to understand maximum collateral

requirements. Some candidates suggested incorrectly that RPI swaps could be “exchange-traded”, with clearing house credit risk cover. Similarly, any suggestion that credit default swaps could be arranged were not awarded marks.


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to protect consumers of financial products to maintain confidence in the financial system to help reduce financial crime

Well answered by most candidates (ii) The financial markets will probably benefit from tighter regulation but the

extra regulation will incur additional cost. The new regulation is likely to reduce the size or at least the growth of the

financial industry – due to financial services companies moving to more “friendly” countries.

The tighter regulation could be considered to be prudent – but all virtues taken

to extremes become vices. The new regulation is likely to hinder new entrants and probably reduce levels

of competition. The new regulation may result in some forms of moral hazard effect on the

financial industry. The new regime may inhibit the creation of new financial products. The new regime may create a competitive disadvantage for local companies

selling on international or foreign markets. Improvement in reputation for prudence of local financial industry. The regime may possibly reduce any information asymmetry in the market. It may include a switch from Principles based regulation to Rules based –

currently most financial markets have a significant emphasis on principles based regulation, more rules based regulation may moderate this somewhat.

One of the main rules in political economics is not to shock the system – a

significant change from “friendly” to not very “friendly” regulation could be considered to be a “shock”.

The question asked for “possible implications of this change in regime”. Many candidates wasted time by exploring potential details of the new regulations.


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13 (i) Advantages of top down

Top down approach is generally better for controlling risk of portfolio (e.g. by the use of load ratios or load differences) as it offers a more balanced diversified portfolio than bottom up. Can be argued that more return comes from differences in asset allocation rather than stock selection. Top down offers a big picture analysis of markets rather than getting lost in individual stocks as bottom up does. Top down strategies can be implemented using cheap instruments such as futures rather than owning physical securities compared to bottom up.

Top down better for ensuring that liabilities are matched. Advantages of bottom up

Bottom up focuses on individual stocks so seek companies with stronger returns rather than just holding a selection of stocks in a portfolio. Bottom up allows more focus on absolute return investing rather than following more market returns in a top down approach. Generally more sustainable than top down, less influenced by external factors that are hard to predict.

Generally well answered. (ii) (a) Mining stocks

Investment strategy focussed on one sector although the mines could be focussed on different areas, such as consumables such as coal or iron or areas such as gold and diamonds. The best investment strategy would involve both a top down and bottom up strategy. It is important to focus on economic factors that will drive demand for the various mined products, i.e. is there likely to be higher demand for gold. Having used top down to look at mining sectors that look most favourable then use bottom up to select the best stocks in each sector.

(b) Investing in classic cars

With an area as bespoke as classic cars the real return on the portfolio will be the cars chosen as an investor would gain very little benefit from analysis on economic conditions as this will impact the market as a whole.


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Therefore, bottom up approach seems most appropriate to choose the right cars that will generate the return.

(c) Fund exploiting differences in exchange rates

The factors that drive the differential in interest rates are economic factors not company specific factors. Therefore, top down analysis would be used to determine pricing differentials and potential returns.

Many candidates discussed the efficiency of foreign exchange markets and the fact that anomalies would quickly disappear, but still recommended a “bottom up” approach despite this.

(d) Fund investing in fitness centre shares

This is a specific sector of the market so it would be expected that the focus would be on stock picking so bottom up analysis. Although it would be a strongly bottom up approach there will be a top down element to it as the fund manager will need to decide which countries will offer the higher returns in the fitness sector industry. Share prices of fitness centres are influenced by the amount of disposable income of people and also the perception of fitness in each country (both of which are top down factors).

Generally well answered.

14 (i) The principal function of custody is to ensure that financial instruments are

housed under a proper system that permits investment for proper purposes with proper authority.

The custodian is thereby able to account independently for any financial transactions.

Custodians are usually banks or other regulated institutions. Fund management firms, who would at one time have included custody within their function, are increasingly outsourcing such activities. Custodians offer not only custody of documents but also a range of services such as: income collection tax recovery cash management securities settlement foreign exchange stock lending


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Also, the custodian will often exercise voting rights on behalf of the manager or trustees. However, the custodian has no duty to investigate the propriety of instructions which appear to be in order (unless a specific monitoring function has been agreed). Administration of investment activities in overseas markets is often a vital element of the custodian’s role. Although the basic process of acquiring and disposing of an asset is essentially the same the world over, processes are very different in different markets. The infrastructure, payments system, clearing house and banking / settlement arrangements in many markets place the investor at varying degrees of risk.

Generally well answered. (ii) Eliminates one link in the settlement chain making process more efficient. Eliminates the potential for sub-custodian error. Provides securities lending and borrowing. Carry out repo settlement. Reduces administration.

Many candidates struggled to identify relevant points. (iii) It is likely that prior to the requirement that many investors, particularly larger

institutions, will maintain their own custody and record keeping functions as internal departments.

Smaller investors will use third party providers as they lack the scale and

internal expertise to operate such functions in-house. To move to the new environment will mean that internal teams will need to

seek regulatory approval, or that the activity they carry out will need to move to external firms.

This will be disruptive in the short-term during the transitional period and

result in setup costs for investors, and potentially a higher ongoing cost. It is likely that both the regulator and institutions will need a considerable

period to achieve a smooth transition. The introduction of regulation may result in moral hazard (e.g. lack of

scrutiny). There may not be sufficient numbers of regulated custodians available. Again, many candidates found difficulty in applying their knowledge to this scenario.


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15 Maximum that could be held in non cash assets Maximum that could be held in non domestic assets They might prohibit investment in a particular asset class completely Might impose the maximum that can be held in any one security or asset class/sector Prohibit the use of some asset classes, such as using derivatives for speculation rather

than hedging or the use of private or unquoted equities. Impose various liquidity constraints Ethical or social limitations Compulsory investment in registered investment schemes (which themselves have

strict guidelines such as well diversified portfolios and risk controls). Require minimum levels of wealth or cash before non-cash assets can be used. Restrict short selling. Require minimum holding / investment period.

Generally well answered, although some candidates suggested “standard” points such as requiring the use of financial advisers or using tax systems to encourage specific investments. The question specifically asked for “restrictions on the type of investments that can be held”, so these answers were not given credit. 16 (i) The return over a given period for an investor subject to income tax is:

2 1 2 1 2 1

1

(1 )( ) ( )I I T XD XD T ACC ACCI

where I1, XD1 and ACC1 are the index number, the ex-dividend adjustment to

date and the accrued interest respectively at the beginning of the period. Similarly I2, XD2 and ACC2 are the respective figures at the end of the period, T is the rate of tax.

The formula for the equity total return index

( )( ) ( 1)( 1) [ ( ) ( 1)]

I tTRI t TRI tI t XD t XD t

was awarded half marks (since the question referred specifically to a gilt index).


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(ii) Return on day 2 = [(171.86 172.52) + 0.8 (170.85 - 168.82) 0.2 (1.904 1.892)] / 172.52 = 0.005574 TRI(2) = 2797.01 (1 + 0.005574) = 2812.60

17 (i) The clean price is the price of a bond excluding any interest that has accrued

(since issue or the most recent coupon payment). The dirty price is the price of a bond including the accrued interest. Thus clean price = dirty price accrued interest.

The treatment of accrued interest must be explicitly specified. Generally well answered. (ii) The “dirty” price of bond per 100 face value is found by discounting the net

coupons and the redemption amount. No adjustment is made to exclude accrued interest. So, dirty price = 102 / 1.0715 + 0.7(2.5 / 1.0100 + 2.5 / 1.0403 + 2.5 / 1.0715)

= 95.1919 + 0.7 (2.4752 + 2.4031 + 2.3331) = 100.24

Any suitable day count was acceptable in determining the discount factors. Some candidates struggled with this “basic” evaluation. Errors encountered included calculating the coupon using the redemption value, omitting to net down coupons for tax, applying the income tax charge to the redemption value and failing to allow for the frequency of coupons.

(iii) The investor has sold an option to the issuer. Investors should assume that the issuer will exercise their right if this is

beneficial to the issuer. Since the bond is identical in all other respects, this bond will have a lower

market value than the original bond.

Many candidates failed to recognise that the issuer had the option to extend. (iv) The difference in price between the two bonds will reflect the likelihood of the

option being exercised (driven by interest rate volatility and time to expiry)…


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…and the value to the issuer in exercising the option (driven by the forward interest rate relative to 5%)

Therefore near to expiry the main reason why the price differential would be

volatile is due to high interest rate volatility, and the forward interest rate being close to 5% (the interest rate applying to the extension).

Supply / demand for each bond. Threat of changes in future tax treatment (in the extension period).

Some candidates had difficulty applying the basic “Black-Scholes” assessment to the scenario given.

18 (i) To improve future performance Comparison of the rate achieved relative to a target rate of return Comparison of performance against other portfolios or index

Well answered.

(ii) Calculate and show outperformance or underperformance for: (a) total portfolio return compared to total benchmark return

Period 1 Period 2 Combined Benchmark return 12.70% 8.55% 22.34% Total portfolio return 12.00% 8.93% 22.00% outperformance 0.70% 0.38% 0.34%

(b) portfolio return for each sector compared to benchmark sector return

Sector return Period 1 Industrials 12.5% Benchmark 12.0% outperformance 0.5% Utilities 9.2% Benchmark 10.0% outperformance 0.8% Financials 13.2% Benchmark 15.0% outperformance 1.8%

(c) attribution from stock performance at the total fund level

Period 1 Period 2 Combined Total Fund stock 0.85% 0.50% 0.35% 12.85% 8.42%


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(d) attribution from sector performance at the total fund level

Period 1 Period 2 Combined Total Fund sector 0.15% 0.13% 0.02%

Some candidates failed to recognise that both managers contributed to “stock” performance. The details of the calculations are set out in the attached schedule.


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(a) Portfolio return Sector portfolio Stock portfolio Total 0 100 100 200 1 (15 1.1) + (20 1.15) + (10 1.12) 100 (0.25 1.12 + 0.25 1.10 + 0.50 1.15) +12.0% + (15 x 1.06) + (20 x 1.2) + (20 x 1.02) = 111.0 = 113.0 224.0 2 111.0 (0.15 1.1 + 0.2 1.2 + 0.1 1.1 113 (0.3 1.15 + 0.3 1.1 + 0.4 1.02) + 8.93% + 0.15 1.15 + 0.2 0.02 + 0.2 0.02) = 121.6 = 122.4 244.0 + 22.0% Benchmark return Period 1 Period 2 0.35 0.12 + 0.25 0.1 + 0.4 0.15 = 12.7% 0.35 0.15 + 0.25 0.1 + 0.4 0.02 = 8.55% = +22.34% Outperformance Period 1 Period 2 12.0% 12.7% = 0.7% 8.93% 8.55% = 0.38% +0.34% (b) Period 1 Benchmark Diff Industrials (15 1.1 + 20 1.15 + 25 1.2) /60 12.0% +0.5% = 67.5 / 60 = 12.5% Utilities (10 1.12 + 15 1.06 + 25 1.1) / 50 10% 0.8% = 54.6 / 50 = 9.2% Financials (20 1.2 + 20 1.02 + 50 1.15) / 90 15% 1.8% = 101.9 / 90 = 13.2% © Stock attribution


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“Average” sector weighting sector benchmark performance Period 1 Period 2 Total ((25 + 35)/200 1.12 + (25 + 25)/200 1.1 ((30 + 35) / 200 1.15 + (30 + 25)/200 1.1 + (50 + 40) / 200 1.15) 1 = 12.85% = (40 + 40) / 200 1.02) 1 = 8.43% Attribution from stock performance 12% 12.85% = -0.85% 8.93% 8.43% = +0.5% 0.35% (d) Sector attribution balance of difference 0.7% (0.85%) = +0.15% 0.38% 0.50% = 0.13% +0.02%


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(iii) In period one the portfolio underperformed the benchmark. This was driven by stock underperformance, especially Stock F. Sector performance provided a positive contribution in period one but was not enough to make up for underperformance of stock selection.

In period two the stock performance was positive whilst the sector

performance was negative. Overall, the stock performance outweighed the sector underperformance which lead to positive return to benchmark.

For the total period the sector manager was in line with benchmark

performance whereas the stock manager underperformed the benchmark. Overall, the sector manager was more successful than the stock manager over the period, although the fund would have performed better in a passive strategy.

Credit was given for any relevant comments based on the candidate's answer to part (ii).



EXAMINATION

24 April 2014 (am)








supervisor. 4. Mark allocations are shown in brackets. 5. Attempt all eight questions, beginning your answer to each question on a new page. 6. Candidates should show calculations where this is appropriate.




ST5 A2014 Institute and Faculty of Actuaries

ST5 A2014–2

1 An investor has an actively managed bond portfolio currently comprising 50% US government bonds and 50% US investment grade corporate bonds.

The portfolio has specified duration targets for each type of bond and there are

various other restrictions on the bonds that can be held. The bond manager is benchmarked against a broad market index comprising all US

denominated investment grade bonds (government, supranational, agency, corporate), and is targeted with outperforming this index by 1% p.a. net of fees.

The manager charges a fee of 0.20% p.a. plus a performance fee of 10% of returns in

excess of the 1% target. Describe the implications of this mandate. [8] 2 (i) (a) Define the beta of a portfolio. (b) State the performance implications of a portfolio with a beta of 2. [2] An equity portfolio aims to have a beta of 1.5. (ii) Outline the investigations that could be performed to determine the value

added by the fund manager to the portfolio, assuming that full data is available. [3]

(iii) List six reasons why the performance of the portfolio might differ from that of

the benchmark index. [3] [Total 8] 3 (i) List the factors that investors should consider in determining the impact of tax

on an investment. [3] A major economy has decided to simplify its tax system by taxing all income (earned,

unearned or gifts) and realised gains and losses at a single rate of 15%. Each citizen will have an annual personal tax-free allowance of $10,000. Interest payments on personal borrowings may be offset against income, but all other allowances will disappear. Activities and investment schemes that previously enjoyed favourable tax treatment will now be taxed at standard rates.

(ii) Describe the potential impacts on the personal investment marketplace. [7] [Total 10]


4 The following information relates to the performance of two investment trusts and their equivalent benchmark index over a three year period. The annual risk-free rate of return over this period was 4% per annum.

Trust A

Trust B Index

Annual return (% p.a.) 9.0 8.0 7.0 Standard deviation (% p.a.) 13.5 9.5 6.5 Correlation coefficient with index 0.36 0.75 1.00

(i) Calculate four different risk adjusted performance measures for each trust. [8] (ii) Comment on the results from part (i), stating any limitations that apply to

them. [4] [Total 12] 5 The manager of a global inflation-linked bond fund valued at US$5 billion wishes to

alter the country allocation, switching all US$2 billion that is currently invested in the UK market to the US market.

(i) Describe the problems (and the costs) that would be encountered in a switch of

this size. [6] After further analysis, it is the expectation that the allocation will be partially reversed

in three to six months’ time to reallocate US$1.5 billion to the UK. (ii) Discuss the advantages and disadvantages of using total return swaps rather

than a physical switch for this combined asset allocation change (i.e. the immediate switch and the planned future reallocation). [7]

[Total 13]

ST5 A2014–4

6 (i) State the main factors affecting equity prices. [2] An individual has recently received an inheritance from a family member and has

decided to invest in the equity market for the first time. They have approached a financial adviser to provide guidance on the individual equities in which they should invest. The individual wishes to have exposure in their portfolio to companies which:

• are large. • are risky. • have a high dividend yield. • have a well-known brand name. • operate globally. • move ahead of the trade cycle. • have volatile profits. • have high gearing.

(ii) (a) Identify five equity sectors which would ensure that all of the

characteristics above are covered. (b) State, for each of these sectors, the characteristics from the above list

which are satisfied. (c) State any additional characteristics that the holdings in each sector

might have. [11] [Total 13] 7 (i) State the main aims of financial regulation. [2] In the middle of a deep recession and with the financial services sector in distress,

Bank A acquired Building Society B and performed due diligence on the transaction using its own internal team of financial analysts. The statutory regulator subsequently discovered that Building Society B held a large amount of bad debt on its books which the bank was unaware of. This resulted in the need for a significant capital injection into Bank A in order for it to remain solvent.

(ii) Show how diligent application of the key principles underlying the financial

services legislative framework can help to avoid this type of problem. [12] [Total 14]

ST5 A2014–5

8 An intern at an asset management company has been given a project to write an investment report on a fast growing on-line fashion company which was founded less than 12 months ago.

(i) Outline the research that the intern could undertake including:

• the factors on which he should focus. • the data he would use.

[6] (ii) Discuss issues that he might face when completing the investment report and

any potential solutions to these issues. [10] (iii) Compare the similarities and differences in the approach if the analysis was

for a credit rating agency rather than an asset management company. [6] [Total 22]

END OF PAPER


EXAMINERS’ REPORT



Introduction The Examiners’ Report is written by the Principal Examiner with the aim of helping candidates, both those who are sitting the examination for the first time and using past papers as a revision aid and also those who have previously failed the subject. The Examiners are charged by Council with examining the published syllabus. The Examiners have access to the Core Reading, which is designed to interpret the syllabus, and will generally base questions around it but are not required to examine the content of Core Reading specifically or exclusively. For numerical questions the Examiners’ preferred approach to the solution is reproduced in this report; other valid approaches are given appropriate credit. For essay-style questions, particularly the open-ended questions in the later subjects, the report may contain more points than the Examiners will expect from a solution that scores full marks. The report is written based on the legislative and regulatory context pertaining to the date that the examination was set. Candidates should take into account the possibility that circumstances may have changed if using these reports for revision. D C Bowie Chairman of the Board of Examiners July 2014



Page 2

General comments on Subject ST5 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. Whilst the examiners will tolerate bullet point style responses, handwriting that is too poor to assess will lose marks. Likewise “text speak” abbreviations will not be accepted. Specific comments on the April 2014 paper Comments on individual questions are incorporated in the solutions below. Many questions represented opportunities to demonstrate higher level skills in terms of non-standard/practical application of theory to current or unusual issues in investment. 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 or application of knowledge and scored lower accordingly. Thus, weaker candidates found difficulties with Question 1 and the later parts of Questions 3, 7 and 8. Whilst some candidates are too narrow in their responses, a greater number 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. Weaker candidates often fail to respond to the specific issues included in the question. Instead, they regurgitate a generic answer based on the syllabus topic. More care needs to be given to crafting answers that directly address the points raised in the question. 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 alongside the approach outlined below.


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1 There is a mismatch between the index used for measuring returns, and the investment guidelines given to the manager.

This leads to an incentive for the manager to align the investment portfolio to the index rather than the investor’s investment guidelines. This may not be the investor’s expectation.

In some circumstances there could be significant deviations between the manager’s target portfolio and the actual portfolio, since the restrictions will constrain the manager. The manager will be uncomfortable with this as their active management process will be constrained. Particular examples of situations where the deviations could be significant include: • Composition of index differs markedly from a 50% government bond / 50%

corporate bond mix

• In particular, the index includes supranational and agency bonds

• Duration of index differs markedly from a 50% government bond / 50% corporate bond mix

• Different segments of the bond markets diverge in their returns (e.g. “flight to quality” scenario benefiting government bonds, or a “dash for trash” benefiting lower grade bonds)

The size of the portfolio will also influence ability to gain access to corporate bond issues. The performance fee strongly incentivises the manager to minimise risk relative to the aggregate index, rather than the investor’s expected portfolio. Indeed, the need to outperform the index by more than 1% to earn the performance fee may incentivise the manager to take excess risk. This may be exacerbated by the relatively low “fixed” fee. For all these reasons, it would be preferable for the benchmark to be aligned more closely to the investment guidelines or if this is not possible, to restructure the fee to remove the performance fee.

Many candidates needed to give more attention to the impact of the fee structure on the manager’s actions.


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2 (i) (a) The Beta of a portfolio is a measure of the portfolio’s volatility relative to movements in the whole market. It is usually defined as the covariance of the return on the portfolio with the return on the market, divided by the variance of the market return.

(b) A beta of 2 means the change in value of the portfolio should be 100%

greater than the change in value of the market. (ii) The performance of the portfolio would be compared to the return on the

index. The portfolio’s target return should recognise the pre specified level of risk. Using an index representative of the market the portfolio is invested in, target returns could be calculated as 1.5x the index return. 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.

Explanations using the Jensen measure or Attribution analysis are valid

alternatives provided they reference a beta of 1.5.

(iii) • The performance will differ because the portfolio will be unlikely to hold

stocks and sectors in weights which are wholly representative of the index.

• The portfolio’s beta over the period may have varied to levels significantly above or below 1.5 affecting returns

• The portfolio may have other objectives/constraints which effect

performance.

• 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 other expenses

• The effects of cash flow

• The impact of tax

• Some securities in the benchmark are unmarketable, and cannot be held.

• The benchmark may not have been available for a long enough period

This question was generally well answered.


Page 5

3 (i) The total rate of tax on an investment. How the tax is split between different components of the investment return. The availability of personal allowances The timing of tax payments. Whether the tax is deducted at source or has to be paid subsequently. The extent to which tax deducted at source can be reclaimed by the investor. To what extent losses or gains can be aggregated between different

investments or over different time periods for tax purposes. (ii) Compared to the previous system, capital gains and income will be treated

equally in terms of the rate of taxation, although there will be some deferral of taxation if capital gains are unrealised. Thus, there may be different effects depending on the individual investor’s personal tax position and their awareness of the impact of taxation.

Under the new regime, no specific savings wrapper (e.g. pension, insurance,

deposit) would be tax favoured. This may lead to behavioural changes and disincentivise saving for long-term needs (e.g. retirement or care).

Due to a simplified tax system, it is likely that product designs will become

simpler and administration costs may fall. However, where a product has now become taxable, additional features may be needed to attract customers.

With the only allowance being the annual personal allowance (covering all

sources of income), product sales are unlikely to have any strong seasonal effects arising from a desire to “use up” allowances in the current tax year.

Managers will respond by restructuring existing products where possible, and

by launching new product designs to maximise demand. Some existing investments will not be amenable to restructuring.

Individuals are likely to find borrowing relatively more attractive since interest

payments are deductible against savings or earned income. The change to the taxation system may influence attitudes to overseas

investment. Other valid points raised were given credit. Many candidates did not focus sufficiently on ‘the personal investment marketplace’ as specified in the question. Instead, they wasted time discussing more general economic issues (which were not required).


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4 (i) First we have to calculate β’s of the two investment trusts

βi = Cov( , )i m

m

R RV

βA = 2(0.36)(0.135)(0.065)

(0.065) = 0.003159

0.004225

= 0.74769

βB = 2(0.75)(0.095)(0.065)

(0.065) = 0.004631

0.004225

= 1.0962

Investment trust A

Treynor measure = 0.09 0.040.74769

− = 0.06687

Sharpe measure = (0.09 0.04)0.135

− = 0.37037

Jensen measure = 0.09 – (0.04 + 0.74769 (0.07 − 0.04)) = 0.02757

Prespecified SD = 0.07 0.040.09 0.04 0.1350.065

−⎛ ⎞− + ×⎜ ⎟⎝ ⎠

= −0.01231 Investment trust B

Treynor measure = 0.08 0.041.0962

− = 0.03649

Sharpe measure = 0.08 0.040.095

− = 0.42105

Jensen measure = 0.08 – (0.04 + 1.0962 (0.07 − 0.04)) = 0.007114


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Prespecified SD = 0.07 0.040.08 0.04 0.0950.065

−⎛ ⎞− + ×⎜ ⎟⎝ ⎠

= −0.00385 (ii) Comments (a) On the basis of SD of return (Sharpe and Prespecified SD) Trust B outperforms A. (b) On the basis of systemic risk (Treynor and Jensen) Trust A outperforms B. Limitations (a) The data is based only on 3 years. There is no guarantee that the same

will hold in future. (b) It is not known whether the returns are gross or net. (c) We have not considered the suitability relative to any liabilities. (d) The Treynor and Jenson measures are based on the validity of the

Capital Asset Pricing Model. Generally well answered, although some candidates did not calculate the trust betas, but rather used the correlation coefficients directly. Not all candidates addressed the limitations in part (ii). 5 (i) The main problems in an asset allocation change of this size are:

• The possibility of shifting market prices (both on the sale of the existing portfolio and the purchase of new assets).

• The time needed to effect the change and the difficulty of making sure that the timing of trades is advantageous.

• The dealing costs (commission, dealing spreads, purchase taxes, etc.)

involved.

• The possibility of the crystallisation of capital gains leading to a tax liability.

These problems are particularly acute in the inflation-linked bond market due

to the relatively low liquidity of these bonds, both in the UK and the US markets.


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This reflects that a large proportion of the bonds in issue are held by investors as hedges against inflation-linked liabilities.

As both UK index-linked gilts and US Treasury Inflation-Protected Securities

have T +1 settlement cycles, it is possible (but unlikely) that there would be significant out of market exposure .

(ii) Total return swaps (TRS) can be helpful in a transaction of this nature for the

following reasons: Dealing costs should be significantly mitigated.

There may be a tax advantage where there is no need to crystallise gains on the portfolio being swapped. Implementing a TRS should not cause asset prices to move.

A TRS on a large allocation can be executed quickly with a bank, unlike a

physical asset sale. Given the size of the switch involved here, this could be significant.

Under a TRS the price of paying or receiving an asset return is transparent

(quoted as LIBOR plus or minus a spread). Therefore if paying one asset return and receiving another asset return, it is very clear what the switch costs are.

Conversely, with a physical switch, it is unclear what the transaction costs will

be for the return switch until it takes place. Thus, the use of TRS can be very helpful from a portfolio management point of view.

Disadvantages

The main disadvantage of a TRS is its fixed term. Since we only have the

expectation that the swap will be amended in three to six months' time there is the prospect that the TRS arranged will have to be rolled over or terminated prematurely. To break a TRS mid-term can be expensive.

Additionally, it is not certain that a TRS will result in lower costs than a

physical switch, particularly if cash settled . Counterparty risk is introduced, since the TRS will only deliver the required

cash flows if the counterparty honours its commitments. Given the size of the switch involved here, this could again be a significant issue.

The requirement to provide collateral for a TRS is also a disadvantage.

It may not be possible to synthesise the underlying portfolio (as the TRS

probably based on an index).


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Generally well answered, but some candidates failed to appreciate the implications of the fixed term swap contract. Rather, they stated that such contracts could be easily closed-out. The specific points relating to inflation-linked bonds (in the US and the UK) were not generally appreciated. 6 (i) The price of an individual company’s shares is affected by the level of supply

and demand for those shares. The key factors affecting relative demand for individual shares are investors’ expectations of:

• future dividend payments • future capital growth • the risks of the business and thus the uncertainty of estimates of the above

Factors that drive expectations for capital and dividend growth are estimates

of profits, free cash flow, and total enterprise value. (ii) Oil and Gas companies – large companies, global and risky Consumer goods companies – brand names Industrial companies – profits move ahead of trade cycle, volatile profits

Utilities – high dividend yield

Financials – high gearing, volatile profits Other sectors which could be used are: Technology stocks – risky, global Consumer services – volatile profits, brand names Additional factors: Oil and Gas – commodity price dependent Consumer goods – capital intensive, low profit margin, high gearing Industrials – cyclical, dependent on government spending, high profits when

conditions good, low gearing, overseas exposure Utilities – natural monopolies, low growth, heavily government regulated Financials – labour costs, brand names Consumer services – poss. high gearing There are other ways of structuring the portfolio and these were given credit. Generally well answered.


Page 10


• to correct market inefficiencies and to promote efficient and orderly markets

• to protect consumers of financial products

• to maintain confidence in the financial system

• to help reduce financial crime (ii) An important aspect of the legislative framework is to maintain confidence in

the financial system and to avoid a systemic financial collapse. To avoid a collapse in this scenario, liquidity was provided to the bank.

Bank A should have observed high standards of integrity and fair dealing

when deciding to purchase Building Society B. If this had happened then the transaction may not have completed.

A particular problem with this scenario was the bank’s decision to undertake

the due diligence itself. It appears that bank did not act with due skill, care and diligence in considering whether to acquire the building society otherwise the bad debts should have been identified.

In undertaking the due diligence itself, the bank was exposed to potential

conflicts of interest which could have been avoided. The bank may have intended to manage these conflicts internally, but decision makers could have interests in the transaction proceeding, despite the bad debt issue. The bank should not unfairly place its interests above others, e.g. its customers and the wider population who may ultimately need to bail out the bank.

Good corporate governance requires management to make decisions based on the interests of relevant stakeholders rather than on their own personal interests. It is possible that these bad debts were discovered but then not disclosed. Full disclosure requirements may therefore have avoided the crisis.

Bank A should organise and control its internal affairs in a responsible manner

and keep proper records, so that this type of scenario could be avoided. Staff involved with the transaction should be suitably qualified, adequately trained and properly supervised. Well defined compliance procedures should be embedded as part of day to day activity.

The fact that a capital injection was required shows that the bank was not fully

monitoring the risks it was exposed to. The bank should have ensured that it maintained adequate financial resources to meet its investment commitments and to withstand the risks to which it is faced.

The bank should be required to disclose all relevant information and be ready

to provide a full and fair account of the fulfilment of its responsibilities to them. The regulator should expect the bank to deal with it in an open and co-


Page 11

operative manner and to keep it fully informed of anything concerning the bank which may cause problems in the future. A strong regulator is likely to be needed to ensure orderly markets and reduce fraudulent activity.

Discussion of the application of these principals to either Bank A or Building Society B was given credit. Simply regurgitating the material in the Core Reading regarding financial services legislation, without referencing the specifics of the question, was not sufficient. 8 (i) Each company needs to be considered individually, but factors that will

generally be investigated include:

• management ability • quality of products • prospects for market growth • competition • input costs • retained profits • history

Thus topics to be investigated include:

• the financial accounts and accounting ratios • dividend and earnings cover • profit variability and growth (by looking at all sources of revenue and

expenditure) • the level of borrowing • the level of liquidity • growth in asset values • comparative figures for other similar companies

It will be necessary to use all the available sources of information. The

primary source is likely to be the company’s published accounts but there are many other sources of information which include:

• the financial press and other commercial information providers • the trade press • 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 company management • discussions with competitors • stockbrokers’ publications


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(ii) When investigating a recently formed company, some of the factors in (i) will not be available.

Not much info on current management ability – look at their experience from

previous companies, if they have any. Input costs – difficult to have a good understanding as they have not been

running long enough to have stable costs. Look to compare against a similar company with longer track record.

Retained profits – don’t have any so would need to model expected profits

stating assumptions. Financial and commercial press – given company is so young there is likely

not to be excessive information. Need to find trade press and fashion articles. Public statements by company – likely to be very few. Online fashion is a fairly new industry so could struggle to find information on

other firms to draw comparisons. Could try and use other online industries that appear to have similar characteristics.

Low barriers to entry which means competition could increase rapidly which

is difficult to factor-in to analysis. Intern has not completed a report before and might lack the knowledge of how

to complete analysis. He should ask for help and possibly a mentor. Intern junior status might mean senior management would not be willing to

meet to discuss. The intern should ask someone with market experience to join them on the visit.

Candidates needed to use the specific details given in the question to answer this part well.

(iii) Investigation of a recently formed company will be an equal problem for both. The differences and similarities between carrying out analysis for investment and the rating agencies’ approach to rating companies:

Similarities

Both will focus on: • the competitive position (relative to peers) • the downside risk of investment vs. the upside potential of the company • the quality of profitability of the company and. EPS growth • cash flow generation vs. book profitability • forward looking analysis • strategy, management track record and risk appetite


Page 13

Differences • The credit agency focuses on fundamental risks of the company’s industry

whereas the asset management analysis is more company focussed from the outset

• Credit agencies give a public ratings and release information on their analysis, whereas asset management company ratings tend to be internal only with less client friendly analysis (higher order)

• Credit agencies are supposed to be more conservative in their approach to

ratings than an asset management company (higher order) • The credit agencies will have more emphasis on the capital structure and

financial flexibility although asset management will carry out some analysis

With respect to the credit rating agencies the review is based on

comprehensive information, both public and private (background and supplemental rating questionnaires). An important component is frequent meetings and discussions between rating analysts and company management, providing crucial information and understanding of the company’s operations, financial condition, competitive market position and future business plans. Although asset managers will focus on similar things credit agencies arguably have greater access to information.

Part (iii) was generally poorly answered. Many candidates gave relevant details, but few focussed sufficiently on comparing the similarities and differences.



EXAMINATION

1 October 2014 (pm)

Subject ST5 – Finance and InvestmentSpecialist Technical A




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.



5. Attempt all seven questions, beginning your answer to each question on a new page.






ST5 S2014–2

1 (i) Define the term risk budgeting in the context of portfolio construction. [2] (ii) Outline how the process of risk budgeting is carried out. [5] [Total 7] 2 The following information has been provided for an investment portfolio:

Year 1 Year 2 Benchmark asset allocation: Equities index 30% 60% Bonds index 70% 40% Actual asset allocation of fund: Equities 50% 50% Bonds 50% 50% Investment returns: Average return for similar funds 6.0% 5.0% Equity index return 10.0% 8.0% Bond index return 2.0% 3.0% Equity return in fund 12.0% 7.0% Bond return in fund 3.0% 4.0%

(i) (a) List three approaches that could be used to assess relative portfolio

performance. (b) Outline the merits and shortcomings of each approach. [6] (ii) Calculate the past performance for the fund as a whole over the two year

period, using the three approaches. [5] [Total 11] 3 (i) State the principal aims of financial regulation. [2] The sales team in an investment bank has developed a new investment product that

offers returns linked to a global equity index. Customer assets are to be pooled centrally to provide economies of scale. The bank will directly invest the funds into equity holdings and will also use derivatives.

The product is being marketed as a savings product via the internet and through direct

selling. The sales team will be incentivised through commission payments after each completed sale.

(ii) Outline the key issues within this scenario that financial regulation aims to

address. [11] [Total 13]


4 In the country of Actuaria, the Society of Actuarian Actuaries has decided to change the format of some of its actuarial examinations to a multiple-choice format (with no negative marking for incorrect answers).

An examiner for the Society is in the process of setting questions and is seeking

advice regarding the ordering of the correct and incorrect answers. The examiner has heard about the theories of behavioural finance and wishes to

ensure that the placement of the correct answers will minimise the chances of the students simply guessing the correct answers. He is seeking recommendations as to whether to put the correct answers as the first choice, the last choice or somewhere in the middle.

Based on the theory of behavioural finance:

(i) Suggest where the examiner should place the correct answer in the list of choices (first, last, 2nd, 3rd or 4th) in multiple choice questions with five options, all outlined in considerable detail. [2]

(ii) Suggest where the examiner should place the correct answer (first or last) in multiple choice questions with two options, both outlined in considerable detail. [2]

(iii) Explain the reasoning behind your answers. [9]

[Total 13] 5 A pension fund has seen its funding level improve in recent years from 85% to 102%.

The pension fund has decided to “de-risk” its investment strategy by reducing its equity exposure and increasing its exposure to corporate bonds.

(i) Discuss the relative advantages and disadvantages of direct investment by the

pension fund in corporate bonds versus indirect investment using credit derivatives. [12]

(ii) Discuss to what extent these advantages and disadvantages would be different

if the fund was a hedge fund rather than a pension fund. [3] [Total 15]

ST5 S2014–4

6 The following market data and information has been provided about a pension fund wholly invested in US equities:

Date Market Value of

fund ($000s) Domestic Share Index

(Capital only) Dividend Yield on

Domestic Share Index (% per annum)

31 Dec 2012 3,600 1500 31 Mar 2013 3,600 1603 4.3 30 June 2013 4,050 1776 4.2 30 Sept 2013 4,500 1797 3.9 31 Dec 2013 4,200 1680 4.2

Period (2013)

Contribution Income (Outgo if negative)

($000s)

Investment Income ($000s)

Q1 56 52 Q2 30 60 Q3 187 60 Q4 −52 68

Contributions and investment income all occur on the last day of each quarter.

(i) Calculate for each period and over the full year:

(a) the time-weighted return. (b) the money-weighted return. (c) the index return. State any assumptions made. [9] (ii) Comment on these returns. [3] (iii) Compare the investment income actually received by the fund with the

investment income that would have been received if the fund had been invested in the index. [2]

(iv) Explain the conclusions that might be drawn about the stock selection policy

of the fund, using the information from parts (ii) and (iii). [3] [Total 17]

ST5 S2014–5

7 A wealthy individual has decided to diversify her portfolio and wishes to gain exposure to property returns.

(i) Outline the main characteristics of direct property investment. [4] (ii) Outline the different ways in which the individual could gain exposure to

property returns. [8] The individual decides to invest directly in property and has narrowed down the

investment choice to the following alternatives:

• a commercial office block in a major financial centre of a developed country

• a residential housing block on the outskirts of a city in a developing emerging market

• a portfolio of hotel rooms situated in, and managed by, a well known hotel chain

(iii) Compare and contrast the potential investments in respect of: (a) the overall characteristics each investment exhibits. (b) the stability of the income stream each investment is likely to produce. (c) the on-going management of each investment. [12] [Total 24]

END OF PAPER


EXAMINERS’ REPORT



Introduction The Examiners’ Report is written by the Principal Examiner with the aim of helping candidates, both those who are sitting the examination for the first time and using past papers as a revision aid and also those who have previously failed the subject. The Examiners are charged by Council with examining the published syllabus. The Examiners have access to the Core Reading, which is designed to interpret the syllabus, and will generally base questions around it but are not required to examine the content of Core Reading specifically or exclusively. For numerical questions the Examiners’ preferred approach to the solution is reproduced in this report; other valid approaches are given appropriate credit. For essay-style questions, particularly the open-ended questions in the later subjects, the report may contain more points than the Examiners will expect from a solution that scores full marks. The report is written based on the legislative and regulatory context at the date the examination was set. Candidates should take into account the possibility that circumstances may have changed if using these reports for revision. F Layton Chairman of the Board of Examiners December 2014

Institute and Faculty of Actuaries

Subject ST5 (Finance and Investment Specialist Technical A) – September 2014 – Examiners’ Report

Page 2

General comments on Subject ST5 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. Whilst the examiners accept bullet point style responses, handwriting that is too difficult to read will lose marks. It should also be stressed that “text speak” abbreviations are not appropriate for professional communications, including exam solutions, and will not be accepted. Specific comments on the September 2014 paper Comments on individual questions are incorporated in the solutions below. Many questions represented opportunities to demonstrate higher level skills in terms of non-standard/practical application of theory to current or unusual issues in investment. Most candidates seemed to identify and understand the key issues being examined and 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 or application of knowledge and scored lower accordingly. Thus, weaker candidates found difficulties with Question 4 and 5, and the later parts of Questions 3 and 7. Whilst some candidates are too narrow in their responses, a greater number 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. Weaker candidates often fail to respond to the specific issues included in the question. Instead, they regurgitate a generic answer based on the syllabus topic. More care needs to be given to crafting answers that directly address the points raised in the question. 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 alongside the approach outlined below.


Page 3

1 (i) The term risk budgeting refers to the process of establishing how much investment risk should be taken and where it is most efficient to take risk in order to maximise return. [2]

(ii) A “feasible” set of asset classes that could be included in the portfolio (subject

to any constraints specified in the mandate / investment agreement) are first analysed. This will consider the expected returns, volatilities and the covariances between asset class returns.

Some risk / return optimisation process is then used to select an initial asset

allocation between the asset classes. A Value at Risk assessment will be used to determine the total risk budget – the risk tolerance in respect of the exposure to potential loss on the portfolio. The total risk budget is then allocated between strategic risk and (total) active risk, and finally the total active risk is allocated among the various asset managers.

It is important that the developing position of the chosen portfolio is

monitored to assess risk exposures (increases and decreases in the value of the positions) and changes in volatilities and correlations. The portfolio will need to be rebalanced in the light of such changes, in order to keep the overall portfolio risk at the level defined as tolerable. [5]

[Total 7] In answering part (ii), weaker candidates did not pay sufficient attention to HOW the risk budget would be determined. Instead, they focussed on how the budget would be administered once it had been determined.

2 (i) Portfolio relative to:

Published Indices Other Portfolios Benchmark portfolio

Pros Easy to do Data readily available, and accurate

Gives an indication of the cost or benefit of a strategy, relative to those adopted by other funds Shows relative manager skill in stock / sector selection

Benchmark portfolio can be constructed to reflect fund objectives Can be helpful in aligning fund manager’s interests with liability requirements


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Cons Index may be inappropriate for investor’s objectives

Comparison may be inappropriate if other funds have very different objectives or are exposed to very different conditions Lack of available data

General cons All methods look at past performance only, so are not a reliable guide to the future Assessments do not take account of risks taken by managers

[6] Candidates who suggested the use of risk-adjusted performance measures were also given credit.

(ii)

Year 1 Year 2 Total Actual-Expected

Actual 7.50% 5.50% 13.41% Index return 6.00% 5.50% 11.83% 1.58% Average return for similar funds 6.00% 5.00% 11.30% 2.11% Benchmark 4.40% 6.00% 10.66% 2.75%

[5] [Total 11] Candidates who analysed stock and sector selection performance attribution were also given credit.

Most candidates scored well on this question. However, it was very disappointing to see that some candidates added together the annual performance returns in order to calculate the two-year result.


Page 5



to protect consumers of financial products to maintain confidence in the financial system to help reduce financial crime

[2]

(ii) Specific issues within this scenario include:

“A new investment product”. The new product will need to comply with the existing legislative framework. As this is a new product there will need to be appropriate documentation describing the purpose and operation of the fund to investors. “Returns linked to the global equity market”. This objective must be clearly set out and defined. Precisely what measure of global equity market performance will be used to determine the return on the new product? Will this be a “capital only” or a “total return”? Will it be gross or net of tax – if so, at what rate? The treatment of income earned needs to be set out. Will the product provide regular income payments, or will these be reinvested? Will the product be issued for a specified term, or in “open-ended” form? What will the charges be on early redemption? What overall charges (initial and recurring) will be levied? Will there be any performance guarantees?

“Customer assets to be pooled centrally”. What arrangements will the bank make for the proper protection of customer assets (e.g. by segregation and identification of those assets)? “Use derivatives”. Are there to be any limitations on the use of derivatives? How will associated risks (e.g. counterparty risk) be addressed? How will any associated margins and collateral payments be funded? In the event of losses (relative to the global equity market returns that the product will track), how will these be recouped? Does the firm have adequate financial resources (now and in the future)? The staff responsible for the investment decisions related to the product should be adequately trained and properly supervised through well-defined compliance procedures. “Marketed as a savings product”. The product appears to be marketed ambiguously as a savings product but could have a high level of risk attached, which needs to be clearly explained to potential customers.


Page 6

“Marketed via the internet”. To market via the internet means that customers do not necessarily receive appropriate advice. This means firms should seek information from their customers about their circumstances and investment objectives. How will the bank seek this information from customers? How will information be provided to customers in an ongoing, comprehensible and timely way? What additional advice services will the bank offer to customers (and what charges will be levied for this)? How will the bank monitor against fraud, money-laundering and tax avoidance by customers? Customers should be allowed a ‘cooling-off’ period to withdraw from the contract. “Marketed via direct selling”. The staff responsible for speaking to potential customers should be adequately trained and properly supervised through well-defined compliance procedures. “...incentivised through commission.” How will possible conflicts of interest be avoided? How will the bank/sales team demonstrate that it is acting with due skill, care and diligence? What arrangements will be made for ensuring that the staff are suitable, adequately trained and properly supervised? Within all the above points there should be an overarching principle that the firm should act with integrity and observe high standards of market conduct.

[11] [Total 13] As with most “case study” questions, candidates were required to use the specific information given in the question to frame their answer. Some candidates, however, produced a “generic” answer on the general subject of financial regulation with little reference to the points set out in the question.

4 (i) Recommend placing the correct answer as the 1st (or possibly the 2nd answer) because the last answer is probably most likely to be chosen (assuming the individual is attempting to read each answer).

If candidates are randomly choosing answers without reading them, then

behavioural finance may not be very relevant. [2] (ii) Recommend placing the correct answer as the last answer because the first

answer is probably most likely to be chosen (assuming the individual is attempting to read each answer).

If candidates are randomly choosing answers without reading them, then

behavioural finance may not be very relevant. [2] (iii) The reasoning is based on the primacy effect, recency effect, anchoring and

the effect of options. Primary effect – people are more likely to choose the first option presented


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Recency effect – in some instances, the final option that is discussed may be preferred.

Anchoring is a term used to explain how people will produce estimates. They

start with an initial idea of the answer (“the anchor”). They then adjust away from this initial anchor to arrive at their final judgement.

A greater range of options tends to discourage decision-making. In (i) the candidate's “anchor” could be considered to be the first answer,

assuming that he/she read each answer and guessing, but they are likely to adjust away from it with each successive answer, making it less likely to be chosen.

The primary effect may be worn-off from this adjusting away. With the

number of options being five, and with each requiring significant consideration due to the detail in each, it is likely that the effect of the greater range of options will discourage decision making – further reducing the primary effect.

This might leave the recency effect to be dominant – and result in candidates

who read each answer and just make a guess, choosing the last answer. So placing the correct answer towards the start is likely to minimise the chances of the candidate just guessing the right answer.

In (ii) the candidate's “anchor” could again be considered the first answer

shown – assuming that he/she read each answer and was guessing. There is only one further answer so the effect of adjusting away from the answer will be smaller than in (i). There is a lower number of options compared to (i) – this would mean decision making will be discouraged to a lesser extent – so impacting to a lesser degree on the primary effect and the anchoring effect.

The recency effect is likely to encourage the candidate to choose the last

answer. However, the combined effect from both the primary effect and anchoring is likely to outweigh it, consequently the dominant bias would probably be to choose the first answer.

So placing the correct answer at the end is likely to minimise the chances of

the candidate just guessing the right answer. Other answers that showed application of the principles of behavioural

finance were also awarded marks (e.g. regarding negative answers being less likely to be chosen, imaginable answers being more likely to be chosen, answers involving change being less likely to be chosen etc.). However, only points relevant to the described scenario were credited. For example, the question stated that the options “were all outlined in considerable detail”. Thus, references to “framing” were not generally relevant.

[9] [Total 13]


Page 8

5 (i) It is more likely that the pension fund and/or their investment managers will have the experience and expertise to invest in corporate bonds than to invest in credit derivatives. However, they might not have the expertise to directly invest in corporate bonds, e.g. they may not have individual corporate bond stock-picking expertise, and instead be relying on investing in a corporate bond fund.

Direct investment in corporate bond could be regarded as being easier to understand and cheaper to manage. Direct investment in corporate bonds may be limited by restrictions, e.g. based on foreign ownership.

Administration arising from investing using credit derivatives is likely to be more involved and require additional administrative expertise, e.g. setting up an ISDA agreement. The indirect investment using credit derivatives could in theory be carried using a pooled vehicle which invested directly using credit derivatives, e.g. an ETF. Alternatively, cash could be invested in government bonds with a credit derivative overlay to provide the required credit exposure. Investing directly in corporate bonds, will likely result in a regular income in the form of coupon payments – investing in credit derivatives will usually not result in such cash flows. This may be an advantage or a disadvantage depending on the cash flow requirements of the pension fund. Where the pension fund does not require the cash flow, it may necessitate coupon reinvestment. The same consideration applies with regard to a government bond / credit derivative overlay structure. Investing directly in individual corporate bonds may result in less diversification than investing using credit derivatives, unless the credit derivatives are also based on individual corporate bonds. Smaller pension funds may not be able to achieve adequate diversification directing investing in corporate bonds and instead may opt to invest in corporate bond funds for diversification reasons. The minimum unit size of the latter is likely to be significantly lower. Alternatively, investment in corporate bonds may allow greater choice and diversification of exposure. In recent years, marketability and liquidity in credit derivatives markets has been better than in the underlying corporate bond markets – making them more attractive from this perspective. The greater marketability and liquidity is also likely to mean that transaction costs (bid/offer spreads etc.) are lower for investing using credit derivatives. If short-dated credit derivatives are used, any necessary rollover of contracts is


Page 9

likely to result in additional costs. However, longer dated contracts are more likely for a pension fund. Using credit derivatives would result in an additional counterparty risk – versus direct investment in corporate bonds. The size of the counterparty risk is linked to the credit rating of the intermediary involved. Credit derivatives may enable longer durations to be available which might be more attractive for a pension fund with liabilities of long durations. Credit derivatives may be short term in nature and be exposed to “roll risk” – due to the costs and risks associated with ‘rolling’ the positions. There may be tax implications depending on the country of origin of the pension fund and could result in either strategy being advantageous over the other from a tax perspective. Credit derivatives may be subject to more onerous regulation than direct investment in corporate bonds. Credit derivatives can allow gearing and leverage – but may not be desirable for pension funds. The investment mandate may not allow use of credit derivatives due to say restrictions on the use of derivatives. Over-the-counter credit derivatives could be customised to suit the specific requirements of the pension funds investment strategy – e.g. regarding duration. In general, indirect investment is particularly suitable for small funds, although even large funds can sometimes benefit from vehicles investing in specialist areas which are outside the funds’ own areas of expertise.

[12] The question related explicitly to the new asset class. Some candidates discussed the use of derivatives in managing transitions between asset classes, but this was generally irrelevant, as was any suggestion that it was planned to reverse the switch in the short term. It was not generally appreciated that the use of credit derivatives in this scenario was to ADD credit exposure e.g. to a core holding in government bonds, in order to replicate the returns that would be expected from a portfolio of corporate bonds. (ii) The gearing and leverage available from using credit derivatives is likely to be

of more interest to a hedge fund than to a pension fund. This is because the pension fund has underlying funds to invest, while hedge funds typically attempt to leverage their clients’ funds.

Since investment mandate of the hedge fund clients is likely to be less

restrictive than that of the pension fund investing in credit derivatives maybe more feasible.


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OTC customisation could be regarded as less important to a hedge fund than to a pension fund – unless it was part of a hedging strategy or as part of an arbitrage trade. [3]

[Total 15]

6 (i) As contributions and investment income all occur on last day of each quarter, the index returns need to be calculated on a similar basis using the yield at the end of each quarter. Assumptions underlying the calculations relate to the impact of tax, dealing costs and the accuracy of the data used.

Time weighted return (%)

Q1

Q2 Q3 Q4

(1.56)% 11.67% 6.49% (5.51%) 10.61% Money weighted return (%) The quarterly returns are the same but the annual return is derived from 3,600 (1 + i) + 56(1 + i)¾+ 30(1 + i)½ + 187(1 + i)¼ = 4,252 This can be approximated by 3,600 (1 + i) + 56(1 + 3i/4)+ 30(1 + i/2) + 187(1 + i/4) = 4,252

(1.56)% 11.67% 6.49% (5.51)% 10.23% Index time weighted return (%) R(t) = ((I(t)*(1 + Y(t)/4))/I(t 1) 1)*100 where R(t) = total return for period t I(t) = index value at time t Y(t) = yield on index at time t

8.01% 11.96% 2.17% (5.53)% 16.72% [9] Not well answered, in general. The question explicitly specifies that “contributions and investment income all occur on the last day of each quarter” but some candidates ignored this and made alternative assumptions. Many failed to appreciate that the fund values given in the question therefore included the income items. (ii) Money and time-weighted are same for each quarter because cash flows occur

at the end of each quarter, but annual is different and reflects time of cash flow v market movements.

Both under performed the index by a considerable amount.


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The first quarter is the period accounting for all the under performance. There is strong out performance in Q3. Given the difference in income, capital return for the fund has been very poor. [3] (iii) Assuming that investment income is received at the end of the quarter (as

specified in the question): Period Fund Index Income Income Q1 52 41.4 [3,600*1,603/1,500*0.043/4] Q2 60 41.9 Q3 60 40.0 Q4 68 44.2 Total 240 167.5 [2] Again, this part of the question was not well answered. Weaker candidates applied the ANNUAL dividend yield to calculate the index income for the QUARTER. Few candidates calculated the quarter-end fund value based on the index performance in order to project the income. (iv) As can be seen the fund was invested in stocks that yielded 40% more than the

average for the index. It is likely that high yield stocks under performed in the year in question as

overall the fund under performed the index by a considerable margin. The fund manager may have a yield requirement. If this is the case then

perhaps a different index should be used to monitor performance. [3] [Total 17]

7 (i) Illiquid Large size Each property is unique Non-exchange traded Expensive to purchase and dispose of Difficult to value Purchase prices are often not disclosed Requires a lot of on-going management Provides real returns Offers diversification from other asset classes


Page 12

Risk of voids Risk of obsolescence [4] (ii) Direct – buying property outright Investing in specialist property fund e.g. REITs Investing in a property index (passive) fund e.g. ETF Equities where underlying company has significant exposure to property (i.e.

property developer) Structured product with link to property returns MBS ABS Swaps [8] (iii) Commercial office

block Residential housing

block Hotel rooms

(a) Overall characteristics

Liquidity Illiquid Most illiquid (non-

prime) Depends on location

Size Sizeable Sizeable May be resold in

smaller lots – more marketable

Uniqueness Not particularly Driven by location

and infrastructure factors

Very location dependent (local transport links, visitor attractions)

Expensive to

trade Less high (unless a high tax economy)

Highest Lower purchase costs

Difficult to

value Stable (stronger demand / more stable economy). Better price data available

Less stable (developing economy). Less reliable price data.

No actual physical property. Volatile

Stability of

value Most stable – stronger demand / stable economy

Less stable Driven by economic environment – more volatile

Real returns Yes Largely, but depends

on local conditions No – volatile returns


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Commercial office block

Residential housing block

Hotel rooms

Risk of voids Professional /

company tenants – most stable

Retail tenants – greater risk of voids

Volatile / unpredictable. May be seasonal (and weather dependant)

(b) Stability of

income stream Most stable. Long leases with upward rent reviews

Will depend on location and economic conditions. Shorter leases. May be affected by political considerations.

Affected by local and international economic conditions (including exchange rates). Least stable.

(c) Ongoing

management Least expenditure needed – mainly maintenance of shared services.

Significant. Estate management costs plus resale / reletting of empty units.

Considerable expenditure needed to maintain quality and standards. Most expensive (but this may be borne by the hotel chain).

[12]

[Total 24] Part (iii) was not well answered by weaker candidates, who failed to apply many of the characteristics identified in part (i) in assessing the alternative investments. There was insufficient appreciation that the portfolio of hotel rooms represented a source of rental income (akin to sale-and-leaseback) rather than a physical property investment.


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