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CM2: Mock Exam-Paper A Questions

In order to answer this paper you may wish to refer to the TFoA Exams Specimen Notation sheet
available from the lInstitute and Foculty of Actuories website, which gives example notation that
may be used to show your working. Where it might speed up your calculations, you should
consider constructing your answer in Excel, but note that ol calculations must be typed out in fu
in Word to ensure you receive appropriaote marks.

Security A has a random monthly percentage investment return of R%. R takes a value from a
normal distribution with a mean of 0 and standard deviation of 10 with probability0.6 ora value
from a normal distribution with a mean of 6 and standard deviation of 20 with probability 0.4.

Security B has a random monthly percentage investment return ofS%. S takes the value-25 with
probability 0.2 and +9.25 with probability 0.8.

Calculate the mean and variance of R. 13

(i) Calculate the mean and variance of S. [3

(ii) An investor is looking to invest $10 million entirely in either Security A or Security B. For
each potential investment calculate the following risk measures:

(a) shortfall probability relative to a benchmark rate of return of 0%

(b) one-month 75% Value at Risk. 5

(iv) Comment on which security the investor is likely to choose based the results from parts
()-(i). [41
The investor has asked you to recommend the most suitable security for them to invest in.

V) Suggest further information you would need from the investor in order to make this
recommendation. [1
ITotal 16)

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 page CM2: Mock Exam - Paper A Questions

2 Company X has issued two zero-coupon bonds. The bonds have outstanding terms of five and
10 years and both have a AAA credit rating, although neither has a quoted market price.

A credit analyst, who is using a two-state continuous-time model to estimate risk-neutral default
probabilities and bond prices, estimates that for bonds with a AAA credit rating:

the risk-neutral transition intensity function is 2(s)= 0.01s at time s years from now

the average recovery rate in the event of default is 60%.

The risk-free force of interest is 5% pa.

(0) Calculate the probability that the five-year bond does not default. (21
(Gi) Calculate the probability that the 10-year bond does not default.

(ii) Calculate the estimated price of each bond. (2

(iv) Calculate the credit spread of each bond. (3
() Comment briefly on the result from part (iv)
Total 9

() Explain the terms 'systematic risk' and 'specific risk. (2

(i) Explain the implications for investment management if a particular investment market is
believed to be weak form inefficient. 13]
Total 5

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 CM2: Modk Exam- Paper A Questions Page 3

A An investor has used historical data to estimate the following parameters in respect of the share
price of a highly geared mining company:

volatility of the continuously compounded monthly return, a=10%

expected monthly return (continuously compounded) = 1%.

Further assume that the monthly risk-free force of interest, r, equals 0.5%.

The investor wishes to model the movement of the share price over the next two months (during
which period the share is not expected to pay any dividends) using a two-period recombining
binomial tree, with up-movement and down-movement factors, u and d, and a risk-neutral
probability q of an up-movement.

() Calculate numerical values for u, d and q and hence show that the value of the
corresponding real-world probability of an up-movement is given by p=0.52519. (3
The investor has a long position in a two-month forward contract on the shares of the mining
company with a delivery price of $100. The current share price is $102.

(i) Calculate the values of the three state price deflators corresponding to the three possible
nodes at time two in the binomial tree and use them to estimate the value of the forward
contract.

Total 8

5 () Explain in words what is meant by a 'self-financing' portfolio strategy. [1

(i) Define the following terms in the context of portfolio theory:

(a) efficient frontier

(b) opportunity set

(c) indifference curve

(d) optimal portfolio. (4

Total 5

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page CM2: Mock Exam - Paper A Questions

Consider two investments both of which have investment returns that follow a continuous
uniform distribution.

Investment 1 has a range of returns from 0% to 10%, whereas the range of returns for
Investment 2 is from 39% to 7%.

Determine the mean and variance of investment returns for each investment and explain
which investment will be preferred by the typical investor. 3
The cumulative probability distribution for the returns for investment 2 is as follows:

1 for 7SxS10

5)= for 3sxs7

4

for 0sxs3

() Determine whether Investment 2 exhibits first-order stochastic dominance over

Investment 1. (4
(ii) Suppose an investor has the following utility function:

U(w)=w*

where w is the level of wealth, and that their initial wealth is $100.

Calculate the investor's expected utility if they invest all of their wealth in Investment 1
Hence determine their certainty equivalent from that investment. [4]
Total 11

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 CM2: Mock Exam - Paper A Questions Page 5

You are given that the fair price to pay at time t for a derivative paying X at time T is

V =eEaX], where Q is the risk neutral probability measure, G is the filtration at time
twith respect to the underlying process and r is the continuously compounded risk-free rate.

The price movements of a non-dividend-paying share are governed by the stochastic differential
equation dS =S (rdt + ad8,), where B is standard Brownian motion under the risk-neutral
probability measure.

At time t=0, the share price is £8. The continuously compounded risk-free rate is 2% per annum.

() Calculate the fair price of a forward contract written on the share at time t =0 with expiry
at time t=3. (1]

An investor purchases a forward contract at time t=0. At time t=1 the share price has risen
to £8.60.

(ii) Calculate the value to the investor of the forward contract at time t=1. 3
The investor expects the continuously compounded risk-free rate to increase to 3% at time t=2.

(ii) Without performing any calculations, explain what impact this change in risk-free rate
would have on the investor's expected profit at maturity. 3
[Total 7

8 The six-month risk-free spot rate of interest is 3% and the 12-month risk-free spot rate of interest
is 4%, both continuously compounded.

(0 Calculate the six-month forward rate for an investment made in six months' time. 2
A bond pays coupons of 5% pa semi-annually in arrears and matures in one year's time.

(Gi) Calculate the price of the bond per £100 nominal:

(a) now

(b) in six months' time. [2

(ii) Briefly describe three theories explaining the shape of the yield curve. [6]
Total 10]

9 The annual rate of return in year k on a particular investment is ig These annual rates of return
are independent and identically distributed with mean 7% pa and standard deviation 29% pa.
1+i is lognormally distributed.

Calculate the parameters and a of the lognormal distribution for 1+ik (3

(i) Calculate the probability that the accumulated value at time 5 of an investment made at
time 0 exceeds 110% of its expected value.
[Total 8)

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10 An insurer has been writing wedding insurance policies for a number of years providing a fixed
payment of £20,000 in the event of cancellation. Claims arrive as a Poisson process with
parameter 2. Historically 2 has been equal to 10 but due to a global pandemic the company
expects this to increase to 20 over the next year. The insurer has closed to new business and has
a surplus of £200,000. All business remaining on the books was written using a premium loading
factor of 15%.

Assuming that all policies were written based on the historical :

Determine the insurer's yearly premium income.

0
(i) Calculate the probability of ruin in one year's time had the pandemic not occurred. [2
(ii) Calculate the revised probability in light of the pandemic.

The insurer is concerned that the probability of ruin has become too high and is considering
reopening to new business to reduce it with the following options:

Reopen to new business with a premium risk loading of 15%.

Reopen to new business with an increased premium risk loading of 30%

(iv) Discuss the potential effectiveness of each option in reducing the probability of ruin. 3

A rival insurer offers to take on 50% of the existing policies for a fee of £115,000.

(v) Calculate the probability of ruin if the insurer accepts this offer and comment on the
answer. [4
(vi) Determine the maximum fee the insurer would be willing to pay in order to reduce the
probability of ruin. [4
[Total 15]

11 The table below shows the cumulative claim amounts paid (in £O00's) by accident and
development years in respect of a portfolio of motor insurance policies:

Development Year
3

2012 1,460 2,440 2,892 3,030

2013 1,792 3,057 3,605
Accident
Year 2014 2,031 3,459
2015 2,209

Use the basic chain ladder method to calculate the outstanding claims reserve that should be held
at the end of 2015. 6)

END OF PAPER

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