CM2A MOCK 6 ACTUATORS EDUCATIONAL INSTITUTE

CM2A
MOCK 6

FINANCIAL ENGINEERING AND

LOSS RESERVING
MOCK EXAM FOR 2023
CA PRAVEEN PATWARI 1 JAI SHREE RAM
CM2A MOCK 6 ACTUATORS EDUCATIONAL INSTITUTE

CM2: MOCK EXAM 6— PAPER A QUESTIONS

1. Colin's preferences can be modelled by the utility function such that:

U'(w) = 3–2w, (w>0).

(i) Determine the range of values over which this utility function can be satisfactorily applied.

(ii) Explain how Colin's holdings of risky assets will change as his wealth decreases.

(iii) Which of the following investments will he choose to maximise his expected utility?

Investment A Investment B Investment C

outcome probability outcome probability outcome probability

0.1 0.3 0 0.3 0.2 0.45

0.3 0.4 0.2 0.2 0.3 0.1

0.5 0.3 0.9 0.5 0.4 0.45

[Total 10]

2. Adam, Barbara and Charlie are all offered the choice of investing their entire portfolio in either a risk-
free asset or a risky asset. The risk-free asset offers a return of 0% pa, whereas the returns on the
risky asset are uniformly distributed over the range -5% to +10% pa. Assuming that each individual
makes their investment choice in order to minimise their expected shortfall, and that they have
benchmark returns of-2%, 0% and +2% pa respectively, who will choose which investment? Com-
ment briefly on your answer. [8]

3. An investor is contemplating an investment with a return of £ R, where:

R = 250,000 – 100,000N

and N is a Normal [1,1] random variable.

Calculate each of the following measures of risk:

(a) variance of return

(b) downside semi-variance of return

CA PRAVEEN PATWARI 2 JAI SHREE SHYAM
CM2A MOCK 6 ACTUATORS EDUCATIONAL INSTITUTE

(c) shortfall probability, where the shortfall level is £50,000

(d) Value at Risk at the 95% confidence level

(e) Tail Value at Risk at the 95% confidence level, conditional on the VaR being exceeded.

[13]

4. Consider a world in which there are only 2 securities, 1 and 2, such that:

E1  5%, V1  10% 
2

E1  10%, V2   20% 
2

Let  denote the correlation coefficient between the returns yielded by the two securities.

(i) Derive the equation of the opportunity set in E –V space. [5]

(ii) Derive expressions for the portfolio expected return E and the portfolio proportion x1 invested
in Security 1 at the point of global minimum variance and hence comment briefly on how E and
x1 vary with  . [5]

[Total 10]

5. (i)  
Write down a formula for E e aX where X ~ N ,  2   and, by differentiating, or otherwise,

derive an expression for E  XeaX  . [2]

(ii) Show that:

1
aB t  a 2 t
X t   B t  at  e 2

is a martingale, where Bt is a standard Brownian motion, and a is an arbitrary constant.

You may assume that E | X t |   . [5]

[Total 7]

6. (i) Write down Ito's Lemma as it applies to a function f  X t  of a stochastic process X t that satisfies

the stochastic differential equation dX t   t dB t   t dt , where B t is a standard Brownian motion.

CA PRAVEEN PATWARI 3 JAI SHREE SHYAM

CM2A MOCK 6 ACTUATORS EDUCATIONAL INSTITUTE

(ii) Hence find the stochastic differential equations for each of the following processes:

(a) G t  exp  X t 

(b) Q t  X 2t

1
(c) Vt  1  X t 

(d) L t  100  10X t

(e) J t  InB t

(f) K t  5B3t  2Bt

[Total 10]

7. Let S t be a geometric Brownian motion process defined by the equation St  exp  t  Wt  , where
Wt is a standard Brownian motion and  and  are constants.

(i) Write down the stochastic differential equation satisfied by X t  log e St . [1]

(ii) By applying Ito's Lemma, or otherwise, derive the stochastic differential equation satisfiedby S t .
[3]

(iii) The price of a share follows a geometric Brownian motion with   0.06 and   0.25 (both ex-
pressed in annual units). Find the probability that, over a given one-year period, the share price
will fall. [3]

[Total 7]

8. Give definitions of the 'Greeks' that could be used as an aid to management in each of the following
situations. State also the desired ranges for their numerical values and define any notation you use.

(a) A hedge fund manager wishes to establish a delta-neutral position that would not need frequent
rebalancing.

(b) A derivatives trader is concerned that a change in the distribution of the daily price movements
of particular shares might affect the values of the options held on those shares.

(c) The trustee of a pension fund that purchased a large number of options last year as a means of
hedging is concerned about changes in the value of the fund as the options approach their expiry
date. [6]
CA PRAVEEN PATWARI 4 JAI SHREE SHYAM
CM2A MOCK 6 ACTUATORS EDUCATIONAL INSTITUTE

9. A company's directors have decided to provide senior managers with a performance bonus scheme.
The bonus scheme entitles the managers to a cash payment of £10,000 should the company share
price have increased by more than 20% at the end of the next 6 months. In addition, the managers will
be entitled to 5,000 free shares each, should the share price have increased by more than 10% at the
end of the next 6 months.

You are given the following data:

Current share price £7.81

Risk-free rate 5% pa (continuously compounded)

Share price volatility 25% pa

No dividends to be paid over the next 6 months.

(i) By considering the terms of the Black-Scholes call option pricing formula, calculate the value of
the bonus scheme to one manager. [6]

(ii) Explain the main disadvantages of this bonus scheme as an incentive for managers to perform.
[2]

(iii) Some shareholders are concerned that this scheme might cause an undesirable distortion to the
managers' behaviour. Suggest some modifications to the scheme that will ensure that the man-
agers' aims coincide with the long-term objectives of the shareholders. [3]

[Total 11]

10. Company X has just issued some 5-year zero-coupon bonds. A continuous-time two-state model is to
be used to model the status of the company and to calculate the fair price of the bonds. It is believed
that the risk-neutral transition rate for failure of the company is   t   0.002t , where t is the time in
years since the issue of the bonds. The 5-year risk-free spot yield is 5.25% expressed as an annual ef-
fective rate.

(i) Calculate the risk-neutral probability that the company will have failed by the end of 5 years. [2]

(ii) In the event of failure of the company, the bonds will make a reduced payment at the maturity
date. The recovery rate for a payment due at time t is:

  t   1  0.05t

CA PRAVEEN PATWARI 5 JAI SHREE SHYAM

CM2A MOCK 6 ACTUATORS EDUCATIONAL INSTITUTE

Calculate the fair price to pay for £100 nominal of a Company X bond, taking into account the
possibility of company failure. [3]

(iii) An analyst is concerned that the estimate of   t  may be too simplistic. Explain the possible rea-
sons for his concern and how the model could be developed to deal with this. [3]

[Total 8]

11. The table below shows the payments, in £'000s, made in successive development years in respect of a
particular class of general insurance business. It may be assumed that all claims are fully settled by
the end of Development Year 3 and that all payments are made in the middle of a calendar year.

Year of origin Development Year

0 1 2 3

2012 342 82 68 37

2013 359 90 73

2014 481 120

2015 591

Use the inflation adjusted chain ladder method to estimate the amount of the reserve required at the
end of 2015 to pay the outstanding amounts in respect of claims from 2013, 2014 and 2015. You
should assume that past inflation has been at the rate of 5% per annum and that future inflation will
also be at 5% per annum. [10]

CA PRAVEEN PATWARI 6 JAI SHREE SHYAM