Institute of Actuaries of India

Subject ST5 – Finance and Investment A

May 2010 Examinations

INDICATIVE SOLUTIONS

Introduction

The indicative solution has been written by the Examiners with the aim of helping
candidates. The solutions given are only indicative. It is realized that there could be other
points as valid answers and examiner have given credit for any alternative approach or
interpretation which they consider to be reasonable.
IAI ST5 0510

Q1

1 (a) 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 risein
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.

(b)
• Risk Management: The contract would hedge longevity risk in the fund, andgive
more certainty to the fund’s financial position. The volatility would be reduced.
Therefore, the scheme may be able to better tolerate the risk of any large equity
allocation

• Term: The scheme probably needs to make payments to pensioners stretching

many years into the future. The contract only provides protection for 10 years.

• Credit Risk: The bank could default in full (or in part) on payments it is obliged
to make to the scheme. Examine the credit rating of the bank and how it has fared
in this global crisis. Buying credit protection on the bank could be relatively
expensive in this economic climate. Spreading of credit risk may be considered.

• Collateral – will be likely in this OTC contract. This will provide some credit
risk protection. However, collateral may be calculated infrequently, because of
infrequent valuations. Investigate methodology used to calculate collateral.

• Illiquidity: What happens if trustees wish to terminate the contract early?

• Due Diligence: Further due diligence to that described above should be

conducted; how does the bank hedge longevity risk it takes on (warehousing,
reinsurance etc)? What is the bank’s expertise in writing longevity- linked
contracts?

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• Behavioural Issues: Trustees may be nervous about entering such an exotic

contract if they have no experience of derivative positions in the fund. They may
be more inclined to enter the contract if similar funds have already entered similar
contracts.

• Competitor: Consider other de-risking solutions offered by competitors

(bulk -buyouts, other swaps)

(c)
• Interest Rates: Interest rates could decrease i.e. rates used to discount the
liabilities fall. This increases the present value of the liabilities.

• Inflation: Inflation increases are higher than allowed for. Higher inflation will
increase projected benefits and the present value of liabilities.
[13]

Q2
(a) Admissibility restrictions encourage investment in certain classes without the
restriction of a more prescriptive policy.

It will be more acceptable to the funds as they are less prescriptive to the outright
restriction on holding.

The impact depends upon the degree to which scheme’s current investments are
admissible and on the solvency position of the fund. A well-funded fund will be
less bothered about the restrictions while a less funded will move to hold
admissible assets.

(b) The government/regulator may consider derivatives as risky investments

(particularly if used for speculative purposes) and hence are unsuitable.

However, derivatives can also be used for hedging purposes, so as an alternative

regulations can be framed just to exclude use of derivatives for speculative
purposes.
Sometimes, derivatives market may be more liquid than the underlying assets, for
example in commodities. So it may be more appropriate to use derivatives.

(c) To avoid concentration of risk i.e. risk that company gets into trouble and
employees lose their job and also that also jeopardize the security of fund.
Self-investment includes not only investment in the sponsor’s shares and debt, but
also loans, but also property that the company rents from the scheme.

The impact on the fund depends upon the level of self-investment and the ease
with which it can be disposed (in case of share and debt).
[6]
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IAI ST5 0510

Q3

(a) The final result of an ALM study will be a recommended investment strategy for the
scheme in the form of:

• A benchmark consisting of fixed percentages allocated to each asset class

• Extraction of a “core” portfolio (typically bonds) with the remaining assets
invested in a balanced fashion.

(b)

1. The key objectives that investment and funding policy should aim to achieve need
to be clarified. These involve objectives such as:

• Future ongoing 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 cashflow is carried out

5. An analysis would be carried out to identify how the scheme might progress in the
future if different investment strategies were adopted

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

(c) (i) Marking to Market: The practice of revaluing an instrument to reflect the current
values of market variables
(ii) Arbitrage: The simultaneous buying and selling of two economically equivalent
but differentially priced portfolios so as to make a risk free profit.
(iii) Par Yield Curve: A plot of coupon value on the y-axis against the term to
redemption on the x-axis. For each term, the coupon that would be required for a
fixed interest bond of that term to be issued at par is plotted.
(iv) Reversion Interest: The interest of a freeholder or long term leaseholder, to
whom the property will revert on expiry of a lease.

[10]

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IAI ST5 0510

Q4

(a)

Strategy 1

15

10
Net Payoff

0
30 35 40 45 50 55 60 65 70 75 80 85 90
-5

-10
Stock Price

Strategy 2

15

10
Net Payoff

0
5 10 15 20 25 30 35 40 45 50 55 60 65 70
-5

-10
Stock Price

(b)

Current price of the underlying security must be Rs. 2/3 lower than Rs. 50 as put prices
are a bit higher than the call prices.
[5]

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IAI ST5 0510

Q5 Process used to determine price range

Firstly a financial model of various cashflows (revenue and cost items) needs to
be built.

Revenues will be mainly from estimated future sales which will depend upon
company’s current capacity, future expansion plans, current prices of various
grade of coal, future expectation of prices, changes in company’s competitive
environment etc.

Cost items will be mainly derives from current expenses, expected increase in
expenses (wage inflation, normal inflation), management ability to control
expenses, interest on loans and overdraft etc.

The forecast P&L accounts will provide estimates of earnings to which expected
payout ratios will be applied to derive estimates of future dividend streams to the
shareholders. The payout ratios will depend upon:

Previous distributions to Govt. of India

Payouts of similar listed companies
Estimates made by the company itself.

The dividend streams would be valued using either:

V = D1/(i-g)

Or V = ∑ Dt * υ (t)

Where:

V = Estimated price of the share

Dt = Estimated dividend at time ‘t’

υ (t) = t-year discount factor

i = Required rate of returns

g = Continuous rate of growth of dividends (derived from the financial model)

The price range would be obtained by considering lower and upper estimates of
earnings, payout ratios, i and g.

Otherwise, next year earnings could be estimated using above analysis and price
can be determined by applying market P/E ratio.

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(2) Generally, the recommended price range should be below the fair market
value to facilitate the full subscription of public offering. Positive public
sentiment could be created by the price rise upon listing. This will also help future
public offering by Government owned companies.

It may be possible that during period of subscription, economic or market

conditions turn negative. To avoid that, it is better to recommend a lower price
range.
[8]

Q6
For with profit policies, the reversionary or annual bonus declared in the past are
guaranteed and because future bonuses can’t be negative even if the assets
produce negative returns in future, the investment risk due to declared past
bonuses is on the shareholders.

The asset portfolio consists of 50% equities, 40% bonds and 10% cash. We can
assume that the market value of cash investments will not fall, but equities and
bonds can fall in market value.

To mitigate against the fall in market value of equities and bond portfolio, the
insurer can buy a put option with the strike price of current unit value if the option
is of one year and strike price will be the rolled up (rolled up by assumed future
bonus rate) unit value at maturity, if option is of remaining term of the policy.

Black-Scholes formula can be used to calculate the value of put. The risk free rate
can be the government bond yield either for one year or yield corresponding to the
remaining term of the policy. The implied volatility for equities and for bond
portfolio can be estimated by using financial economics.

The sum of the value of the put options for all policies can be considered as cost
of guarantee.
[4]

Q7

(a)
• Switching: Need details on the size of portfolio, the assets(and their size) which
are intending to be liquidated, and the size of the potential investment in CDOs.
Any large sales could result in a sizeable capital gains tax liability. A sizeable
switch could incur large transaction costs plus costs of market impact. Seek
methods to minimise these costs as far as possible.

• Tactical: Market conditions – is this the best time to switch?

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• Liability Matching: Need to understand company’s liabilities in detail. Ideally

want the new portfolio to hedge liabilities at least as well(if not better) than the
current portfolio. Assess how the new investment strategy affects risk/capital
position within the company. Investigations from asset liability models (ALM)
and other risk metrics are useful for this.

• Risk/return: These CDOs are alternative assets – the desired allocation could
increase yield and expected return of the portfolio. Low correlation of CDOs with
mainstream asset classes could decrease portfolio volatility.

• Business: Any increases in expected return could benefit policyholders via lower
premiums or higher benefits, thereby increasing business volumes. Marketing
literature may need to be updated with new investment strategy.

• Concentration: Portfolio may already have sizeable concentration to CDOs, as it

has sizeable exposure to hedge funds, and hedge funds may invest in these exotic
instruments.

• Risks: Need to examine the assets underlying CDO structures to fully assess
potential credit risk. May be difficult to purchase effective credit protection on
these securities. CDOs are relatively illiquid instruments.

• Expertise: Company may need considerable external investment management

expertise, as company has never invested in CDOs. Extra fees will be incurred
and this could reduce potential returns

Other issues to investigate:

• The CDOs may not be fully admissible (or at least admissible to the same extent
compared to conventional corporate bonds) when assets are valued for statutory
purposes
• Examine the ratings of each CDO tranche, seniority of the tranches the company
is investing in, any degree of overcollateralistion, any guarantees third parties
may offer
• Investigate peer group (similar life offices) allocation to CDOs

(b)
• Hedge fund index could have suffered from several data biases which has
artificially improved performance statistics.
• Survivorship Bias –if survivors only included in the index, average returns
overestimated and volatility underestimated.
• Selection Bias – Funds with good history more likely to apply for inclusion in
index. “Backfilling” causes significant upward bias.
• Marking to Market Bias –underlying securities typically illiquid, so funds use
latest reported price or their own estimates of market value. The use of “stale”
prices can lead to underestimation of true variances and correlation.
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IAI ST5 0510

• Other factors - past performance may not be repeated in future; further allocation
increases hedge fund concentration risk in portfolio

(c) (i)
• Decide VaR to be calculated - need timescale for measurement (e.g 1 month) and
confidence level (e.g 95%)
• Collect data – need current asset values, asset allocations and historical data on
investment returns for asset classes within portfolio
• Fit data to a normal distribution – estimate standard deviation of returns,
correlations between returns.
• Calculate standard deviation of entire return distribution.
• Estimate the point on the distribution, where there is only a 5% chance of falling
below this point.
• The VaR is the level of underperformance which is equated to this 5% tail.

(ii)
• VaR is potentially subject to large error – it is an estimate that is highly
dependent on method of calculation, the period of data extraction.
• Estimates - Biases in the hedge fund data and use of “stale” prices (as
mentioned above) could bias estimates of volatilities and correlations in the
VaR calculation.
• Non-Normal Distributions – VaR assumes normal distribution of returns, but
portfolio contains hedge funds (which have non – normal returns)
• Market crisis- VaR does not allow for simultaneous increase in correlations
and volatility in extreme market events. The hedge funds could well become
more correlated with the mainstream asset classes in the portfolio during
market stress
• Stress Testing - needed to identify weak areas in this portfolio, the
sensitivities to a variety of risk factors, and possible losses in a market crisis.
• Portfolio analysis - need to fully investigate portfolio composition e.g
concentrations, perform due diligence on hedge funds and strategies employed
• Analyse other risk indicators – vs market benchmarks (indices) and
appropriate liability benchmarks.
[20]

Q8 (a)

Interest rate floors can be valued as a portfolio of call options on zero-coupon

bonds.

Interest rate floorlet provides a payoff at time tk+1 of:

L*λk *max (Rx - Rk, 0)

Where:

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IAI ST5 0510

L : Principal amount
λk : Tenor of the contract
Rx : Floor interest rate
Rk : Variable interest rate

Rk is the floating rate and effective rate from tk+1 to tk+1 is Rk* λk. Thus the above
payoff at tk+1 has same present value as payoff at tk of:

L*λk *max (Rx - Rk, 0)/(1+ Rk* λk)

Or, max [(Rx - Rk)* L*λk /(1+ Rk* λk),0 ]

Or, max [((Rx - Rk)* L*λk + L – L) /(1+ Rk* λk),0 ]

Or, max [L(1 + Rx* λk) / (1+ Rk* λk) – L,0 ]

Now L(1 + Rx* λk) / (1+ Rk* λk) is value at tk of a zero-coupon bond that pays
L(1 + Rx* λk) at tk+1.

Therefore, this is equal to the value of pay-off from a call option with an exercise
date and price of tk and L respectively on a zero-coupon bond with a principal of
L(1 + Rx* λk) payable at time tk+1.

(b) Value of swaption is:

LA (Rx*N(-d2) – Fo*N(-d1))

L = 50m

Sigma = 0.15

T=2

A = exp(-0.0303*3) + exp(-0.0306*4) + exp( -0.0308*5) = 2.6517554

Rx = 0.03

Fo = forward swap rate = exp (-0.0296*2) – exp(-.0308*5) / A = 0.0321057

d1 0.4258467
d2 0.2137147

N(-d1) 0.3351098
N(-d2) 0.4153848

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IAI ST5 0510

Hence swaption value is:

50 * 2.6517 * ( 0.03 * 0.4153 – 0.0321057 * 0.3351098 )

=USD 0.226037 Million (i.e 226,037 USD)

[10]

Q9
(a) At T = 0,

I(0) = (∑ Ni,0 * Pi,0 )/ B(0)

B(0) : Base value or divisor at T = 0

I(0) : Index value at T = 0
Ni,0 : No. of outstanding shares of ith company at T = 0
Pi,0 : Share price of ith company at T = 0

Therefore, 1000 = (1,00,00,000 * 1,000 + 50,00,000 * 800) / B(0)

So, B(0) = 1,40,00,000

Value of capital index before bonus and rights issues:

I(1) = (∑ Ni,1 * Pi,1 )/ B(0)

I(1) = (1,00,00,000 * 1,200 + 50,00,000 * 1,000) / 1,40,00,000 = 1,214.29

Theoritical ex-bonus share price of RIL should be = 1,200/3 = 400

Theoritical ex-rights price of ICICI Bank should be = (5*1,000 + 1*600)/6 =
933.33

At no gains/losses, the index value at T = 1, should remain the same as increase in

market capitalization just because of Rights issue doesn’t change the index value.
Bonus issue doesn’t change the market capitalization.

So, I(1) = (3,00,00,000 * 400 + 60,00,000 * 933.33)/B(1)

So, B(1) = 1,44,94,050

Now, actual ex-bonus share price of RIL = 320

Actual ex-rights share price of ICICI Bank = 900
So, capital index value at T = 2

I(2) = (3,00,00,000 * 320 + 60,00,000 * 900)/ 1,44,94,050 = 1,034.91

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IAI ST5 0510

(b)

Total Returns Index :

Total return index is a measure of not only the movement in capital values but
also includes income received.

Total returns can be calculated using ex-dividend adjustments or yields.

Ex-dividend adjustment or XD adjustment is calculated by assuming that the

dividend or interest payments are reinvested back into the index on the ex-
dividend date.

So, xdi,t = (Ni,t * Di,t )/B(t-1)

And XDit = ∑xdit

XDit = Accumulated dividend by ith share over the full calendar year.

XDt = ∑XDit

XDt = Total XD adjustment for all the constituents of the index

Therefore, the value of total returns index will be the value of capital index
combined with the total dividend adjustment.

So, TRI(t) = TRI(t-1) * (I(t) + XD(t) – XD(t-1))/I(t-1)

(c) Property Indices:

Portfolio-based indices:

They measure rental values, capital values or total returns of actual rented
properties. Different indices of this type will give different results because the
underlying portfolio of properties will vary in size, regional spread and sector
weighting.

The rate of returns will typically be money-weighted.

The main shortcoming is that the current rentals are fixed until next review, the
response to the movement in rentals is sluggish.

Barometer Indices:

They are designed to act as barometer of current market conditions.

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IAI ST5 0510

They aim to track movement in property market by estimating the maximum full
rental values of a number of hypothetical rack-rented properties.

Therefore, the values underlying the indices are based on valuers’ estimate of
current rack rent rather than actual rents.

The main use of these type of indices is in measuring short term changes in the
level of the market in terms of rents and yields. These indices can’t be used for
portfolio performance measurement.

[12]

Q 10

Though the assets are valued monthly, liabilities are valued on quarterly
basis and these quarterly valuations are the basis of MVA factors used for
adjusting the surrender values.

If we assume that quarterly valuations take around 2 weeks of time to be

completed, the MVA factors are around 2 to 15 weeks out of date.

Firstly, it is important to value the unit liabilities more frequently particularly on

daily basis by applying some conservative bonus rate for the current year (if we
are assuming that bonus is declared in arrears) and then try to actually value the
assets more frequently (if possible on daily basis) or at-least estimate the asset
values on daily basis. Based on the actual valuation of assets or estimates of
assets, MVA factors can be estimated on daily basis. In this way, adverse
selection against the UWP fund could be avoided.

Now, 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 investment
performance of each separately managed fund and the net inflow/outflow of
money from each fund.

To avoid very frequent trades and money movements most fund operate an
account for everyday cash movements, for example premiums, claims and
expenses, and on a periodical basis will transfer larger amounts between the
account and the investment funds.

The investment manager may make a tactical investment switch of money

between individual funds that could significantly alter the investment mix. A
procedure is required for the investment manager to notify where money is moved
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into or out of the individual funds. This will allow the reported investment mix to
be adjusted on a more frequent basis.

The investment performance of each fund, and fund valuations are not known on
a daily basis, so more frequent data is not available. Therefore it will be necessary
to estimate the investment performance between valuations and to update the
performance when the actual investment mix and performance data becomes
available.

The investment performance needs to be monitored on a daily basis.

The required accuracy of the fund performance estimate depends on importance

of the sub-fund, and the volatility of the investment performance, i.e. there is a
need to be more accurate for equities and fixed interest bonds that forms 53% of
the UWP fund than the Commercial mortgage forms 2% of the fund.

Similarly, floating rate notes and cash investments exhibit very little volatility,
therefore, very frequent estimates of the funds managing these investments are not
needed.

For each of the segregated fund, it is important to investigate appropriate index.

Compare the actual past performance of the segregated funds with the movements
of the chosen index to determine the suitability.

Indian Equities

Indian equities constitute 15% of the total UWP portfolio assets. Given the
volatility of Indian market, it is important to estimate the performance on daily
basis. An insurance company is likely to have a broad spread of equity investment
covering both small and large companies.

Therefore the BSE - 500 Share index investment performance should be

investigated. It will be necessary to compare the actual investment held by the
Indian equity fund to BSE - 500 in order to verify that this is a suitable index,
rather than using a weighted combination of sub-indices.

Non-Indian Equities:

This fund holds 5% of the total portfolio and therefore its volatility may not affect
the movement of overall fund, but never-the-less this fund is also very important
given its volatility. But based on the size of this fund, the actual investment
performance for each country can be avoided for estimation purposes and
available international equity indices FTSE World Indices series and Morgan
Stanley Capital International Indices series could be investigated as they both
cover both developed and emerging markets.

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It is important that the price indices and XD adjustments are in the domestic
currency, i.e. already adjusted currency fluctuations.

Fixed Interest long term corporate bonds (AA rated):

This fund is around 23% of the whole portfolio. Because of the long term nature
of the bonds, the interest volatility will be relatively high. Similarly being AA
rated, additional volatility will be induced due to the changes in credit risk
perception.

It will be difficult to find a suitable benchmark as they are constructed subject to

specific constraints such as duration or credit rating, but the fund can have bonds
having duration in a wide range and similarly having varying credit rating, though
the average could be AA.

To estimate the fund performance between valuations it would be suitable to

construct a benchmark using combination of indices to reflect the actual portfolio.

Fixed interest medium term GILTs

Due to medium term duration of bonds, the interest rate volatility is not very high,
but as this fund constitutes 10% of the whole portfolio, the impact of movement
in bond values on the overall portfolio can be substantial particularly when
interest rates movements are significant.

Government securities indices are there, but they are sub-divided by term.
Investigate the current holdings and amounts of those holdings and compare these
with each category of the price indices to determine appropriate weights.

Fixed Interest medium term corporate bonds (AAA rated):

The yield on these bonds will be a bit higher than the corresponding government
securities due to some additional credit risk and due to this these bonds are more
volatile than the government bonds.

A benchmark can be constructed by combining various indices to reflect the

actual portfolio or alternately, appropriate government securities can also be used
after some moderation to reflect the credit risk.

Property:

Investigate the current holdings of the property fund to determine the level of
direct property holding to indirect property holding (property shares).

For the indirect property proportion a property sub-index of BSE or NSE is likely
to be appropriate.
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Direct property investment tends to have a stable performance over a short period
because valuations are carried out periodically for each property.

Investigate the recent monthly past performance and, say calculate an average
performance for use.

If the recent performance has not been reasonably stable because of the effect of
property revaluations, then a procedure for the investment manager to notify you
of significant property revaluations will be required.

Commercial mortgages:

Commercial mortgages constitute a very small part of the UWP fund, so we do

not have to do anything too complicated to estimate the values on daily basis.
[12]
Total Marks 100

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