Sample Examination Paper Final Examination Questions

Portfolio Management Derivative Valuation and Analysis Fixed Income Valuation and Analysis

Exam Guide

Subject Area Fixed income valuation and analysis Fixed income valuation and analysis Derivative valuation Derivative valuation Portfolio management Portfolio management Portfolio management Portfolio management

Question Number Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8

Weight 20 points 25 points 25 points 33 points 30 points 20 points 7 points 20 points 180 points

Time allowed : 180 minutes

ACIIA: June 2000

Exam Guide

Answer all questions

Question 1: Bond Valuation and Analysis (20 points) You are considering investing in a bond for the next twelve months. You are limiting your choice of bond to one of the following, both of which pay annual coupons at year end and have identical credit risk:
Bond A B Maturity 2 years 3 years Coupon 8% 9% YTM 7.842% 8.027%

(a) (b) (c) (d)

If the one year, two year and three year spot rates are 7.65%, 7.85% and 8.05% respectively, determine the prices of bond A and bond B. Estimate, using duration, the expected change in price of bond B for a 0.2% change in yield to maturity. Calculate the difference in the one year holding period return on the bonds, assuming that spot rates will fall in twelve months time by 0.2% across the maturity spectrum. When estimating holding period return, what are the implications of each of the following assumptions? (i) the yield to maturity or spot rate curve will remain constant; and (ii) the forward rate curve correctly estimates future spot rates

(4 points) (5 points) (6 points)

(5 points)

ACIIA: June 2000

Exam Guide

Question 2: Bond Valuation and Analysis (25 points) A pension fund is currently showing a surplus in its asset/liability position (see table below). Under International Accounting Standards (IAS), which were recently adopted, pension liabilities must be valued at market interest rates, and, if they are larger than fund assets, the difference must be posted to the corporate balance sheet as a liability. You have been asked to invest in bonds in such a way as to avoid this happening. Answer the following questions about your investment strategy.
Pension Fund Asset/Liability Position Value ($1 million) Pension assets Bonds Equities Pension liabilities Surplus 120 80 40 110 10 Modified duration (years) 6 7 4 12

(a)

(b)

Assume that the amount of future pension benefits is fixed in nominal terms and that you want to maintain a surplus even if there is a movement in interest rates that causes a change in the liability. You may also assume for the following questions that interest-rate movement is parallel and that the convexity effect can be ignored. (i) If you keep your current asset mix, how many percentage points up or down will interest rates need to move before the surplus is negative? (ii) You want to keep the current asset mix ($80 million in bonds, $40 million in equities), but change the composition of the bond portion so that the current surplus is maintained even if interest rates move. How many years should the bonds modified duration be? (iii) If you put all of your assets into bonds, what modified duration will enable you to maintain the current surplus even if interest rates move? (iv) Referring to the previous two cases, i.e. (a)(ii) and (a)(iii), discuss the pros and cons of lengthening the duration of your bond investments. Pension benefit amounts will be usually indexed to inflation, and you need to take this factor into account in valuing pension liabilities and in managing bond portfolios. (i) Assume the kind of investments described in Question (a)(iii). If there is inflation, what effect will it have on assets and liabilities and on the surplus? (ii) If pension benefit amounts are indexed to inflation, what discount rate should you use to value liabilities? (iii) Discuss the kind of bonds you should invest in if pension benefit amounts are indexed to inflation.

(3 points)

(3 points) (3 points) (4 points)

(4 points) (4 points) (4 points)

ACIIA: June 2000

Exam Guide

Question 3: Derivative Valuation and Analysis (25 points) You are currently managing a well-diversified stock portfolio with a beta of 1.2 on the TOPIX* index of Tokyo Stock Exchange stock prices. The TOPIX is now at 1600, oneyear (riskless) interest is 3%, and the aggregate market value of your portfolio is 16 billion. Ignoring dividends, answer the following questions. (Where calculations are necessary, include the calculations clearly in your answer sheet.)
*TOPIX: The weighted average stock price index of all TSE 1st Section listed stocks.

(a) (b)

Given a TOPIX value of T one year from now, what will be the Value V of your portfolio at this time? Express V as a function of T. (i) Assume the prices and deltas of a put option on the TOPIX with one year to maturity are as follows:
Exercise Price Put Price Delta 1600 72.8 0.393 1608 76.3 0.406 1616 80 0.419 1624 83.3 0.431 1632 87.6 0.444 1640 91.6 0.457 1648 95.7 0.470

(4 points)

(c)

Depending on the TOPIX value one year hence, your portfolio may suffer a loss and you have thought of hedging with a purchase of puts capable of maintaining the minimum portfolio value (before put premium, of 16 billion). Assuming that one TOPIX option corresponds to an amount 10,000 times that of the index, how many puts should you buy at what exercise price? (ii) How much will this hedge cost? Since it is difficult to buy puts with one year to maturity on the market, you think of achieving the same results as in Question 2 by using futures for dynamic hedging. (i) Assuming that one-month (risk-free) interest is now 3% (at an annual rate) and that the TOPIX futures with one month to maturity are at their theoretical price, how many futures should you sell for the purpose of dynamic hedging? Assume that the trading unit of the TOPIX futures is 10,000 times the index and that the amount corresponding to the costs required for the puts purchased in Question 2 is invested at the risk-free interest rate. (ii) Assume that immediately afterwards, stock prices rise and TOPIX hits 1632. Now how many futures should you sell in order to effect dynamic hedging? The prices and deltas of a put with one year to maturity when TOPIX is at 1632 are as follows: (iii) The put prices and deltas given in the table for Question (c)(ii) above are the figures given an estimated volatility of 15%. Explain what the results of dynamic hedging would be if volatility were actually greater than 15% and TOPIX fell.

(5 points) (2 points)

(5 points)

(5 points)

(4 points)

ACIIA: June 2000

Exam Guide

Question 4: Derivative Valuation (35 points) The date is 20 April. You are a stockbroker at a large Australian firm and specialise in dealing in derivative markets. As part of your daily routine, you discuss a range of opportunities and strategies with clients. (a) You take a call from an investor who has decided to set up a buy/write fund, which is not allowed to gear/lever. Her strategy is to buy and always hold BHP shares and write options against the holding. She also states that the fund will earn over 20% per annum over the next year with no risk of loss. (i) What type of option trades would the investor seek to enter into, given that she is already holding BHP shares? Buy/sell, puts/calls or both? Justify your answer. (ii) Discuss the investors comment as to no risk of loss with reference to what assumptions would be required to make this statement true and what will generate the return from the strategy. (iii) Outline a strategy that would give a similar result to that outlined above but using different types of options and underlying security. (b) Your next call is from the Head of Asset Allocation at a fund manager. She tells you that they expect the equity market to be extremely volatile over the next three months and that she thinks there is an equal chance of either a 15% rise or fall over the period. (i) Using the following data, suggest an option strategy that would suit the managers view. Draw a payoff diagram that will graphically demonstrate the outcome of the strategy at maturity for various levels of the All Ordinaries Index1 (include break-even points and maximum profit/loss). Current all 2610 June SPI 2626
June SPI Calls Strike 2450 2600 2750 Bid price 210 120 55 Ask price 220 130 65 Strike price 2450 2600 2700 June SPI Puts Bid price 50 110 205 Ask price 60 120 215

(3 points)

(3 points) (3 points)

(6 points)

(ii)

Assume that the manager only wanted to protect $10 million of her portfolio against a fall in the market over the long term. What additional information do you require to calculate the number of options contracts required to implement the strategy? (3 points)

1. The All Ordinaries Share Price Index (SPI) also referred as the All Ordinaries is the predominate measure of the overall performance of the Australian sharemarket at any point in time. It is made up of shares of approximately 250 of the largest Australian companies on ASX, weighted according to each companys size in term of market capitalization.

ACIIA: June 2000

Exam Guide

(c)

Your next call is from a trader of options who has a number of different options positions open. She is about to go on four weeks holiday and asks for your opinion on her Newscorp positions and if any action needs to be taken prior to departing for the South Pole.
Long/ Short Number 10,000 15 15 Security Newscorp Ordinary Newscorp June $9.00 Newscorp April $9.50 Price 9.5 0.24 0.5 0.3 0.5 Moderate High Moderate High Options Delta Option Gamma Option Theta

Short Short Long

(i)

(d)

What is the effective exposure to underlying Newscorp shares? (Assume 1000 shares per option contract.) Show your calculations. (4 points) (ii) Assume that Newscorp shares move sharply higher overnight. How would your answer to (c)(i) above change and why? (Calculations are not required.) (3 points) (iii) You notice that the implied volatility of Newscorp options is currently very high, which is at odds with your view that the share price will stay at the same level over the next three months. Suggest a course of action (along with reasons) to the trader that would hedge the portfolio to unexpected price moves in Newscorp over the period of absence. Use only the type of securities currently represented in the portfolio. (4 points) You notice that take-over activity in the equity market has become a current theme affecting stock prices. Outline how implied volatility would compare to historical volatility in Western Mining options in the following scenarios. Give reasons why. (i) (ii) A strong market rumour suggests an offer is imminent, but is not formally announced. A cash offer, which is expected to succeed, is announced at a price significantly above current market levels. (3 points) (3 points)

ACIIA: June 2000

Exam Guide

Question 5: Portfolio Management (33 points) You are a consultant to a big institutional client. He shows you the brochure of a product with the title Invest your money in stocks but sleep well! which he has got from his bank. The product has the following characteristics:
maturity: payoff at maturity date: 1 3 years C, if Imd < Isd I I C 1 + md sd P1 , if Imd Isd Isd

where: C = invested capital (in USD), minimum: 10 Mio. USD Isd = Index level at starting date Imd = Index level at maturity date Index = S&P500 P 1 = positive number, determined at starting date The client can chose the maturity according to his preferences and the parameter P1 is determined by the bank. (a) Explain to your client the characteristics of this product. Sketch the payoff diagram indicating every level and slope. Describe to your client how the portfolio manager could implement this strategy. Illustrate your description with the special case where the manager should not use any stocks or future, under the assumption that all other necessary assets are available. (b) The client wants to know the meaning of the parameter P1 and which market parameters or other parameters determine its value. Explain this to him in detail. The bank also offers another product with the following payoff:
C, if Imd < Isd payoff at maturity date: I I C 1 + md sd P2 Isd , if I I I sd md max I I C 1 + max sd P2 Isd , if I > I md max

(9 points) (6 points)

(c)

(d)

(e)

where: Imax = certain Index level (determined at issue date) with Imax > Isd P2 = positive number, determined at starting date Explain to your client the characteristics of this product and how they differ from those of the first product. Sketch the payoff diagram indicating every meaningful level and slope. Describe how the portfolio manager could implement this strategy. What can you say about the parameters P1 and P2 in both the products (qualitatively)? Do you expect them to be equal or not? If yes, explain why: if not, indicate which of the two you expect to be higher and why. Does the level of Imax have any impact on P2? Justify your answer.

(9 points)

(6 points) (3 points)

ACIIA: June 2000

Exam Guide

Question 6: Portfolio Management (21 points) Pension Fund Z currently allocates its equity investments to three active managers (Companies A, B, and C) and one passive manager (Company P).
Manager Style Alpha (a) Standard deviation of tracking error(s) 10.0% 8.0% 5.0% 0.0% IR Current allocation 0.2 0.2 0.1 0.5

A B C P

Active Active Active Passive

2.0% 1.6% 0.5% 0.0%

0.20 0.20 0.10

The alpha ( ) column in the table indicates the expected excess return of the fund (i.e. the return earned by the fund minus the benchmark return); indicates the standard deviation of excess return; and IR is an abbreviation for Information Ratio, which is defined as /. The formulas below give the theoretical allocation to each manager, assuming that there is no correlation between the excess return and benchmark return for any of the funds and that excess returns of individual funds are mutually independent. Allocation to active manager: Allocation to passive manager: i xi =

IR i 2 i

Note that is a parameter indicating the degree of risk tolerance given for each investor. Answer the following questions with reference to the information above. Pension Fund Z thinks that the stock market has been fairly efficient so far. It had previously decided on a 0.5 allocation to the passive component, but has reviewed its policy and now wishes to change its allocations between active and passive managers based on the theoretical formulas shown above. (a) It is often said that the passive investment component should be increased the more efficient the market is. Why is this so? Explain by using the theoretical formulas above. (b) Pension Fund Zs degree of risk tolerance is estimated at 20. Find the optimal allocation ratios for each fund, assuming the excess returns of individual active funds to be mutually independent. (c) The actual correlation between the excess returns of A and B was positive since they had similar investment styles. How would this change optimum allocation ratios to individual managers (A, B, C, and P) from what they were in (b) above? (d) The a and s for each fund are estimated based on past performance, but there may be some problems raising allocation ratios based on these numbers. Explain why that is.

P x p = 1 ix i

(5 points)

(6 points)

(5 points) (5 points)

ACIIA: June 2000

Exam Guide

Question 7: Portfolio Management (8 points) As a portfolio manager you decide to answer a request for a proposal by a pension fund. Its committee, responsible for the asset allocation, needs passive management relative to the following benchmark: 50 % SMI (Swiss Market Index / 23 stocks) 50 % MSCI Europe ex Switzerland (multi-country Index / 524 stocks / 21 countries) Assume that the pension fund portfolio will be measured against its benchmark on a monthly basis. What is the main problem you will face when indexing this portfolio in the long run? What potential negative impact do you expect and what positive effects, if any, could you exploit? (8 points) Question 8: Portfolio Management (20 points) You have divided the market in 4 portfolios following 2 dimensions: Value/Growth and Small/Large. The weight of each portfolio in the index is given. The risk free rate is 2%. Furthermore, you have designed the following model:
Portfolios Weight Sensitivity to Factor I (Market beta) 0.85 0.95 0.9 1.1 8% Sensitivity to Factor II (Price/Book) 0.8 1.3 2 3 2% Sensitivity to Factor III (Average capitalisation) 1 1 8 10 0.10%

Small value Small growth Large value Large growth Risk premium

5% 5% 40% 50%

(a) (b) (c) (d)

When using the APT, which portfolio has the highest expected return? Show your calculations. Using the APT, what is the expected return of the market and how does it compare with the returns of the other 4 portfolios? One of your competitors uses the CAPM. Based on the betas above, which portfolio will he choose to maximise his expected return? In order to diversify his perceived risk, another competitor wants to combine the Small Value and the Large Growth Portfolios. The new portfolio should have an overall sensitivity to Factor I (market beta) of 1. Show how much the competitor must invest in Small Value and how much in Large Growth. The portfolio must be fully invested and without any short sale.

(8 points) (4 points) (4 points)

(4 points)

10

ACIIA: June 2000

Exam Guide

Question number
1

Database references
BV o 11 IIMR Fi-Fo 3.

CKB references
Bond valuation and analysis

2.2.5.1 Spot rates 2.2.5.3 Forward rates 2.4.1 2.5.2 2 BV o 3 SAAJ Fi 3. 2.4.3 2.5.2 3 DV o 2 SAAJ Fo-Fi 4. 2.1 2.1.5 4 DV o 11 SIA Fi 4. 2.2 2.2.6 5 PM o 60 TCIP Fi 1. 4.3 4.2.2 6 PM o 3 SAAJ Fi 1. 4.1 4.1.1 4.1.2 4.1.3 7 PM o 56 TCIP Fi 1. 5.1 5.1.3 8 PM o 52 TCIP Fi 1. 1.5 1.5.4 Basic price/yield relationship Duration and modified duration Bond valuation and analysis Valuation of coupon bonds Duration and modified duration Derivatives valuation and analysis Futures Hedging strategies Derivatives valuation and analysis Options Options strategies Portfolio management Derivatives in portfolio management Portfolio insurance Portfolio management Managing an equity portfolio Active management Passive management Combined strategies Portfolio management Performance measurement and evaluation Relative investment performance Portfolio management Arbitrage pricing theory Arbitrage pricing theory

5.1.3.2 Indices and benchmarks

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