PaperlD:00104

THE UNIVERSITY OF NEW SOUTH WALES

SEMESTER 2 2014

ACTL5303 / ACTL4303: ASSET-LIABILITY MANAGEMENT

FINAL EXAMINATION

1) TIME ALLOWED - 2 HOURS.

2) READING TIM E -10 MINUTES

3) THIS EXAMINATION PAPER HAS 6 PAGES

4) TOTAL NUMBER OF QUESTIONS 5

5) TOTAL MARKS AVAILABLE-100

6) ALL QUESTIONS ARE NOT OF EQUAL VALUE . MARKS AVAILABLE FOR EACH QUESTION ARE SHOWN IN THE
EXAMINATION PAPER

7) ALL ANSWERS MUST BE WRITTEN IN INK. EXCEPT WHERE THEY ARE EXPRESSLY REQUIRED, PENCILS MAY
BE USED ONLY FOR DRAWING, SKETCHING OR GRAPHICAL WORK

8) THE PAPER MAY BE RETAINED BY THE CANDIDATE.

9) CANDIDATES MAY BRING THEIR OWN CALCULATORS. CALCULATORS MUST BE HAND-HELD, INTERNALLY
POWERED AND SILENT, ANY PROGRAMMABLE MEMORY MUST BE CLEARED ~ UNSW approved..

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Question 1: (25 marks]
You are an asset consultant to an industry superannuation fund that is currently
reviewing how it balances alpha (active management) and beta (market) risk in its
investment policy. The Chair of the Investment Committee associates the idea of market
risk premiums with the CAPM. Some of the client relationship_ people employed by the
Fund's investment managers have told her CAPM has long been discredited as an
isolated theory depending on unrealistic assumptions. They have also asserted that it is
wide ly contradicted by empirical evidence. The Chair has therefore been convinced that
the Fund should swing its emphasis to pure alpha strategies, such as he·dge funds, rather
than relying on market risk premiums. The Fund has recently appointed a Chief
Investment Officer who was a finance academic in the early part of his career. He is
firmly of the view that markets are efficient and that the fund should convert all public
markets investments to passive, and definitely avoid any futile pursuit of alpha. The
Investment Committee is terribly confused by the conflicting views.

(a) The CEO of the Fund has asked you to write a brief paper for the Investment
Committee to help his senior investment people find some common ground. Provide
a draft of your response in which you should address the criticisms made of the
CAPM, the concepts of market efficiency with reference to studies of market
·anomalies and behavioural finance explanations, and the related question of passive
management.

[15 marks]

(b) Having established the respect of the new CIO, he shows you some preliminary
modelling he has been doing to estimate the likelihood of investment options
meeting objectives over medium term time frames (7-10 years). He has modelled
Australian equities as a submartingale, whereby log returns are independent and
identically distributed normal. He has attempted to validate the strategic asset
·allocations of the fund's investment options using Markowitz optimisation and
historical return data, but is finding the framework very unstable. Comment on the
suitability of the equity model for the horizon he is interested in and include some
suggestions on how he might improve the stability of his portfolio optimisation
framework.

[10 marks]

Q2 OVER PAGE

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Question 2: [18 marks]
A closed defined contribution fund has a substantial direct property weighting of 40% of
tota l assets ($200m of $500m}, half of which is overseas property with the currency
hedged back to Australian dollars. It believes the steady returns of property are
attractive to its workforce, a large proportion of which are nearing retirement. The fund
is considering a new property investment of a 20,000 sq m block of land in a semi-rural
area, zoned light industrial. The property last changed hands 5 years ago for $Sm when
the area was without water and electricity. Since then a small industrial park has been
developed on half of the block, with the other half as yet undeveloped. The industrial
park draws gross rent of $900,000 with outgoings of $100,000. The cost of current
improvements (basic warehouse and parking) was $4.0m and a similar improvement
would cost about the same today. The market capitalisation rate for comparable
properties is 8%. There is firm demand for industrial space in the area, which is
positioned close to road and rail.

(a) Provide an approximate valuation of the property and estimate its impact on the
total property weighting of the fund, assuming no other property is sold.

[6 marks]

(b) The Investment Committee is considering funding the acquisition and slightly
reducing its overall property weighting by disposing of a problematic property. This
property is a small regional retail centre in the mid-West of the US, leased to
specialist retailers. The centre has been experiencing high vacancies due to
competition from a new rival mall in a nearby area, and the property manager is
concerned about the potential for a sharp reduction in valuation. A US property
consultant has suggested buying a put option to protect the value at a strike 5%
below the current valuation {$30m), and with a one year expiry. Over that period the
intention would be to find a buyer at a price above the strike, although that could be
challenging. Two quotes have been obtained for the put premium. The first is from a
small regional investment bank that specialises in equity derivatives. The second
quote is from a large US pension fund with consid erable property expertise and an
expanding portfolio. The premium quoted by the investment bank is 4% of current
valuation {$1.2m) versus 5% from the pension fund ($1.Sm). The property consultant
has suggested another alternative, which is to sell the property to a cooperative of
existing tenants, with the finance for the sale {100% loan to value at the current
valuation) to be provided by the fund. The interest income would be comparable to
current net rental income. The fund CEO likes this option because it converts the
asset to debt and reshapes the funds asset allocation to be better diversified.
Provide an evaluation of the alternatives, focussing on the risks involved and give a
recommendation based on your analysis.

[12 marks]

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Question 3: [18 marks]

(a) Descri be how a regim e swit ch ing model works.

[6 marks]

(b) You are employed as an investment strategist for a fund . Your Chief Investment
Officer is concerned that at some point over the next decade there could be a supply
side shock to the global economy due to food and water shortages, possibly
aggravated by climate change. This would be inflationary. He would like to explore
his idea using a regime switching model with two inflation scenarios - one tame, and
one subject to this supply side shock. He has asked you to consider how bonds,
equities, property and currency might perform under such a scenario, relative to the
base case of moderate inflation. Discuss what you expect and give reasons why?

[12 marks]

Question 4: [23 marks]

(a) An equity investment manager has described itself as a 'value manager'. Explain
what this means Discuss the potential risks in seeking out 'cheap' stocks and how
might these be avoided.

[10 marks]

(b) The fund has asked you to take a closer look at its active equity manager
configuration. It currently employs a passive manager and three active managers:

The table below summarises performance expectations, active risk targets and the
current allocation .

Allocation Net Alph a Trackin g Error

Value 30% 1.6% 4%
Growth 30% 1.6% 4%
Core 15% 1.25% 2.5%
Passive 25% 0.0% 0.0%
Total 100% 1.15% 1.74

The fund wants to maximize the expected composite information ratio (currently
0.66) subject to the tracking error of the composite not exceeding 2%. Ignoring any
correlation across active returns, determine an efficient allocation across
managers. Show all your calculations.

[7 marks]

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 (c) During the initial due diligence process the fund's Chief Investment Officer requested
details of each manager's investment universe, and their internal stock rankings over
time, which correlated very highly with the performance of stocks in their respective
universes. Based on this analysis he initially anticipated much higher information
ratios, but his expectations have been modified by experience. He was also
meticulous in carefully specifyi ng investment mandates with a range of risk controls.
Explain why you think outcomes have been less than expected.

[6 marks]

Question 5: [16 marks]

You work for a life office that has a large book of annuity business. The investment
policy is to tolerate a degree of asset-liability mismatch, and the office is investigating
the potential for that mismatch to be problematic. Central to the asset-liability model
will be a realistic simulation of the bond market as this will drive the liability valuation
over time and also the performance of fixed interest investments. An analyst has put
together some background data on the bond market. He has observed that over the last
twenty years the Reserve Banks's inflation target has been constant at 2-3%pa,
although it took a little while to be acknowledged. By the mid-1990s inflation targeting
had gained credibility with the bond market. Since the global financial crisis of 2008
global bond yields have been driven lower by aggressive central bank intervention
particularly in the US. The chart below shows the history of Australia's bank bill and ten
year bond yields over the last twenty years and the spread between them.

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 Australian Bank Bill and Bond Yields
12 .,
'
10
Spread - - Bank Bills - Ten Year Bond
8

6
*-
32
.9:!
>- 4

·2 .J..___ --·-···-·

Jun-1994 Jun-1999 Jun-2004 Jun-2009 Jun-2014

The analyst has suggested simulating the yield curve through time by generating
independent log normally distributed random variables. Using the previous month's
average yield on the bond index, and the bond index duration he could then reverse
out the implied parallel shift in the yield curve that generated the simulated return.
The index average yield through time would be updated by adding the calculated
yield change. The system he proposes is:

log(Rt) - i. i. d N(µ, CT)

~y = (Rt - Yt- 1 /12)/(Index Duration)

Yt = Yt-1 + ~y
The full yield curve would be determined by generating a random variable for yield
curve slope (i.i.d), based on the historical distribution of yield curve slopes and
combining that with the index yield level.

Evaluate his approach, commenting in particular on how realistic his simulations of

the yield curve are likely to be, assuming calibration is based on this data sample. In
your answer explain how the yield curve evolves over time in response to the
changing financial environment.

[16 marks]

END OF PAPER