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Sample Paper CT8 Financial Economics

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Please note: The material of the sample papers are the collection of the questions from the IAI/IOA exams based on our analysis. Actuarial Answers is not declaring/saying anywhere that this is the product created by Actuarial Answers. There is every possibility that students will find the questions of this sample paper in past year IAI/IOA exams

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Sample Paper - CT8 Financial Economics

Our Analysis
After analyzing the IAI CT8 examinations of last 7 years, we have identified some trends which could help candidates in preparing for this exam in a better manner. As the result of CT8 exam in the last attempt is 18%, we believe there is a need to identify the more important sections where paying more attention from students can help them in cracking the exam. Below graphs indicate the chapter wise-weightage for CT8 papers historically:
30.00% 27.50% 25.00% 22.50% 20.00% 17.50% 15.00% 12.50% 10.00% 7.50% 5.00% 2.50% 0.00% 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Chapters

May2011 May2010 Nov2010 May2009 Nov2009 May2008 Nov2008 May2007

Exam weightage Exam weightage

14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Chapters Last 5 years IAI exams Last 7 years IAI exams

Keeping this in mind, we have developed this paper from the most appearing chapters, i.e. Chapter 5 Chapter 11 Chapter 12 Chapter 15 This will help you do targeted revision for the upcoming examinations. Its recommended though that you do revise for other chapters also, but focusing on this paper will help you get the maximum ROI on your effort

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Sample Paper - CT8 Financial Economics

SAMPLE PAPER I
Max. Marks: 100 Time Allotted: 3 hours Note: Use of Scientific Calculators & Actuarial Tables is allowed Q.1 (i) Describe the forward rate F (t,T,S). (2)

You are the head of the portfolio risk management department of your company. Your investment team has subscribed to fresh issue of two uncorrelated bonds as follows: INR 1 million face value of an A3 rated bond, Annual coupon 10% per annum (with annual compounding), Term 4 years INR 1 million face value of a B2 rated bond, Annual coupon 15% per annum (with annual compounding), Term 4 years These are the only two bonds in the portfolio. The investment department provided the following rating specific rates F(0,1,S). Rates are quoted at per annum with continuous compounding.

(ii) Assuming there are no rating changes during the year and the investment department believes that at the end of the first year F(1,1,S) = F(0,1,S) , calculate the expected value of the portfolio at the end of the first year just before the first coupon payment. (4) [6] Q.2 (i) State the expression for the delta of a call option on a non-dividend paying stock. Define all terms used. (2) You are a long term investor and hold 1,000 units of a non-dividend paying stock in your portfolio. You have observed that the markets are excessively volatile during the cricket world cup. (ii) When are stock prices considered to be excessively volatile? (2)

The stock is priced at 100 and the price of a 6 month at-the-money European call option on the stock is 9.1990.

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Sample Paper - CT8 Financial Economics

(iii) Calculate the implied volatility to 0.5% of accuracy if the risk free force of interest is 6% per annum (with continuous compounding). (6) Long term outlook of the stock you hold remains stable during this period. (iv) Construct a delta neutral portfolio using 6 month call options on the stock to benefit from excessive volatility? Describe the challenge you will face in maintaining a delta neutral portfolio. (5) The volatility reaches its long term mean level of 10% after a month and you unwind your derivative positions. The interest rates and stock price remains the same. (v) Assuming that you unwind the position after one month, calculate the profit made assuming you do not perform further trades after constructing the delta neutral portfolio in (iv). State the assumptions made. (5) [20] Q.3 Consider a three-period binomial model for a non-dividend paying stock whose current price is 100. You buy a special option on the stock that pays 10 units of cash if the spot price of the stock is either more than 120 or less than 90 at maturity. Assume that: Risk free force of interest is 5% per period (with continuous compounding) Over each period the stock price can either move up by a factor of 1.1 or go down by a factor of 0.9 Prove that the market is arbitrage free and derive the price of the option. [7] Q.4 (i) Describe three key assumptions underlying the empirical verification of the validity of the CAPM. (3) (ii) In the context of the CAPM discuss the concept of systematic risk for a risky security. (3) (iii) You are given the following historical information for a share in ABC company and for a portfolio of 100 shares:

Under which conditions, the figures in the above table are consistent with the CAPM. (3)

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Sample Paper - CT8 Financial Economics

(iv) A student has commented that ABC s lower return and higher standard deviation, relative to the 100 share portfolio, contradicts the predictions of the CAPM. Discuss the students comment. (3) [12] Q.5 Assume that the Black-Scholes framework holds. A non dividend paying share is currently priced at Rs 100 and the volatility implied by one year term to maturity option on the share is 10%. The force of interest is 5%. A long call strip option trading strategy involves buying a series of call options with rising strike prices for the same term to expiry on the same underlying. You are a speculator and you want to implement this strategy by buying four call options with one year term to maturity on the share. The strike price on these options is 100%, 105%, 110% and 120% of the shares current price (i) Calculate the maximum loss you can incur if you implement this strategy? Ignore trading expenses. (6) (ii) What is the maximum profit you can make through this strategy? (2) (iii) Calculate the overall profit/loss at maturity given that You borrowed money from a friend at 10% per annum simple to execute the strategy, You hold all the options to maturity, and You know that the share price at maturity is Rs 112.5 (3) (iv) What opinion concerning the share price would you have, to adopt this strategy? (2) [13] Q.6 You are the head of analytics at an investment bank. You observe that the shape of the yield curve implied by the market price of government bonds follows a humped curve. You choose the following model for instantaneous forward rate f(t,T) f (t,T) = Long Rate + (Shape Factor I)*0.5(T-t) + (Shape Factor II)*0.52(T-t) You observe the following prices for government bonds Term to maturity Price (100 Nominal) 3 months 98.20745 2 Years 78.08764 10 Years 33.02450 (i) Calculate the missing parameters in the model such that it reproduces the prices of the zero coupon government bonds. (8)

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Sample Paper - CT8 Financial Economics

(ii) Prove that the fair price rounded to two decimal places of a 3 year zero coupon government bond based on the above formulation is 68.73 per 100 nominal? (2) [10] Q.7 The fund manager of Alpha Asset Management Company Limited has a welldiversified portfolio that mirrors the performance of the BSE-SENSEX and is worth 8000 crores. The current value of the SENSEX is 16000 points. The fund manager would like to hedge the risk against a reduction of more than 10% in the value of the portfolio over the next six months. The risk free rate of interest is 6% per annum (with continuous compounding) and the volatility of the SENSEX is 25% per annum (with continuous compounding). (i) What would the hedging cost be if the fund manager decides to hedge the risk using traded European put options on BSE-SENSEX? (6) (ii) What are the alternate strategies available to the fund manager using traded European call options on BSE-SENSEX? Show that this strategy leads to the same result as strategy used in part (a) (4) (iii) If the fund manager decides to hedge the risk by keeping part of the portfolio in the risk free securities, what should the initial position be? (3) [13] Q.8 A stock price is currently at Rs.100. Over the next two three-month periods it is expected to go up by 4% or down by 3%. The risk free rate of interest is 6% per annum with continuous compounding. (i) What is the value of a six-month European call option with a strike price of Rs.102? (3) (ii) What is the value of a six-month European put option with a strike price of Rs.102? (2) (iii) Verify that the European call and European put prices satisfy the put-call parity. (2) (iv) If the put option in part (b) were American, would it be ever be optimal to exercise it early at any of the nodes on the tree? (3) [10] Q.9 What is the market price of risk under CAPM? Define all the terms you use. (2) With discovery of water on moon, three countries have set up colonies on it. Investment market on moon is in its nascent stage and investors have only three risky assets to

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Sample Paper - CT8 Financial Economics

choose from. The annual returns from these three assets are as in the table below depending on which country manages to send more settlers:

India has a distinct cost advantage. The respective probabilities of three different scenarios are as follows:

Annual rate of return on Moons government bond stands at 20% pa for all terms. (ii) Calculate the market price of risk for Moons investment market.

(4) [6]

Q.10 Use a 2-step binomial tree to calculate the price of a European put option on a non-dividend-paying share. The following parameters are given: Current Share price: 50 Strike price: 55 Risk free rate: 10% p.a. (continuously compounding) Time to maturity: 2 months Upward or downward move over a month: 10% Probability of upward move over a month: 25% [3]

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Sample Paper - CT8 Financial Economics

Evaluation
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