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You are on page 1of 172

Institute of Actuaries

EXAMINATION

28 April 2010 (am)

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1.

Enter all the candidate and examination details as requested on the front of your answer

booklet.

2.

You must not start writing your answers in the booklet until instructed to do so by the

supervisor.

3.

4.

Attempt all nine questions, beginning your answer to each question on a separate

sheet.

5.

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this

question paper.

In addition to this paper you should have available the 2002 edition of the Formulae

and Tables and your own electronic calculator from the approved list.

CT8 A2010

Faculty of Actuaries

Institute of Actuaries

t

X t = X 0 + s ds + s dWs

where W is a standard Brownian motion.

Let f : be a function, twice partially differentiable with respect to x, once

with respect to t.

(i)

[2]

Let dX t = X t dt + dWt .

(ii)

Prove that the solution of this stochastic differential equation is given by:

t

[6]

[Total 8]

Consider a stock paying a dividend at a rate and denote its price at any time t by St .

The dividend earned between t and T, T t, is St (e(T t ) 1) .

Let Ct and Pt be the price at time t of a European call option and European put option

respectively, written on the stock S, with strike price K and maturity T t . The

instantaneous risk-free rate is denoted by r.

Prove put-call parity in this context by adapting the proof of standard put-call parity

that applies to put and call options on a non-dividend paying stock.

[8]

CT8 A20102

Consider a two-period binomial model for a non-dividend paying stock whose current

price is S0 = 100. Assume that:

over each six-month period, the stock price can either move up by a factor u = 1.2

or down by a factor d = 0.8

(i)

(a)

(b)

Construct the binomial tree.

[2]

(ii)

Calculate the price of a standard European call option written on the stock S

[5]

with strike price K = 100 and maturity one year.

Consider a special type of call option with strike price K = 100 and maturity one

year. The underlying asset for this special option is the average price of the stock

over one year, calculated as the average of the prices at times 0, 0.5 and 1 measured in

years.

(iii)

Calculate the initial price of this call option assuming it can be exercised only

at time 1.

[5]

[Total 12]

Consider the following stochastic differential equation for the instantaneous risk free

rate (also referred to as the short-rate):

dr (t ) = a ( b r (t ) ) dt + dWt

t

0

T

r ( u )du = b (T t ) + ( r (t ) b )

t

1 exp ( a (T t ) )

a

+ 1 exp ( a (T s ) ) dWs

a

(i)

[10]

(ii)

(a)

(b)

model for the short-rate that is not subject to the drawback.

[2]

[Total 12]

CT8 A20103

A European call option on a stock has an exercise date one year away and a strike

price of 320p. The underlying stock has a current price of 350p. The option is priced

at 52.73p. The continuously compounded risk-free interest rate is 4% p.a.

(i)

Estimate the stock price volatility to within 0.5% p.a. assuming the BlackScholes model applies.

[5]

A new derivative security has just been written on the underlying stock. This will pay

a random amount D in one years time, where D is 100 times the terminal value of the

call option capped at 1p (i.e. 100 times the lesser of the terminal value and 1p).

(ii)

(a)

State the payoff for this derivative security in terms of two European

call options.

(b)

[5]

(iii)

Calculate the risk neutral probability that the stock price is greater than 320p.

[4]

[Total 14]

(i)

Describe the-two state model for credit ratings under the real world measure.

[9]

(ii)

model.

[3]

[Total 12]

(i)

(ii)

standard Brownian Motion.

[3]

[3]

St = S0 exp(0.2Bt + 0.2t), where B is a standard Brownian Motion under the

real-world measure.

A derivative security written on this stock in the same market has price:

Dt = 2exp(0.6Bt + 0.39t) at time t.

(iii)

(a)

Motion under the Equivalent Martingale Measure.

(b)

[8]

[Total 14]

CT8 A20104

Outline the main points you would make in a discussion of the statement:

The efficient markets hypothesis states that the market price is always correct and

therefore it is not possible for investors to make money from investing in shares.

[10]

An asset is worth 100 at the start of the year and is funded by a senior loan and a

junior loan of 50 each. The loans are due to be repaid at the end of the year; the

senior one with interest at 6% p.a. and the junior one with interest of at 8% p.a.

Interest is paid on the loans only if the asset sustains no losses.

Any losses of up to 50 sustained by the asset reduce the amount returned to the

investor in the junior loan by the amount of the loss. Any losses of more than 50

mean that the investor in the junior loan gets 0 and the amount returned to the investor

in the senior loan is reduced by the excess of the loss over 50.

The probability that the asset sustains a loss is 0.25. The size of a loss, L, if there is

one, follows a uniform distribution between 0 and 100.

(i)

(ii)

Calculate the variances of return for the investors in the junior and senior

loans.

[8]

Calculate the shortfall probabilities for the investors in the junior and senior

loans, using the full return of the amounts of the loans as the respective

benchmarks.

[2]

[Total 10]

END OF PAPER

CT8 A20105

Faculty of Actuaries

Institute of Actuaries

EXAMINERS REPORT

April 2010 examinations

Core Technical

Introduction

The attached subject report has been written by the Principal Examiner with the aim of

helping candidates. The questions and comments are based around Core Reading as the

interpretation of the syllabus to which the examiners are working. They have however given

credit for any alternative approach or interpretation which they consider to be reasonable.

R D Muckart

Chairman of the Board of Examiners

July 2010

Faculty of Actuaries

Institute of Actuaries

Subject CT8 (Financial Economics Core Technical) April 2010 Examiners Report

(i)

f (t , X t )

f (t , X t )

1 2 f (t , X t )

dt +

dX t +

( dX t )2

2

t

x

2

x

df (t , X t ) =

f (t , X t )

f (t , X t )

1 2 f (t , X t ) 2

dt +

t dt

( t dt + t dWt ) +

2

t

x

x 2

f (t , X t ) f (t , X t )

f (t , X t )

1 2 f (t , X t ) 2

=

+

t +

dt

+

t dWt

t

2

x

2

(ii)

Consider Xt = Ut et.

Then

dUt = d(et Xt) = et Xt dt + et dXt

= et Xt dt + et( Xt dt + dWt) = et dWt .

Thus

t

Ut = U0 + e s dWs

0

and consequently

Xt = e

Ut = X 0e

s t

+ e ( ) dWs

0

The proof of this result is an adaptation of that of the standard call-put parity. Two

(self-financing) portfolios are considered:

Portfolio A: buying the call and selling the put at time t. Its value at time t is

Pt Ct and at time T, it is ST K in all states of the universe.

ST K by taking into account the dividends which are paid continuously at rate

.

Page 2

Subject CT8 (Financial Economics Core Technical) April 2010 Examiners Report

Using the absence of arbitrage opportunity, both portfolios should have the same

value at any intermediate time, in particular at time t. Hence:

Ct Pt = St exp ( (T t ) ) K exp ( r (T t ) ) .

Another proof can include the following portfolios:

Portfolio A: At time t, buying a call option and lending K exp ( r (T t ) )

Portfolio B: At time t, buying the put option and buying one share.

(i)

There is no arbitrage in the market since d = 0.8 < exp(0.05) < u = 1.2.

(ii)

To price the call option, we use the risk-neutral pricing formula. We use the

following simplifying notation:

Cuu = u 2 S0 K

= 44;

Cud = ( udS0 K ) = 0;

Cdd = d 2 S0 K

= 0.

C1 ( u ) = exp ( r ) qCuu + (1 q ) Cud = 26.29 ,

and in the lower state

C1 ( d ) = exp(r ) qCud + (1 q ) Cdd = 0

where the risk-neutral probability of an upward move is

q=

exp ( r ) d

ud

= 0.628 .

At time 0,

C0 = exp ( r ) qC1 (u ) + (1 q ) C1 (d ) .

Hence

C0 = 15.71 .

Page 3

Subject CT8 (Financial Economics Core Technical) April 2010 Examiners Report

(iii)

For the special option, we need to compute the average for the different

possible trajectories, the probability of each path and the associated payoff:

trajectory

average

probability

up up

X uu = 121.33

q 2 = 0.394

X ud = 105.33 q (1 q ) = 0.234

up down

down up

X du = 92

down down

X dd = 81.33

(1 q ) q = 0.234

(1 q )2 = 0.138

payoff

of

the option

( X uu K )+ = 21.33

( X ud K )+ = 5.33

( X du K )+ = 0

( X dd K )+ = 0

X 0 = exp ( 2r ) q 2 ( X uu K ) + q (1 q ) ( X ud K )

(i)

) = 8.744 .

T

B (t , T ) = E exp r ( s )ds Ft .

Since

t

price of the zero-coupon bond in terms of the expected value and variance

T

(conditional) of

r ( u )du :

t

T

1 T

t

2 t

1 exp ( a (T t ) )

where E r ( s )ds Ft = b (T t ) + ( r ( t ) b )

and

a

t

T

2

2

2 2

V r ( s )ds Ft = 2 (T t ) 3 exp ( 2a (T t ) ) 1 + 3 exp ( a (T t ) ) 1 .

2a

a

t

a

(ii)

Main issue: possibility to have negative interest rates when using the Vasicek

model. An alternative is the CIR model:

dr (t ) = a ( b r (t ) ) dt + r ( t )dWt .

Page 4

Subject CT8 (Financial Economics Core Technical) April 2010 Examiners Report

(i)

Try = 40%. Black Sholes formula gives a price of p40 = 76.05.

Interpolating gives a trial value of

(76.05 52.73) / (76.05 44.05) * 10 + (52.73 44.05) / (76.05 44.05) * 40

= 20.2%.

Evaluating gives p20.2 = 52.96.

Interpolation with p40 give

= ((76.05 52.73) * 20.2 + (52.73 52.96) * 40) / (76.05 52.96) = 21.9%

(to the nearest .5%)

p21.9 = 54.75.

Actual answer is 20%.

(ii)

The payoff is

100min(1, max(ST 320,0)) = 100(max(ST 320,0) max(ST 321,0))

so is 100 times the difference between two call options with the corresponding

strikes.

Using the Black-Scholes formula, the price of the second call option is 52.06p

and hence the value of the derivative is p = 100 * (52.7352.06) = 67p.

(iii)

The option essentially pays 1 if the final security price is greater than 320p.

Thus its price is approximately erP(S1 > 320) (where P is the EMM).

So

P(S1 > 320) = e.04 * p = 0.70.

Other answers are also possible. In particular, using the distribution of

S

ln 1 and use it to calculate the probability directly.

S0

Page 5

Subject CT8 (Financial Economics Core Technical) April 2010 Examiners Report

(i)

A model can be set up, in continuous time, with two states N (not previously

defaulted) and D (previously defaulted). Under this simple model it is

assumed that the default-free interest rate term structure is deterministic with

r(t) = r for all t. If the transition intensity, under the real-world measure P,

from N to D at time t is denoted by (t), this model can be represented as:

No default, N

(t)

Default, D

If X(t) is the state at time t. The transition intensity, (t), can be interpreted as:

PrP(X(t + dt) = N | X(t) = N) = 1 (t) dt + o(dt)

PrP(X(t + dt) = D | X(t) = N) = (t) dt + o(dt)

as dt 0,

as dt 0.

T

= inf{t : X(t) = D} (with inf 0/ = )

and if N(t) is a counting process defined as:

0 if > t ,

N(t) =

1 if t.

Then can be interpreted as the time of default and N(t) can be interpreted is

the number of defaults up to and including time t.

It is assumed that if the corporate entity defaults all bond payments will be

reduced by a known, deterministic factor (1 ) where is the recovery rate,

i.e. for a zero-coupon bond which is due to pay 1 at time T, the actual

payment at time T will be 1 if > T and if T.

Page 6

Subject CT8 (Financial Economics Core Technical) April 2010 Examiners Report

P ( t , T ) = B ( t , T ) 1 (1 ) 1 exp s ds

Where P(t,T) is the price at time t of a risky zero-coupon bond and B(t,T) is

the price at time t of a risk-free zero-coupon bond.

(ii)

A more general and more realistic model with multiple credit ratings rather

than the simple default/no default model, used above was developed by

Jarrow, Lando and Turnbull. In this model there are n 1 credit ratings plus

default.

If the transition intensities, under the real-world measure P, from state i to

state j at time t are denoted by ij(t) where the ij(t) are assumed to be

deterministic then this model for default risk can be represented by the

following diagram:

2j(t)

2

12(t)

j2(t)

j,n-1(t)

n()

21(t)

n1

1n(t)

2n(t)

n-1,n(t)

n

In this n-state model transfer is possible between all states except for the

default state n, which is absorbing.

Page 7

Subject CT8 (Financial Economics Core Technical) April 2010 Examiners Report

(i)

Suppose that Zt is a standard Brownian motion under P . Furthermore

suppose that t is a previsible process. Then there exists a measure Q

t

0

under Q .

Conversely, if Zt is a standard Brownian motion under P and if Q is

equivalent to P then there exists a previsible process t such that

t

0

1 2

. This can be proved using two different approaches:

2

for showing all working correctly using one of the approaches below.

The answer is a =

(ii)

(iii)

(1)

Write the martingale condition and consider the expected value of the

process at time t, conditional on the filtration up to an earlier time s.

(2)

Write Itos formula for the function f(t,Bt) = exp(sigma Bt at), and set

the drift term equal to 0.

We know that ert St is a martingale under the EMM and so is ertDt. So,

setting Wt = Bt + ct we can write ert St = S0exp(0.2Wt (r + 0.2c 0.2)t) and

we require r + 0.2c 0.2 = 1/2(0.2)2 = 0.02.

Similarly, we can write ertDt = 2exp(0.6Wt (r + 0.6c 0.39)t) and we then

require r + 0.6c 0.39 = 1/2(0.6)2 = 0.18.

Eliminating r from these two equations gives

0.4c 0.19 = 0.16, or 0.4c = 0.35 so c = 0.875.

Substituting in the first equation gives r + 0.175 0.2 = 0.02 so r = 4.5%.

Page 8

EMH states that market fully reflects all available information and the implication

is therefore that investors are not able to make excess returns (rather than any

returns at all!).

historical price information, semi-strong for all public information and strong for

all information.

Subject CT8 (Financial Economics Core Technical) April 2010 Examiners Report

Reasonable to conclude the other way round as studies of directors share

dealings suggest that, even with inside information, it is difficult to out-perform.

difficult-to-obtain information enables profits but at a high cost of obtaining the

information.

Investors taking higher risks may earn higher returns this does not contradict the

EMH.

EMH does not specify how information is priced, so very difficult to test.

(i)

J = 54, with probability 0.75

= 0 with probability 0.25 * 0.5

= 50 * U with probability 0.25 * 0.5, where U is uniform over (0,1)

E[J] = 0.75 * 54 + 0.25 * 0.5 * 0 + 0.25 * 0.5 * 0.5 * 50 = 43.625

E[J2] = 0.75 * 542 + 0 + 0.25 * 0.5 * 502 * E[U2]

= 0.75 * 542 + 312.5 * (0.25 + 0.083) = 2291

Var[J] = 2291 43.6252 = 388

S = return to investor in senior loan

S = 53 with prob 0.75

= 50 with prob 0.25 * 0.5

= 50 * U with prob 0.25 * 0.5

E[S] = 0.75 * 53 + 0.125 * 50 + 0.125 * 50 * 0.5 = 49.125

E[S2] = 0.75 * 532 + 0.125 * 502 + 0.125 * 502/3 = 2523

Var[S] = 2523 49.1252 = 110

Page 9

Subject CT8 (Financial Economics Core Technical) April 2010 Examiners Report

Alternative answers:

The word return can be interpreted in different ways, leading to several

possible answers.

In the detailed solution above, it is total return.

If using percentage return, as a percentage, then

J = 0.08 with probability 0.75, 1 with probability 0.25 * 0.5 and U 1 with

probability 0.25 * 0.5 with U uniformly distributed over [0,1]

The expected value is then E(J) = 0.1275 and the variance is V(J) = 0.1552

S = 0.06 with probability 0.75, 0 with probability 0.25 * 0.5 and U 1 with

probability 0.25 * 0.5 with U uniformly distributed over [0,1].

The expected value is then E(S) = 0.0025 and the variance is V(S) = 0.0441.

(ii)

Pr(S < 50) = 0.125

Page 10

Faculty of Actuaries

Institute of Actuaries

EXAMINATION

8 October 2010 (am)

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1.

Enter all the candidate and examination details as requested on the front of your answer

booklet.

2.

You must not start writing your answers in the booklet until instructed to do so by the

supervisor.

3.

4.

Attempt all nine questions, beginning your answer to each question on a separate

sheet.

5.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this

question paper.

In addition to this paper you should have available the 2002 edition of the Formulae

and Tables and your own electronic calculator from the approved list.

CT8 S2010

Faculty of Actuaries

Institute of Actuaries

An investor holds an asset that produces a random rate of return, R, over the course of

a year. The distribution of this rate of return is a mixture of normal distributions,

i.e. R has a normal distribution with a mean of 0% and standard deviation of 10% with

probability 0.8 and a normal distribution with a mean of 30% and a standard deviation

of 10% with a probability of 0.2.

S is the normally distributed random rate of return on another asset that has the same

mean and variance as R.

(i)

(ii)

(a)

(b)

0%

a benchmark rate of return of 10%

[3]

[4]

(iii)

levels illustrate about the asset returns, by referring to the calculations in (i)

and (ii).

[3]

[Total 10]

(i)

(ii)

prices to events.

[4]

[Total 6]

[2]

Discuss whether one-factor models are good models for the short-rate of interest

(instantaneous risk free rate). Include discussion of extensions that may be

considered to improve the model. Illustrate your discussion by defining and referring

to particular models.

[10]

(i)

(a)

(b)

(c)

(ii)

give three examples of an outcome of a default

define the recovery rate

[7]

[4]

Two companies have zero coupon defaultable bonds in issue. Bond A has 2m

nominal in issue. Bond B has 3m nominal in issue. Both bonds redeem in exactly

2 years time.

Under a risk neutral measure, each bond defaults (not necessarily independently) at a

constant rate. Both bonds have a 60% recovery rate.

CT8 S20102

Assume:

the issue of bond A is priced at 1.6m

the issue of bond B is priced at 2.2m

(iii)

[4]

There is also a traded derivative security, D, priced at 52 which pays 100 after

2 years if (and only if) at least one of the bonds defaults.

(iv)

(a)

Determine a hedging portfolio for the security which pays 100 after

2 years if and only if both bonds default by considering fixed

portfolios consisting of bond A, bond B and security D and a risk-free

zero-coupon bond paying 100 at redemption in exactly 2 years.

(b)

Calculate the fair price for the security that pays 100 if and only if

both bonds default.

[8]

[Total 23]

(i)

market in terms of the risk-neutral measure.

[2]

A European call option on a stock has an exercise date one year away and a strike of

6. The underlying stock has a current price of 5.50. The option is priced at 60p.

The stock price volatility has been estimated from other option prices as 20%.

(ii)

Estimate the risk free rate of interest to within 0.5% p.a. assuming the BlackScholes model applies.

[5]

A new derivative security has just been written on the underlying stock. This will pay

a random amount D in one years time, where D = S12.

(iii)

Calculate the fair price for this new derivative security, quoting any further

results that you use.

[5]

(iv)

Determine the initial hedging portfolio (in units of the underlying stock and

cash) for this new derivative security.

[4]

[Total 16]

CT8 S20103

Under the real-world measure P, W is a standard Brownian motion and the price of a

stock, S, is given by St = S0exp( Wt + ( 1/2 2)t). The continuously compounded

risk-free rate of interest is r and a zero coupon bond with maturity T has price

Bt = er(Tt). Suppose that in the market any contract which pays f(ST) at time T is

valued at:

pt = E[er(Tt) f(ST) T |Ft],

where:

t =exp(mWt 1/2m2t) for t T for some real number m.

(i)

(a)

(b)

[5]

(ii)

(a)

(b)

[5]

[Total 10]

(i)

[3]

(ii)

Explain how gamma and vega can be used in the risk management of a

portfolio that is delta-hedged.

[4]

[Total 7]

Consider a particular stock and denote its price at any time t by St . This stock pays a

dividend D at time T ' .

Let Ct and Pt be the price at time t of a European call option and European put option

respectively, written on S, with strike price K and maturity T T ' t . The

instantaneous risk-free rate is denoted by r.

Prove the put-call parity in this context by adapting the proof of standard put-call

parity.

[Hint: assume that when the dividend is paid it is used to pay off any borrowed

positions required as part of the proof.]

CT8 S20104

[7]

Consider a two-period binomial model for a non-dividend paying stock whose current

price is S0 = 100. Assume that:

over each of the next six-month periods, the stock price can either move up by a

factor u = 1.2 or down by a factor d = 0.8

(i)

(ii)

(a)

(b)

[2]

Calculate the price of a standard European call option written on the stock S

[5]

with strike price K = 100 and maturity one year.

Consider a special European call option with strike price K = 100 and maturity one

year. The owner of such an option has the right to exercise her option at the end of

the year only if the stock price goes above the level L = 130 during or at the end of

the year.

(iii)

(a)

(b)

option and the option in (ii).

[4]

[Total 11]

END OF PAPER

CT8 S20105

EXAMINERS REPORT

September 2010 examinations

Core Technical

Introduction

The attached subject report has been written by the Principal Examiner with the aim of

helping candidates. The questions and comments are based around Core Reading as the

interpretation of the syllabus to which the examiners are working. They have however given

credit for any alternative approach or interpretation which they consider to be reasonable.

T J Birse

Chairman of the Board of Examiners

December 2010

Subject CT8 (Financial Economics Core Technical) September 2010 Examiners Report

(i)

E[R2] = 0.8 * 10%2 + 0.2*(30%2 + 10%2) = 0.028

(ii)

Prob(R < 0) = 0.8 * N(0; 0, 10%) + 0.2 * N(0; 30%, 10%) = 0.8 * 0.5 + 0.2 *

0.00135 = 0.4 + 0.00027 = 0.40027

Prob(S < 0%) = N(0; 6%, 15.62%) = 0.3504

Prob(R < 10%) = 0.8 * N(10%; 0, 10%) + 0.2 * N(10%; 30%, 10%) = 0.8

* 0.1587 + 0.2 * 0 = 0.1269

Prob(S < 10%) = N(10%; 6%, 15.62%) = 0.1528

(iii)

Benchmark at 0% suggests R riskier than S weight of probability around

0% with R makes R look riskier than S

Benchmark at 10% suggests S riskier than R overall wider spread of S

dominates at more extreme risk levels

standard normal lookups from tables.)

(i)

volatility), cannot be justified by the news arriving. This is claimed to be

evidence of market over-reaction which was not compatible with efficiency.

(ii)

two of these):

1. Stock prices continue to respond to earnings announcements up to a year

after their announcement. An example of under-reaction to information

which is slowly corrected.

2. Abnormal excess returns for both the parent and subsidiary firms

following a de-merger. Another example of the market being slow to

recognise the benefits of an event.

3. Abnormal negative returns following mergers (agreed takeovers leading to

the poorest subsequent returns). The market appears to over-estimate the

benefits from mergers, the stock price slowly reacts as its optimistic view

is proved to be wrong.

Page 2

Subject CT8 (Financial Economics Core Technical) September 2010 Examiners Report

One-factor models

All are arbitrage-free.

Vasicek: easy to implement but problem of possible negative interest rates

CIR: more tricky to implement but positive rates (for suitable choice of parameter

values).

HW: more flexible as time-inhomogeneous, so better fit to market data (in particular

option prices)., but negative rates are possible

Limitations:

1)

historical data shows changes in the prices of bonds with different terms to

maturity are not perfectly correlated

2)

there have been sustained periods of both high and low interest rates with

periods of both high and low volatility

3)

we need more complex models to deal effectively with more complex derivative

contracts e.g. any contract which makes reference to more than one interest rate

should allow these rates to be less than perfectly correlated

Multiple-factor models: to capture more features of market data, better for pricing

exotic derivatives.

There is no perfect model. A good model depends on the data available and the use of

the model (basic assets, plain vanilla derivatives, more exotic derivatives, short or

long maturities).

Fit to historical data; realistic dynamics

(i)

(a)

A credit event is an event which will trigger the default of a bond and

includes the following:

(b)

loss event

bankruptcy

rating downgrade of the bond by a rating agency such as Standard

and Poors or Moodys

is:

rescheduled

cancelled by the payment of an amount which is less than the

default-free value of the original contract

continues but at a reduced rate

totally wiped out

[any three of the above]

Page 3

Subject CT8 (Financial Economics Core Technical) September 2010 Examiners Report

(c)

(ii)

In the event of a default, the fraction of the defaulted amount that can

be recovered through bankruptcy proceedings or some other form of

settlement is known as the recovery rate.

The model is in continuous time; it has two states N (not previously defaulted)

and D (previously defaulted).

Under this simple model it is assumed that the default-free interest rate term

structure is deterministic with r(t) = r for all t.

If the transition intensity, under the real-world measure P, from N to D at time

t is denoted by (t), then if X(t) is the state at time t:

PrP(X(t + dt) = N | X(t) = N) = 1 - (t) dt + o(dt) as dt 0,

PrP(X(t + dt) = D | X(t) = N) = (t) dt + o(dt) as dt 0.

(iii)

The formula for the unit ZCB price is erT(1 (1 )(1 e(i)T)), where is

the recovery rate and (i) is the (constant) default rate for bond i and T is the

redemption time.

Thus

1.6 = 2e0.06(1 .4(1 e2(A))) and

2.2 = 3e0.06(1 .4(1 e2(B))),

so (A) = 0.2361

and

(B) = 0.4029

(iv)

(a)

units of 100 nominal of bond B, d units of the derivative, D, and c

units of cash.

If this is to perfectly hedge the security then its value at time 2 should

be zero unless both bonds default, in which case it should be 100.

At time 2 there are four possibilities: no defaults, bond A only has

defaulted, bond B only has defaulted, both bonds have defaulted.

Equating the corresponding values of the portfolio and of the new

security (at time 2) we obtain:

100a + 100b + c = 0;

60a + 100b + 100d + c =0;

100a + 60b + 100d + c = 0

60a + 60b + 100d + c = 100

Page 4

Subject CT8 (Financial Economics Core Technical) September 2010 Examiners Report

(b)

Since this is a perfect hedge, the initial value of the hedging portfolio is

the fair price for the new security, so the fair price is

500e0.06 250(1.6/2) 250(2.2/3) 52 = 34.55

(i)

(ii)

14.5%

(iii)

EP[er S12] = EP[S02er exp(2B1 + 2r 2)] = S02 exp(r +

2)=5.52exp(.185)=36.40.

(iv)

The amount of stock to hold in the hedging portfolio is Delta = f/S, where f

is the price as a function of current stock price S. Thus the initial hedging

portfolio holds 2S0exp(r + 2)=13.235 units of stock and is short S02exp(r +

2) =36.40.

(i)

It follows from Itos formula that

dt = (g/t (Wt , t) + (1/2) 2g/2x(Wt , t))dt + g/x(Wt , t) dWt

= ((1/2)k2g + (1/2)k2g)dt + kg dWt = kg dWt .

It follows that is a (local) martingale.

Hence 1 = 0 = E[T] = E[exp(kWT 1/2k2T)

= E[exp(kWT]exp(1/2k2T) so E[exp(kWT]=exp(1/2k2T)

(ii)

(a)

When

f(x)

(b)

= x, p0 = E[ert ST t|F0]

= E[ert S0exp( Wt +( 1/2 2)t)t|F0]

= E[ert S0exp(( + m) Wt +( 1/2 2 1/2 m2)t)|F0]

= ert S0exp(1/2 ( + m)2t + ( 1/2 2 1/2 m2)t)

= S0exp((m + r)t)).

which holds if and only if m = (r )/, there is an arbitrage

opportunity.

Page 5

Subject CT8 (Financial Economics Core Technical) September 2010 Examiners Report

(i)

underlying security S

f f

(t, St ).

s s

2 f

s 2

= f

(ii)

If the portfolio is Delta-hedged and has a high value of then it will require

more frequent rebalancing or larger trades than one with a low value of

gamma. The need for rebalancing can, therefore, be minimised by keeping

gamma close to zero.

The value of a portfolio with a low value of vega will be relatively insensitive

to changes in volatility. Since is not directly observable, a low value of

vega is important as a risk-management tool. Furthermore, it is recognised

that can vary over time. Since many derivative pricing models assume that

is constant through time the resulting approximation will be better if is

small.

The proof of this result is an adaptation of that of the standard call-put parity. Two

(self-financing) portfolios are considered:

Portfolio A: buying the call and selling the put at time t. Its value at time t is

Ct Pt and at time T, it is ST K in all states of the universe.

and added to the portfolio. Therefore the value at maturity of the portfolio is then

ST K , taking into account the dividend payment.

Using the absence of arbitrage opportunity, both portfolios should have the same

value at any intermediate time, in particular at time t. Hence:

Ct Pt = St K exp ( r (T t ) ) D exp ( r (T ' t ) ) .

Page 6

Subject CT8 (Financial Economics Core Technical) September 2010 Examiners Report

(i)

(a)

d = 0.8 < exp ( 0.06 ) < u = 1.2

(b)

144

120

100

96

80

64

(ii)

To price the call option, we use the risk-neutral pricing formula. We use the

following simplifying notation:

Cuu = u 2 S0 K

= 0.

C1 ( u ) = exp ( r ) qCuu + (1 q ) Cud = 27.12 , and in the lower state

upward move is q =

exp ( r ) d

ud

= 0.6545 .

Hence C0 = 16.72 . (this could be seen directly as C=e-2rp2*44)

(iii)

(a)

Only one path is relevant for this barrier option up-up. Its

probability of occurrence is q2 and the associated payoff is Xuu = 44.

Using the risk-neutral valuation formula, we get:

X 0 = exp ( 2r ) q 2 X uu = 16.72

(b)

In practice this option clearly has less value than the option (ii)

because it pays off in fewer cases. However it has the same price

when calculated using the binomial tree approach this reinforces the

need for choosing binomial trees carefully when pricing derivatives.

Page 7

EXAMINATION

20 April 2011 (am)

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1.

Enter all the candidate and examination details as requested on the front of your answer

booklet.

2.

You must not start writing your answers in the booklet until instructed to do so by the

supervisor.

3.

4.

Attempt all 10 questions, beginning your answer to each question on a separate sheet.

5.

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this

question paper.

In addition to this paper you should have available the 2002 edition of the Formulae

and Tables and your own electronic calculator from the approved list.

CT8 A2011

(i)

(ii)

Z0 = 0.

[5]

(i)

[2]

Asset i

1

2

3

Expected return Ei

4%

6%

8%

Volatility i

6%

12%

18%

The correlation between assets 1 and 2 is 0.75; while the correlation between asset 3

and both of the other two assets is zero.

(ii)

(a)

minimum variance portfolio associated with a given expected return,

defining any notation used.

(b)

minimum variance portfolio which yields an expected return of 5%.

[7]

[Total 9]

A securities market has only three risky securities, A, B and C with the following

annual return attributes:

Asset A Asset B Asset C

Market capitalisation

100bn 150bn 250bn

6%

Annual expected return

4%

rB

Assume that:

the market price of risk is 10% per annum

the risk free rate is 3.3% per annum

the expected annual return on the market portfolio is 5.3% per annum.

(i)

portfolio. Quote any results that you use.

[1]

(ii)

[2]

(iii)

Calculate the covariance of the annual returns on each asset with the annual

return on the market portfolio. State any further results that you use.

[4]

[Total 7]

CT8 A20112

(i)

[6]

XYZ has just announced that its profits are up by 52% on last year. On the

announcement XYZ shares fell in price by 20%. Analysts had been predicting a rise

in profits of 65%. A friend says that this shows that the efficient markets hypothesis

is false.

(ii)

[3]

[Total 9]

Assume that a non-dividend-paying security with price St at time t can move to either

St u or St d at time t + 1. The continuously compounded rate of interest is r, and u >

er > d. A financial derivative pays if St+1 = St u and if St+1 = St d.

A portfolio of cash (amount x) and the underlying security (value y) at time t exactly

replicates the payoff of the derivative at time t + 1.

(i)

(ii)

value St u at time t + 1 in terms of (x + y), r, and .

[2]

[4]

(iii)

(a)

(b)

Check that the put-call parity holds for this model.

[4]

[Total 10]

CT8 A20113

(i)

[2]

A security price, St, is assumed to follow a lognormal model with drift = 4.28% per

annum and volatility 12% per annum. The price now is S0 = 1.83. The continuously

compounded risk-free rate of interest is 2% per annum.

(ii)

[2]

Someone now offers you an option which will pay 1000 if and only if the stock price

S1 > 2.20. They propose to charge 1000e0.02p.

(iii)

[4]

Assume now that the value of 4.28% for has been estimated from observations of

the security price over 10 years using the estimator ={log(S0) log(S10)}/10.

(iv)

(v)

(a)

(b)

Deduce the probability that > 3%.

(a)

Explain how your answer to (iii) would change if you knew that <

1.28% rather than 4.28%.

(b)

[4]

[3]

[Total 15]

(a)

List five factors that effect the price of a European put option on a nondividend paying share.

(b)

State how the premium for a European put option would change if each of

these factors increased.

[5]

CT8 A20114

(i)

maturity date T in terms of the risk-neutral measure.

[2]

An at the money European call option on a stock has an exercise date one year away

and a strike price of 118.57. The option is priced at 10. The continuously

compounded risk-free rate is 1% per annum.

(ii)

(a)

(b)

1000 options on the share, quoting any results that you use.

(c)

[10]

(iii)

Price a put on the same stock with the same expiry date and a strike price of

110.

[2]

The hedging portfolio of the call option has the same value, the same Delta and the

same Vega as the option.

The Delta of the put option is 0.29975 and its Vega is 39.435.

(iv)

Determine the hedging portfolio of the call option in terms of shares, cash and

the put option.

[4]

[Total 18]

In an extension of the Merton model, a very highly geared company has two tiers of

debt, a senior debt and a junior debt. Both consist of zero coupon bonds payable in

three years time. The senior debt is paid before the junior debt.

Let Ft be the value of the company at time t, L1 the nominal of the senior debt and L2

the nominal of the junior debt.

(i)

(a)

(b)

Deduce the value of the junior debt at maturity.

[4]

The current gross value of the company is 3.2m. The nominal of the senior debt is

1.2m and that of the junior debt is 2m. The continuously compounded risk-free rate

is 4% per annum, the volatility of the value of the company is 30% per annum and the

price of 100 nominal of the senior bond is 88.26.

(ii)

CT8 A20115

[6]

[Total 10]

10

Let B(t,T) be the price at time t of a zero-coupon bond paying 1 at time T, rt be the

short-rate of interest, P be the real world probability measure and Q the risk neutral

probability measure.

(i)

Write down two equations for the price of a zero-coupon bond, one of which

uses the risk-neutral approach to pricing and the other of which uses the stateprice-deflator approach to pricing.

[2]

(ii)

State the Stochastic Differential Equation (SDE) of the short rate rt under Q

for the Vasicek model and the general type of process this SDE represents. [3]

(iii)

(iv)

Deduce the form of the distribution of the zero-coupon bond price under this

model.

[2]

[Total 12]

END OF PAPER

CT8 A20116

[5]

EXAMINERS REPORT

April 2011 examinations

Core Technical

Introduction

The attached subject report has been written by the Principal Examiner with the aim of

helping candidates. The questions and comments are based around Core Reading as the

interpretation of the syllabus to which the examiners are working. They have however given

credit for any alternative approach or interpretation which they consider to be reasonable.

T J Birse

Chairman of the Board of Examiners

July 2011

Overall the paper was answered well and candidates performance was satisfactory. The

comments below each question indicate where candidates had the most difficulty.

1

(i)

[Unit 13 pp1-2, Unit 8 p2] I

The assumptions underlying the Black-Scholes model are as follows:

(ii)

1.

motion.

2.

3.

The risk-free rate of interest is constant, the same for all maturities and

the same for borrowing or lending.

4.

5.

6.

small numbers of units.

[Unit 8 p3 para 1]

A Brownian Motion Z has the following properties:

(1)

{Zr, r s} whenever s < t.

(2)

only on t s.

(3)

(4)

Candidates seemed to know this material well, and had no particular problems with this

question.

Page 2

(i)

expected return and the variance of that return over a single time horizon.

of returns are known for all assets and pairs of assets.

Investors are never satiated. At a given level of risk, they will always

prefer a portfolio with a higher return to one with a lower return.

(ii)

(a)

Investors dislike risk. For a given level of return, they will always prefer a

portfolio with lower variance to one with higher variance.

Let the proportion invested in asset i, be xi , with expected return Ei ,

variance Vi and correlation 12. Let E be the return on the portfolio of

the three assets and let and be Lagrange multipliers. Then, the

Lagrangian function W satisfies:

W=

i =1

(b)

W

= 0 72x1 + 108x2 4 = 0

x1

W

= 0 108x1 + 288x2 6 = 0

x2

W

= 0 648x3 8 = 0

x3

W

= 0 4x1 + 6x2 + 8x3 = 5

W

= 0 x1 + x2 + x3 = 1

x2 = 0.075 and x3 = 0.2125.

72x1 + 108x2 4 = 0

108x1 + 288x2 6 = 0

648x3 8 = 0

4x1 + 6x2 + 8x3 = 5

x1 + x2 + x3 = 1

(1) = 72x1 + 108x2 4

into (2) 36x1 + 180x2 2 = 0 = 18x1 + 90x2

(4) and (5) into (3) 648x3 144x1 468x2 = 0

(5) x3 = 1 x1 x2

(7) into (4) 4x1 + 6x2 + 8 8x1 8x2 = 5

4x1 + 2x2 = 3

x2 = 1.5 2x1

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

(9)

(10)

Page 3

(10) and (9) into (8) 648 792x1 1116x2 = 0

648 792x1 1674 + 2232x1 = 0

1440 x1 1026 = 0

x1 = 0.7125

x2 = 0.075

x3 = 0.2125

Although most candidates could write down the Lagrangian, several missed the factor of 2

in front of the covariance term. The handling of the Lagrangian showed that many

candidates could write down the partial differential equations for optimisation, but were

unable to solve them simultaneously.

(i)

The market price of risk is (EM r)/M so M = (EM r)/0.1 = .02/.1 = 20%

(ii)

investor holds risky assets in proportion to that portfolio. Thus the market

portfolio is .2A +.3B + .5C and so EM = .2EA + .3EB + .5EC so

EB = (.053 .2.04 .5.06)/.3 = 5%.

(iii)

Assets all lie on the securities market line, so Ei r = i(EM r), where

i = Cov(Ri, RM)/Var(RM).

It follows that A = .007/.02 = .35, B = .017/.02=.85 and C = .027/.02 =

1.35.

Then Var(RM) = .04 (from part (i)) so Cov(RA, RM) = 0.014, Cov(RB, RM) =

0.034 and Cov(RC, RM) = 0.054.

(i)

Bookwork Unit

Strong form EMH: market prices incorporate all information, both publicly

available and also that available only to insiders.

Semi-strong form EMH: market prices incorporate all publicly available

information.

Weak form EMH: the market price of an investment incorporates all

information contained in the price history of that investment.

Page 4

(ii)

efficiently on the release of insider information. This does suggest that Strong

form EMH doesnt hold. It doesnt seem to contradict weak or semi-strong

EMH. However, the price fall could be an over-reaction which would

contradict the semi-strong form.

Part (i) was well-answered by most candidates. In part (ii) the comments on the statement

were disappointingly unclear.

(i)

value of this portfolio to the value of the derivative at time t = 1 we find the

two simultaneous equations:

xer + yu = ,

xer + yd = .

Rearranging we find:

y=

, and

ud

x = er

(ii)

u d

.

ud

x + y = er[q + (1 q)]

where q is the risk-neutral probability we are seeking.

(iii)

So q =

( x + y )e r

.

(a)

y = 55 95 , x = 44 94 , and so x + y = 11 19 .

x = 55 95 , y = 44 94 , and so x + y = 11 19 .

(b)

Therefore, the put-call parity relation holds.

Several candidates misread the question and took y to denote the number of shares rather

than their initial value. There were also a significant number of careless errors in the

calculation.

Page 5

(i)

The lognormal model has independent, stationary normal increments for the

log of the asset price. Thus, if Su denotes the stock price at time u, then

log(St /Ss) ~ N((t s), 2(t s)) where is the drift and is the volatility

parameter.

(ii)

.0428)/.12) = 1 (1.17784) = 0.1194

(iii)

No, I would not buy the contract. Assuming the log normal model, we are in a

Black-Scholes market and the fair price for the option is f = EQ[e.02 C] where

C is the contract value at expiry date, and Q is the EMM. Under the EMM, the

discounted stock price will be a martingale i.e S will be lognormal with drift

.02 2 = .0128 and volatility . Now f = 1000e.02 p ,

where p = Q(S1 > 2.20), and since S has a smaller drift under Q than under

the real-world measure, this will be a smaller price than I am being offered.

(iv)

(a)

(b)

= 1 (.79057) = .21459.

(a)

option is a bargain!

(b)

large even though we have 10 years of data.

(v)

generally.

The poorer candidates answered this question in a way that is inconsistent with the Core

Reading, taking the drift parameter to refer to the parameter in the Black Scholes model.

This resulted in incorrect numerical answers.

According to the Core Reading the factors and the effect they would have are:

(1)

(2)

(3)

(4)

(5)

The premium would increase as the strike price increased.

The premium would increase as the time to expiry increased.

The premium would increase as the volatility of the underlying share

increased.

The premium would decrease as interest rates increased.

Page 6

(i)

(ii)

(a)

as follows:

using Black-Scholes, C = S0(d1) kerT (d2), with

d1= (rT + 2T)/T = (.01 + 2)/

and d2 = (.01 + 2)/, S0 = k = 118.57 and C = 10.

Trying = 15% gives a value of d1 = .14167 and d2 = .00833 which

gives (d1) = .55633, (d2) = .49668, and thus a trial value for C of

118.57 (.55633 e.01 .49668) = 7.65868.

Trying = 25% gives a value of d1 = .165 and d2 = .085 which

gives (d1)=.56553, (d2)=. 46613, and thus a trial value for C of

118.57 (.56553 e.01 .46613) = 12.33579.

Interpolation gives a new trial value of of

15 + (10 7.65868)/(12.33579 7.65868) 10 = 20%.

With this value for we get a value of

d1 = 0.15 and d2 = .05 which gives

(d1) = 0.5596, (d2) = 0.4801, and thus a trial value for C of

118.57 (0.5596 e.01 0.4801) = 9.993.

Thus = 20%.

(iii)

(b)

d1 = (log(S/K) + rT + 2T) / T = 0.15 and

(.15) = 0.55962, so the hedge is 1000 = 559.62 units of stock and

10,000 118.57 559.62 = 56,354 in cash.

(c)

= (S(d1) d1/ KerT (d2) d2/)

= (S(0.15)( r/2) + KerT ( 0.05)( + r/2))

= 118.57 (0.25Xe.01125 + 0.75e.00125e.01)/(2)

= 46.773

[since d2 = (log(S/K) + r 2T)/T = 0.05 and

d2/ = ( + (r + log(S/K))/2)]

d1 = (S/K) + r + 2T)/ T = 0.52512 and

d2 = (log(S/K) + r 2T)/ T = 0.32512.

So the price is 110Xe.01.37254 118.57.29975 = 5.0303

Page 7

(iv)

value, Delta and Vega of the option. This gives three equations:

(1)

(2)

(3)

aS + bp + m =10

a + b P = C

bVP = VC

equation (2) then gives a = 0.91484;

equation (1) gives m = 104.43.

This question was generally not well answered, with errors being made in simple

calculations of hedging portfolios.

(i)

(ii)

(a)

Under the Merton model, the value, Ft, of the firm follows a

Geometric BM under the EMM. It follows that the terminal value of

the debt is min(FT, L1), where Li is the tier i nominal debt (since FT is

available to pay the senior debt).

(b)

Subtracting this value from the value of the firm we see that the assets

available to redeem the junior debt are max(FT L1 ,0). It follows that

the terminal value of the junior debt is min(L2, max(FT L1 ,0)).

E[erT min(FT, L1)] = E[erT (FT max(FT L1,0)] = F0 C1, where C1 is

the initial value of a call on the value of the firm with strike L1. The current

value of the junior debt is V2 = E[erTmin(L2, max(FT L1 ,0))].

We obtain immediately V1 = 88.26*12,000 = 1059120

Now the value of the junior debt is C1 C2= F0 V1 C2 where

C2 = E[erTmax(FT (L1 + L2), 0))].

Using Black-Scholes, C2 = F0(d1) (L1 + L2) erT (d2), with

d1 = (ln(F0/L1 + L2) + rT +2T)/T

= (ln(1) +.12 + *.09*3)/.3*3 = 0.49075

and d2 = (ln(F0/L1 + L2) + rT2T)/T = .02887.

C2 = 3.2*.68819 e0.12*3.2*.48848 = 0.81583m = 815,830. Thus the

junior debt is worth = C1 C2 = 32000000 1059120 815830 = 1325050.

This is the value of 2m nominal so the value of 100 nominal is 66.25.

With some notable exceptions, this question was generally very poorly answered.

Candidates were unable to perform calculations related to the Merton model, and were

unable to identify the payoffs from simple contingent contracts.

Page 8

10

(i)

Risk-neutral approach:

T

B (t , T ) = EQ exp ru du Ft

t

B (t , T ) =

E P { A(T )Ft }

A(t )

(ii)

The dynamics of the short rate rt under Q for the Vasicek model are:

drt = ( rt )dt + dZt,

This is an Ornstein-Uhlenbeck process.

(iii)

dst = etrtdt + et drt

= etdt + et dZt

t

0

and consequently

t

0

(iv)

So rt has a Normal distribution and hence from (i), B(t, T) has a lognormal

distribution.

This question was largely from a section of the core reading with which some candidates

seemed unfamiliar. Candidates need to study the sections relating to interest rate models

more carefully. Candidates who knew the bookwork performed well.

Page 9

EXAMINATION

28 September 2011 (am)

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1.

Enter all the candidate and examination details as requested on the front of your answer

booklet.

2.

You must not start writing your answers in the booklet until instructed to do so by the

supervisor.

3.

4.

Attempt all 11 questions, beginning your answer to each question on a separate sheet.

5.

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this

question paper.

In addition to this paper you should have available the 2002 edition of the Formulae

and Tables and your own electronic calculator from the approved list.

CT8 S2011

(i)

[1]

A market consists of two assets A and B. Annual returns on the two assets (RA and

RB) have the following characteristics:

Asset

A

B

Expected return %

6

10

Standard deviation %

20

20

(ii)

(a)

assets in a minimum variance portfolio.

(b)

[3]

[Total 4]

Ri = i + i1I1 + i2I2 + i3I3 + i

Where:

i, i1, i2 and i3 are security-specific parameters

I1, I2 and I3 are the changes in the three factors on which the model is based; and

i are independent random normal variables, each with variance 2

(i)

Describe three categories of model that could be used to help choose the

factors I1, I2 and I3.

(ii)

[6]

List examples of the variables that could be used for the factors I1, I2 and I3,

for two of these three categories of model.

[2]

[Total 8]

CT8 S20112

An investor wishes to save for a retirement fund of 100,000 in 10 years time. The

instantaneous, constant continuously compounded risk-free rate of interest is 4% per

annum. The investor can purchase shares on a non-dividend paying security with

price St governed by the Stochastic Differential Equation (SDE):

dSt = St(dt + dZt)

where:

= 12%

= 25%

t is the time from now measured in years; and

S0 = 1

(i)

(ii)

(a)

(b)

shares to give a 50:50 probability of building up a retirement fund of

100,000 in 10 years time.

[4]

Calculate the following risk measures applied to the difference between the

value of the fund and 100,000, if the investor invests A.

(a)

(b)

(c)

Variance

Shortfall probability relative to 90,000

99% Value at Risk

[6]

The investor decides that they do not need more than 100,000 so they write a call

option giving up any upside return above 100,000. They also buy a put option to

remove the downside risk of receiving less than 100,000.

(iii)

Calculate the net cost at time zero of purchasing enough shares to give

themselves a 50:50 chance of building up a retirement fund of 100,000,

writing the call option on those shares and buying the put option on the shares.

[2]

[Total 12]

CT8 S20113

physical asset. The continuously compounded costs of managing the asset are x% of

its value, and it provides an income stream of y per ton payable at six monthly

intervals, a payment has just been made.

Let St be the spot price of one ton of the asset at time t and let r be the continuously

compounded risk-free rate of interest per annum which is assumed to be constant.

Derive the current price of a forward contract written on one ton of the asset with

maturity T years where (6 months < T < 1 year).

[8]

(i)

List the desirable characteristics of a model for the term structure of interest

rates.

[4]

(ii)

Write down the stochastic differential equation for the short rate rt under _ in

the Hull-White model.

[1]

(iii)

Indicate whether or not the Hull-White model shows the characteristics listed

in (i).

[4]

[Total 9]

Under the real-world probability measure, P , the price of a zero-coupon bond with

maturity T is given by:

2

B(t, T) = exp (T t )rt +

(T t )3

6

where rt is the short rate of interest at time t and satisfies the following stochastic

differential equation under the real-world measure P :

drt = rtdt + dZt,

where > 0 and Zt is a standard Brownian motion under P .

(i)

Derive a formula for the instantaneous forward rate f(t, T), based on this

model.

[2]

(ii)

[4]

(iii)

measure _ defining all terms used.

CT8 S20114

[2]

[Total 8]

A non-dividend-paying stock, St, has a current price of 200p. After 6 months the

price of the stock could increase to 230p or decrease to 170p. After a further 6

months, the price could increase from 230p to 250p, or decrease from 230p to 200p.

From 170p the price could increase to 200p or decrease to 150p. The semi-annually

compounded risk-free rate of interest is 6% per annum and the real-world probability

that the share price increases at any time step is 0.75. Adopt a binomial tree approach

with semi-annual time-steps.

(i)

[5]

(ii)

Calculate, using the state-price deflator from (i), the price of a non-standard

option which pays out max{0, log(S1 180)} one year from now.

[4]

(iii)

State how the answer to (ii) would change if the real-world probability of a

share price increase at each time step was 0.6.

[1]

[Total 10]

exercisable at two dates, after exactly one year and at expiry, after exactly two years.

If it is exercised at expiry it returns $1000 if and only if the stock price is below $2. If

it is exercised after one year it returns $500 if and only if the stock price is above $2.

Assume the market is a Black-Scholes one with a continuously compounded risk-free

rate of 2% per annum and a stock volatility of 30% per annum.

(i)

(a)

not exercised at t = 1).

(b)

[4]

(ii)

Denoting the price just after 1 year by p1+, explain why the fair price, p1, at

t = 1, is given by p1 = max(p1+, 500) if S1 < $2 and by p1 = p1+ if S1 > $2. [2]

(iii)

(a)

suitable value of k.

(b)

[4]

[Total 10]

CT8 S20115

A European call option and a European put option on the same stock with the same

strike price have an exercise date one year away and both are priced at 12p. The

current stock price is 300p.

The continuously compounded risk free rate of interest is 2% per annum.

(i)

Calculate the common strike price, quoting any results that you use.

[3]

10

(ii)

(iii)

Construct the corresponding hedging portfolio in shares and cash for 5000 of

the call options.

[2]

[Total 9]

(i)

process.

(a)

(b)

[4]

where the Z(t)s are iid N(0, 2) random variables and 0 < a < 1.

[4]

(ii)

walk models for share prices, interest rates and inflation.

[5]

[Total 9]

CT8 S20116

11

(i)

default, defining any notation used.

[4]

The economy is in one of three states: 1 (good), 2 (bad) and 3 (default).

Transition intensities i,j are constant and as follows:

1,2 = 1; 1,3 = 0; 2,1 = 0.25, 2,3 = 0.75; 3j = 0 for all j and 1,1 = 2,2 = 1.

It follows that if pi(t) is the probability that the economy is in state i at time t then:

dp1 (t )

= p1 (t ) + 0.25 p2 (t )

dt

and

dp2 (t )

= p1 (t ) p2 (t ) .

dt

Set h(t) = 2p1 (t) p2(t).

(ii)

dh(t )

= 1.5h(t ).

dt

(a)

Show that

(b)

[2]

(iii)

[4]

recovery rate of 60%.

(iv)

(a)

Deduce the price under this model for a zero-coupon bond in this

country with a redemption value of 100 and a redemption date in two

years time.

(b)

[3]

[Total 13]

END OF PAPER

CT8 S20117

EXAMINERS REPORT

September 2011 examinations

Core Technical

Purpose of Examiners Reports

The Examiners Report is written by the Principal Examiner with the aim of helping

candidates, both those who are sitting the examination for the first time and who are using

past papers as a revision aid, and also those who have previously failed the subject. The

Examiners are charged by Council with examining the published syllabus. Although

Examiners have access to the Core Reading, which is designed to interpret the syllabus, the

Examiners are not required to examine the content of Core Reading. Notwithstanding that,

the questions set, and the following comments, will generally be based on Core Reading.

For numerical questions the Examiners preferred approach to the solution is reproduced in

this report. Other valid approaches are always given appropriate credit; where there is a

commonly used alternative approach, this is also noted in the report. For essay-style

questions, and particularly the open-ended questions in the later subjects, this report contains

all the points for which the Examiners awarded marks. This is much more than a model

solution it would be impossible to write down all the points in the report in the time allowed

for the question.

T J Birse

Chairman of the Board of Examiners

December 2011

Subject CT8 (Financial Economics Core Technical) Examiners Report, September 2011

General comments on Subject CT8

Subject CT8 introduces the main concepts and principles of financial economics. These are

developed in later subjects in the ST series of exams. This subject combines various types of

skills. In particular, along with CT7, it is one of the first where candidates are expected to

write lengthy passages of reasoned thought, rather than just complete calculations. This is a

skill that will be new to many, and candidates are advised to pay particular attention to the

answers to this type of question by studying many past papers.

Comments on the September 2011 paper

The general performance was slightly worse than in April 2011 and candidates found this

paper more challenging, but well-prepared candidates scored well across the whole paper and

the best candidates scored close to full marks. As in previous diets, questions that required an

element of application of the core reading to situations that were not immediately familiar

proved very challenging to most candidates. The comments that follow the questions

concentrate on areas where candidates could have improved their performance. Candidates

approaching the subject for the first time are advised to concentrate their revision in these

areas and the ability to apply the core reading to similar situations.

Page 2

Subject CT8 (Financial Economics Core Technical) Examiners Report, September 2011

(i)

A portfolio is efficient if the investor cannot find a better one in the sense that

it has the same expected return and a lower variance, or the same variance and

a higher expected return.

(ii)

We have:

V = x 2AVA + xB2VB + 2 x A xB C AB

Which is a minimum at

xA =

VB C AB

VA 2C AB + VB

= 0.5

So xB = 0.5

And the expected return on the portfolio is 8%.

Generally candidates scored well on this question. Some students struggled to calculate the

weighting in each asset class or failed to distinguish between the correlation and the

correlation coefficient.

(i)

These use observable economic time series as the factors. They could include

factors such as the annual rates of inflation and economic growth, short term

interest rates, the yield on long term government bonds, and the yield margin

on corporate bonds over government bonds. A related call of model uses a

market index plus a set of industry indices as the factors.

Fundamental factor models

addition to) macroeconomic variables the factors used are company specific

variables. These may include such fundamental factors as:

the price earnings ratio;

the level of R&D spending; or

the industry group to which the company belongs.

Commercial fundamental factor models are available which use many tens of

factors. They are used for risk control by comparing the sensitivity of a

portfolio to one of the factors with the sensitivity of a benchmark portfolio.

Page 3

Subject CT8 (Financial Economics Core Technical) Examiners Report, September 2011

Statistical factor models

returns data. Instead a technique called principal components analysis can be

used to determine a set of indices which explain as much as possible of the

observed variance. However, these indices are unlikely to have any

meaningful economic interpretation and may vary considerably between

different data sets.

(ii)

Macroeconomic factor model

Fundamental factor model

belongs

The candidates who were familiar with the bookwork scored very well. Some candidates

were able to score some marks using economic knowledge from subject CT7.

(i)

d log St =

1

1

dSt + 2 (dSt ) 2

St

2 St

2

=

dt + dZt

2

log St = log S0 +

t + Zt .

t + Zt .

Or, finally, St = S0 exp

2

So, St has a lognormal distribution with parameters

t = 0.08875t and

2t = 0.0625t.

Page 4

Subject CT8 (Financial Economics Core Technical) Examiners Report, September 2011

The initial investment (based on a 50:50 chance) can be calculated by

choosing the 50th percentile point of Zt = 0, i.e. the initial investment is:

100, 000

= 41,168 = A

exp(0.08875 10 + 0.25 0)

(ii)

(a)

We know that:

2

(e

2t

41,1682Var(S10) = 41,1682 e2.4(e0.625 1)

= 41,1682 9.571

= 16,220,971,227.90

(b)

P(41,168 S10 < 90,000) = P (S10 < 2.1862) = P (logS10 < 0.7821)

(c)

So the 99th percentile worst outcome for the investment is:

S10 = 41,168 e0.8875 0.6252.3263 = 15,896.

So the VaR relative to A is 25,272 and relative to 100,000 is

84,104.

(iii)

In this case the investor has removed all risk, so by the principle of no

arbitrage the portfolio will earn the risk free rate. Therefore, the amount they

need to invest at time 0 is:

100, 000

e104%

= 67,032.

Many candidates scored well on part (i) which was a fairly standard proof using Ito's

lemma.

Many struggled with manipulating the log-normal distribution and calculating risk metrics

relating to it.

Page 5

Subject CT8 (Financial Economics Core Technical) Examiners Report, September 2011

The proof of this result is an adaptation of that of the standard no arbitrage approach

to pricing forward contracts. For ease of exposition we use 100x% rather than x% in

the calculations.

Two self-financing portfolios are considered at time zero:

Portfolio A: entering into the forward contract to receive one ton of the asset at time

T. Its value at time zero is zero, and at time T it is ST F0T .

Portfolio B: buying exT units of the underlying asset and borrowing

x (T 1 ) r

F0T e rT + ye

T

0

of the storage costs and the income stream.

Using the absence of arbitrage opportunity, both portfolios should have the same

value at any intermediate time, in particular at time 0. Hence:

F0T = S0e( x + r )T ye

( x + r )(T 12 )

Many candidates struggled with the concept of creating two portfolios using the principle of

no arbitrage. They were unable to apply the core reading to a related situation. The

question was challenging overall, with many candidates struggling to score well.

(i)

Arbitrage free.

Positive interest rates.

Mean reversion of rates.

Ease of calculation of bonds and certain derivative contracts.

Realistic dynamics.

Goodness of fit to historical data.

Ease of calibration to current market data.

Flexible enough to cope with a range of derivative contracts.

(ii)

Where in both cases Z is a Brownian motion under

(iii)

Positive interest rates. No

Mean reversion of rates. Yes

Ease of calculation of bonds and certain derivative contracts. Yes

Realistic dynamics. No

Goodness of fit to historical data. Yes.

Ease of calibration to current market data. Yes

Flexible enough to cope with a range of derivative contracts. No.

This was standard material from the core reading and more successful candidates tended to

score well, although some struggled to get all points required for full marks.

Page 6

Subject CT8 (Financial Economics Core Technical) Examiners Report, September 2011

(i)

f(t, T) =

= [rt

(ii)

log

2

(T t ) 2 ]

2

m(t , T ) rt

,

S (t , T )

t =

where

dB(t, T) = B(t, T)[m(t, T) dt + S(t, T) dZt ].

Now,

B(t , T )

2

= B(t , T ) rt

(T t ) 2

t

2

B(t , T )

= B(t , T )[(T t )]

rt

2 B (t , T )

rt2

= B (t , T )(T t ) 2

dB(t, T) = B(t, T){[ (T t) rt + rt] dt (T t) dZt}

and so

rt

.

t =

(iii)

given by

is

drt =

where Z is a standard Brownian motion under

drt = rt dt + (dZ t dt )

r dt

= rt dt + dZ t

Page 7

Subject CT8 (Financial Economics Core Technical) Examiners Report, September 2011

= rt dt rt dt + dZ

= dZ .

Question 6 was generally challenging. While part (i) was generally straightforward for most

candidates, part (ii) where application of first principles was necessary was only answered

well by the best candidates.

(i)

share price from each state:

q(200) =

= 0.6

230 170

q(230) =

= 0.738

250 200

q(170) =

= 0.502

200 150

A2(250) =

A2(200) =

A2(150) =

(ii)

q (200)q (230)

(0.75 1.03) 2

= 0.742

2 0.75 0.25 1.032

[1 q (200)][1 q (170)]

(0.25 1.03) 2

= 0.900

= 3.004

V = EP (A2V2)

= 2.784

(iii)

This question was overall well answered, showing that many candidates have understood the

broad concept of state price deflators. Well- prepared candidates were able to score near full

marks on all three parts of the question.

Page 8

Subject CT8 (Financial Economics Core Technical) Examiners Report, September 2011

Some candidates lost marks through ignoring the semi-annual interest rate. Part (iii) was

designed to test the understanding of the candidates on how option pricing theory works in

practice, but disappointingly many candidates got this part wrong.

(i)

If the first exercise date has passed then the owner now has a derivative

contract which pays $1000 at time 2 years if and only if the stock price S2 < 2.

The derivative should then be priced using the formula

pt = EQ[er(2t)C|Ft],

measure.

This gives a value of pt of

1000 er(2t) Q(S2 < 2|Ft)

= 1000 er(2t) Q(S2/St < 2/St)

= 1000 er(2t) Q(log(S2/St) < log(2/St))

= 1000 er(2t) ({log(2/St) (.02- 0.045)(2 t)}/ (.3 (2 t))).

(ii)

At t=1 the holder can choose between the value of the residual contract: p1+

and the current immediate exercise reward of $500 if S1 > 2 (and 0 otherwise).

A rational holder will maximise value by choosing whichever has a greater

current value.

There was a typo in the question where the inequalities were the wrong way

around, full credit will be given to students who assumed this part was correct

and had the inequalities the other way around.

In other words, an acceptable answer would be: At t=1 the holder can choose

between the value of the residual contract: p1+ and the current immediate

exercise reward of $500 if S1 < 2 (and 0 otherwise).

A rational holder will maximise value by choosing whichever has a greater

current value.

(iii)

(a)

Since the current exercise value increases with S1 and the value of

p1+ decreases with S1, the holder will choose to exercise the option at

t = 1 if and only if the stock price is greater than some critical value k.

(b)

have p1+ = $500. So we seek k such that

1000 er ({log(2/k) + .025}/.3) = 500

so ({log(2/k) + .025}/.3) = 0.51010

Page 9

Subject CT8 (Financial Economics Core Technical) Examiners Report, September 2011

so k = 2.0343

Performance on this question was very variable.

Part (i) was generally well-answered. A number of candidates highlighted that the inequality

was the wrong way around in part (ii). Part (iii) was generally poorly answered.

(i)

(ii)

d1 = (log(S/K) + r +2T) / T = ,

while = (log(S/K) + r 2T)/T = .

Thus C= S(d1) KerT (d2) = S(() ()) = 300(2() 1)

so () = 0.52 so = .1003 = 10.0%.

(iii)

and 600 2600 3 = 7200 short in cash.

Generally answered well by candidates. Most candidates were able to score full marks on

part (i) and proceed to score well on parts (ii) and part (ii).

10

(i)

(a)

Mean reversion means that the force of inflation will tend to move

towards its average value.

An AR(1) process is a linear auto-regressive model of order one (i.e.

the impulse at time t depends on the process one step before) whose

formula is of the form of the equation given in the question.

(b)

(ii)

Denote by i(t) the mean value of I(t), then taking expectations in the

formula, we see that i(t) = m + a(i(t 1) m)

or i(t) m = a(i(t 1) m). It follows that i(t) m tends to zero at a

geometric rate.

A random walk process can be expected to grow arbitrarily large with time.

If share prices follow a random walk, with positive drift, then those share

prices would be expected to tend to infinity for large time horizons.

However, there are many quantities which should not behave like this. For

example, we do not expect interest rates to jump off to infinity, or to collapse

back to zero.

Instead, we would expect some mean reverting force to pull interest rates back

to some normal range. In the same way, while inflation can change

substantially over time, we would expect them, in the long run, to form some

stationary distribution, and not run off to infinity. Similar considerations

apply to the annual rate of growth in share prices.

Page 10

Subject CT8 (Financial Economics Core Technical) Examiners Report, September 2011

In each case, these quantities are not independent from one year to the next;

times of high interest rates or high inflation tend to bunch together i.e. the

models are auto-regressive.

One method of modelling this is to consider a vector of mean reverting

processes. These processes might include (log) yields, or the instantaneous

growth rate of income streams. The reason for the log transformation is to

prevent negative yields.

The question was straightforward bookwork. Candidates struggled to score full marks on

part (ii) but were generally able to describe the basic concepts of the two models.

Unfortunately many candidates chose to write extensive details about share price models and

their characteristics rather than focus on the question about the random walk versus mean

reverting models.

11

(i)

(ii)

(a)

Similarly

k (t ) = 2 p1 (t) + p2 (t) = p1(t) p2(t) = k(t).

(b)

h(0) = 1 and k(0) = 1 we get h(t) = e3/2t and k(t) = et.

Page 11

Subject CT8 (Financial Economics Core Technical) Examiners Report, September 2011

It follows that p1(t) = (h(t) + k(t)) = (et e3/2t)

while p2(t) = (k(t) h(t)) = (et + e3/2t).

Now, since p3(t) = 1 p1(t) p2(t),

we obtain p3(t) = 1 3/4et 1/4 e3/2t.

And so p3(2) = .71164.

(iv)

(a)

(b)

Thus the credit spread is 16.75%.

Few candidates failed to score well on parts (i) and (ii). In contrast, very few students were

able to apply the results to part (iii) where scores were disappointing and often nil.

Candidates did not understand the relevance of h(t) and k(t) and they may have gotten further

if they had worked with them. Marks were picked up in question (iv) where candidates

continued with the question.

Page 12

EXAMINATION

25 April 2012 (am)

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1.

Enter all the candidate and examination details as requested on the front of your answer

booklet.

2.

You must not start writing your answers in the booklet until instructed to do so by the

supervisor.

3.

4.

Attempt all 10 questions, beginning your answer to each question on a separate sheet.

5.

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this

question paper.

In addition to this paper you should have available the 2002 edition of the Formulae

and Tables and your own electronic calculator from the approved list.

CT8 A2012

(i)

[3]

(ii)

[2]

(iii)

assumptions in (i) and (ii).

[4]

[Total 9]

In a market where the CAPM holds there are five risky assets with the following

attributes per year.

Asset number

Expected return

6%

5%

8%

13% 11%

Market capitalisation (in $) 2.6m 3.9m 5.2m

1.3m

Beta

1.5

The risk-free rate is r = 1% p.a.

(i)

[1]

(ii)

Deduce the market capitalisation of asset 4 and the betas of all the other assets.

[3]

(iii)

Calculate the beta of a portfolio P which is equally weighted in the five assets

and the risk-free asset.

[1]

(iv)

Explain whether or not this portfolio P lies on the Capital Market Line.

[2]

[Total 7]

A non-dividend paying stock has a current price of S0 = 150p and trades in a market

which is arbitrage free and has a constant effective risk-free rate of interest r. After

one year the price of the stock could increase to 280p, or decrease to 120p. Over the

following year the price could increase from 280p either to 420p or to 322p. If the

stock price had decreased to 120p, then over the following year it could increase to

168p or decrease to 112p.

(i)

Determine the range of values that the annual risk-free rate of interest could

take.

[3]

(ii)

CT8 A20122

( S 2 100) 2 at the end of two years.

[6]

[Total 9]

Let c be the price of a four- month European call option on a dividend paying share.

Assume the strike price is $30, the underlying is currently valued at $28 and a

dividend of $0.50 is expected in 2 months. The continuously compounded risk-free

rate is constant and equal to 5% p.a.

(i)

Derive upper and lower bounds on the price c of this call option, taking into

account the dividend.

[5]

The price of a put option with the same underlying, the same strike price and the same

maturity is $3.

(ii)

[5]

[Total 10]

Let X be a random variable denoting the rate of return on the fund ABC. The

distribution of X is N , 2 .

(i)

(ii)

Show that:

VaR = + 1 ( )

[1]

(Hint: Consider the probability that X is less than VaR ).

(iii)

[4]

TailVaR =

1

E ( X |X < VaR ) .

[4]

An investor holds 350m invested in ABC, the expected return on the fund is 10%

and the standard deviation of that return is 25%.

(iv)

CT8 A20123

[2]

[Total 11]

(i)

Write down a stochastic differential equation for the short rate r (t ) for the

Vasicek model.

[1]

(ii)

State the type of process of which the Vasicek model is a particular example.

[1]

(iii)

[5]

(iv)

[1]

(v)

Derive the expected value and the second moment of r(t) for t given.

[3]

(vi)

[1]

[Total 12]

The remuneration package for the CEO of a quoted company in the tax year 2012/13

includes a bonus proportional to the excess of the share price over 100p at

5 April 2013 at a rate of 50,000 per penny.

The companys Finance Director wants to hedge the cost of this bonus as at 6

April 2012. The share price at that date is S0 = 90p.

The continuously compounded interest rate is 1% p.a. and the share price volatility is

18% p.a.

(i)

[2]

(ii)

Calculate the hedging portfolio of shares and cash the Finance Director should

hold to hedge the liability for the CEOs bonus.

[3]

The CEO will be liable to tax at 80% on the excess over 1m of this bonus and at

40% up to 1m. The Finance Director realises that if she purchases for the CEO a

portfolio of a call options with a strike of 100p and b call options with a strike of

120p and gives this portfolio to the CEO on 6 April 2012 then the proceeds will be

liable for tax at only 40%.

(iii)

(a)

Calculate the values of a and b which ensure that the CEO would

receive the same net bonus.

[5]

options are exercised).

(b)

CT8 A20124

[2]

[Total 12]

underlying (non-dividend bearing) stock with price process S, pays 100p at time T if

and only if the stock price at time T, ST, is more than a. Let Ia (x) denote the function

which takes the value 1 if x>a and 0 otherwise.

(i)

Write down a formula, in terms of expectation, Ia, and the underlying stock

price, for the price D0(a) at time 0 of this security, specifying any other

notation that you use.

[2]

(ii)

Write down an equation connecting the price, C0(K) of the call option on S

with maturity T and strike price K, to the price of the special option on S, using

[2]

(iii)

Find a formula for the price of the special option on S, by differentiating the

Black-Scholes formula with respect to K.

[3]

Suppose S0 = 110p, the continuously compounded risk-free rate is 1% p.a., and the

volatility of S is 20% p.a.

(iv)

Calculate the price for a derivative security which pays S1 20p if S1 > 120p

and 0 otherwise.

[3]

[Total 10]

(i)

Describe the two state model for credit ratings and its generalisation to the

Jarrow-Lando-Turnbull model.

[4]

Companies A and B are joint investors in a high risk project to build a new space

plane. Each of the two companies zero-coupon bonds are modelled according to a

two-state model. Company As bonds have a recovery rate of A = 60%, while

Company Bs have a recovery rate of B = 50%. All bonds mature in nine months.

Company As bonds have a current price of $82 per $100 nominal, Company Bs

bonds have a current price of $79 per $100 nominal. The continuously compounded

risk-free rate is 1.5% p.a.

(ii)

they are constant.

[4]

A competitor to the space plane project now starts to sell a derivative security which

pays $100,000 at the end of nine months if and only if both companies default within

the nine months (a double-default). The current price for the derivative is $7900.

(iii)

(iv)

CT8 A20125

corresponding constant rate.

[2]

Calculate the maximum price for this derivative, by considering the maximum

possible double-default rate.

[4]

[Total 14]

10

(i)

Describe Arbitrage Pricing Theory (APT) in the context of factor models. [4]

(ii)

END OF PAPER

CT8 A20126

[2]

[Total 6]

EXAMINERS REPORT

April 2012 examinations

Core Technical

Purpose of Examiners Reports

The Examiners Report is written by the Principal Examiner with the aim of helping

candidates, both those who are sitting the examination for the first time and who are using

past papers as a revision aid, and also those who have previously failed the subject. The

Examiners are charged by Council with examining the published syllabus. Although

Examiners have access to the Core Reading, which is designed to interpret the syllabus, the

Examiners are not required to examine the content of Core Reading. Notwithstanding that,

the questions set, and the following comments, will generally be based on Core Reading.

For numerical questions the Examiners preferred approach to the solution is reproduced in

this report. Other valid approaches are always given appropriate credit; where there is a

commonly used alternative approach, this is also noted in the report. For essay-style

questions, and particularly the open-ended questions in the later subjects, this report contains

all the points for which the Examiners awarded marks. This is much more than a model

solution it would be impossible to write down all the points in the report in the time allowed

for the question.

T J Birse

Chairman of the Board of Examiners

July 2012

Subject CT8 introduces the main concepts and principles of financial economics. These are

developed in later subjects in the ST series of exams. This subject combines various types of

skills. In particular, along with CT7, it is one of the first where candidates are expected to

write lengthy passages of reasoned thought, rather than just complete calculations. This is a

skill that will be new to many, and candidates are advised to pay particular attention to the

answers to this type of question by studying many past papers.

Comments on the April 2012 paper

The general performance was good and better than on the previous session (September 2011).

Candidates generally found this paper challenging, but well-prepared candidates scored well

across the whole paper and the best candidates scored close to full marks. As in previous

diets, questions that required an element of application of the core reading to situations that

were not immediately familiar proved more challenging to most candidates. The comments

that follow the questions concentrate on areas where candidates could have improved their

performance. Candidates approaching the subject for the first time are advised to concentrate

their revision in these areas and the ability to apply the core reading to similar situations.

Page 2

(i)

1. The price of the underlying share follows a geometric Brownian motion.

2. There are no risk-free arbitrage opportunities.

3. The risk-free rate of interest is constant, the same for all maturities and the

same for borrowing or lending.

4. Unlimited short selling (that is, negative holdings) is allowed.

5. There are no taxes or transaction costs.

6. The underlying asset can be traded continuously and in infinitesimally

small numbers of units.

(ii)

1. Zt has independent increments, i.e. Zt Zs is independent of

{Zr , r s} whenever s < t.

2. Zs has stationary increments, i.e. the distribution of Zt Zs depends only

on t s.

3. Zs has Gaussian increments, i.e. the distribution of Zt Zs is

N(0, t s).

4. Z has continuous sample paths t Zt (note that Property (4) is a

consequence of (1)(3)).

(iii)

values of volatility over the term of the option. Given observed option prices

in the market, it is possible to work backwards to the implied volatility, that is,

the value of which is consistent with observed option. Examination of

historic option prices suggests that volatility expectations fluctuate markedly

over time.

The candidates who were familiar with the bookwork scored very well.

Page 3

(i)

EM = 9%

(ii)

Asset number

Expected return

6%

5%

8%

13% 11%

Market capitalisation (in $) 2.6m 3.9m 5.2m 6.5m 1.3m

Beta

5/8

1/2

7/8

1.5

5/4

(iii)

P = 19/24

(iv)

P does not belong to the Capital Market Line because (except in degenerate

cases) portfolios on the efficient frontier consist of linear combinations of the

market portfolio and the risk-free asset.

Generally answered well by candidates. Most candidates were able to score full marks on

parts (i) and (ii). The rest of the question proved to be a bit more difficult.

(i)

At the current time, this implies that 0.8 < 1 + r < 1.8667 .

After an up move we have 1.15 < 1 + r < 1.5.

After a down move we have 0.9333 < 1 + r < 1.4.

Since the rate of interest has to satisfy all of these inequalities, we obtain

15% < r < 40% .

(ii)

q2

q1

S 0 = 150

S 1 = 280

S 1 = 120

q3

Page 4

and

q1 =

180 120

336 322

= 0.375 , q2 =

= 0.14286

280 120

420 322

q3 =

144 112

= 0.57143.

168 112

V=

(1 + r )2

= 15, 984.

(i)

of money equal to $30e

5%

3

+ $0.50e

5%

6

After 4 months, portfolio A has a value which is equal to the value of the

underlying share plus the dividend invested for two months, provided that the

share value is above $30. If the value of the share is below $30, then the

payoff from portfolio A is great than that from the share with the dividend

reinvested. So

c + $30e

5%

3

+ $0.50e

5%

6

$28

c $2

The call option gives the holder the right to buy the underlying share for $30.

So the payoff is always less than the value of the share after 4 months.

Therefore the value of the call option must be less than or equal to the value of

the share:

c0 $28.

Page 5

(ii)

B: one put option plus one share

After four months both portfolios have value

5%

5%

6

5%

6 .

Therefore they should have the same value at any time before 4 months, so

c0 + $30e

5%

3

+ $0.50e

5%

6

= $3 + $28,

and so c0 = 1.

Generally answered well by candidates. Most candidates were able to score full marks on

part (i).

(i)

(ii)

= P ( X < VaR )

X VaR

= P

<

VaR

= P Z <

VaR

Therefore =

VaR

1 ( ) =

,

Page 6

(iii)

TailVaR = E ( X |X < VaR )

1

=

VaR

x, ( x ) dx

1( )

x0,1 ( x ) dx

1( )

0,1 ( x )

1 ( )

(iv)

1

2

25% 1 22.32635

= 198.21m

TailVaR = 350m 10%

e

1% 2

There were typographical errors in the question which should have defined

TailVaR = E( X |X < VaR ) . Generous consideration was given to all scripts containing

any reasonable attempt in the marking of this question.

(i)

(ii)

(iii)

Let r ( t ) = s (t )e t so

ds ( t ) = d r ( t ) et =et r ( t ) dt + et dr ( t )

= et r ( t ) dt + et ( r ( t ) ) dt + et dW ( t )

= et dt + et dW ( t ) .

Page 7

Thus s ( t ) = s ( 0 ) + et 1 + es dW ( s ) ,

0

and r ( t ) = r ( 0 ) e

+ 1 e

) + e

( s t )

dW ( s ) .

(iv)

(v)

t

E ( r ( t ) ) = E r ( 0 ) e t + 1 e t + e ( s t ) dW ( s )

0

Hence,

E ( r ( t ) ) = r ( 0 ) e t + (1 e t )

E ( r (t ))

E (r ( t )

2

t

( s t )

t

t

= E r ( 0) e + 1 e

+ e

dW ( s )

) = (r ( 0 ) e

+ 1 e

))

2 ( s t )

ds

(vi)

rate model

This was again standard material from the core reading and more successful candidates

tended to score well, although this question proved to be generally challenging.

(i)

The CEO essentially holds 5,000,000 call options on the stock with strike

100p and maturity 1 year.

(ii)

with

and

(d2) = .26770

so that C = 3.2009p.

Page 8

so the hedging portfolio is 5,000,000 .33005 = 1,650,250 shares

and 5,000,000 .032009 1,650,250 .9 = 1,325,180 short in cash.

(iii)

(a)

0.6 a (S 100) = 0.6 5,000,000 (S 100)

so a = 5,000,000;

For S>120, then we need

0.6 {a(S 100) b(S 120)}= 600,000 + 0.2 5,000,000(S 120)

Equating coefficients of S, we must have b = 3,333,333.

We can then check that the constant terms agree in this equation, too.

(b)

The amount saved is the cost of b call options with the higher strike.

We get C = S(d1) KerT (d2), with S = 90, K = 120, d1 =

1.45268, d2 = 1.63268, (d1) = .07316, S(d2) = 0.05127

So C = .4932p

The saving is 3,333,333 .004932 = 16,440.

Question 7 was generally found to be difficult. While part (i) was generally straightforward

for most candidates, parts (ii) and (iii) proved to be very challenging and were only answered

well by the best candidates.

(i)

(ii)

C0(K) =

(iii)

D0 (a )da.

It follows that

D0(K) = d/da C0(K) = d/dK(S(d1) KerT (d2))

= erT (d2) S(d1)(dd1/dK) KerT (d2)(dd2/dK),

where is the standard normal density.

Page 9

and

S(d1) = (1/2) exp(log S d12/2) = KerT (d2)

and so D0(K) = erT (d2).

(iv)

We can decompose the payoff for this security as the sum of a call with strike

120 and 1 special option also with strike 120p.

Thus the price is

(S(d1) KerT (d2) + 100e-rT(d2))

p = 110(d1) (120er 100e-r) (d2)

= 110 * (.3877867) ( 19.80100) * 0.3138046 = 36.443p

This question proved to be a bit challenging, despite being well within the syllabus..

(i)

In the two state model, the company defaults at time-dependent rate (t) if it

has not previously defaulted. Once it defaults it remains permanently in the

default state. It is assume d that after default all bond payments will be

reduced by a known factor (1 ), where is the recovery rate. Now we need

to change to the risk neutral measure, which will change the default rate to

(t ). This rate is that implied by market prices.

The Jarrow-Lando-Turnbull model generalises the two-state model to n 1

credit ratings plus the default state with transitions possible between any pair

of states except for the default state which is absorbing.

(ii)

82 = 100ert(1 (1 A) (1-exp(At))),

and

79 = 100ert(1 (1 B) (1-exp(Bt))),

so

A = log [1-(1 e.75r 82/100) / (1 A)] / .75 = .74204

and

B = log [1-(1 e.75r 79/100) / (1 B)] / .75 = .68583.

(iii)

of the derivative security we have

V = 100,000 e.75rp,

Page 10

So

P = (7900/100000) * e.75r = 0.07989,

the corresponding constant rate is log (1 p) / .75 = 0.111016.

(iv)

happen at rate faster than min(A, B) = B = .68583. This would give rise to a

price for the derivative of V = 100000e.75r p , where p = 1 exp( .75 B)

= 0.40212 so V = $39,763.

Alternatively, we can buy $200,000 nominal of risk-free zero coupon bond

and sell $200,000 nominal of company Bs bond. This will cost

200,000(e.75r .79) = $39,763 and will pay $100,000 in 9 months if and only

if company B defaults.

Clearly, we would not be willing to pay more than this for the derivative.

10

(i)

APT requires that the returns on any stock be linearly related to a set of factor

indices as shown below

Ri = ai + bi,1 I1 + bi,2 I2 + ... + bi ,L IL + ci ,

where Ri is the return on security i,

ai and ci are the constant and random parts respectively of the component of

return unique to security i,

I1 ... IL are the returns on a set of L indices,

bi,k is the sensitivity of security i to index k.

The more general result of APT, that all securities and portfolios have

expected returns described by:

Ei = 0 + 1 bi,1 + 2bi,2 + ... + Lbi,L .

The principal strength of the APT approach is that it is based on the noarbitrage conditions.

Page 11

(ii)

Weaknesses:

(1)

(2)

We also need to come up with the correct factor forecasts. The hard part

is the factor forecasts: finding the amount of expected excess return to

associate with each factor. The simplest approach is to calculate a history

of factor returns and take their average. This implicitly assumes an

element of stationarity in the market.

This was standard material from the core reading and more successful candidates tended to

score well, although some struggled to get all points required for full marks.

Page 12

EXAMINATION

4 October 2012 (am)

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1.

Enter all the candidate and examination details as requested on the front of your answer

booklet.

2.

You must not start writing your answers in the booklet until instructed to do so by the

supervisor.

3.

4.

Attempt all 10 questions, beginning your answer to each question on a separate sheet.

5.

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this

question paper.

In addition to this paper you should have available the 2002 edition of the Formulae

and Tables and your own electronic calculator from the approved list.

CT8 S2012

The effective risk free interest rate is 4% p.a. Company AA has issued a one year

zero coupon bond with a yield of 6% p.a. and Company BB has issued a one year zero

coupon bond with a yield of 8% p.a. All rates are annually compounded.

Recovery rates on the bonds in the event of default are zero and there are no frictional

costs.

(i)

(ii)

Calculate the 95% VaR and 95% TailVaR at the end of the year for the

following portfolios, assuming defaults by AA and BB are independent:

(a)

(b)

(c)

[2]

100 invested in BB bonds.

50 invested in AA bonds and 50 invested in BB bonds.

[6]

(iii)

[4]

[Total 12]

A non-dividend-paying stock has a current price of S0 = 400 p . Over each of the next

three years its price could increase by 20% (so St +1 = 1.2St ), or decrease by 20% (so

St +1 = St /1.2 ). The continuously compounded risk-free rate is 6% p.a. The stock

price move in each year is independent of the move in other years.

A non-standard derivative pays off

over three years the stock price has moved up in one year and then immediately down

in the following year. Otherwise, the derivative pays zero.

[8]

(i)

[3]

(ii)

Write down equations for the expected return, E and variance, V of a portfolio

of N securities, defining any notation used.

[3]

(iii)

CT8 S20122

[4]

[Total 10]

two three-month periods it is expected to go up by 6% or down by 5% on each period.

The continuously compounded risk free interest rate is 5% p.a.

(i)

Calculate the value of a six-month European call option with a strike price of

82.

[5]

(ii)

Calculate the value of a six-month European put option with a strike price of

82.

(a)

(b)

(iii)

Directly.

Using put-call parity.

[2]

[3]

Explain whether, if the put option were American, it would ever be optimal to

exercise early.

[4]

[Total 14]

(i)

State the Stochastic Differential Equations for the short rate r(t) in the Vasicek

model and the Cox-Ingersoll-Ross model.

[2]

(ii)

Explain the impact of a movement in the short rate on the volatility term in

both models.

[2]

[Total 4]

[8]

Widget Inc with a strike price of $1.30 has current price of $0.8557.

The continuously compounded risk free rate is 0.5% p.a. The current stock price is

$1.20. Assume all the Black-Scholes assumptions hold.

(i)

Calculate the implied volatility for the underlying stock to within 1% p.a. [2]

It is known that in three months Universal Widget Inc will embark on a major

restructuring. It is anticipated that this will double the volatility of the stock price

thereafter.

(ii)

Write down a formula in terms of the underlying Brownian motion, Z, for the

stock price in three months and in six months time.

[3]

(iii)

Derive the corresponding price of a six month European put on the Universal

Widget Inc stock with strike price $1.20

[6]

[Total 11]

CT8 S20123

(i)

[4]

A very highly geared company, Risky plc, has issued zero coupon bonds payable in

three year time for a nominal amount of 3,200m.

A Black-Scholes model for the value of the company is adopted.

(ii)

[3]

The current gross value of the company is 6,979m. The continuously compounded

risk-free interest rate is 2% p.a. and the price of 100 nominal of the bond is 92.603.

An insurance company is offering default insurance on Risky plc. They will charge a

premium of 55,000 for a contract which pays 1m at the end of three years if Risky

plc defaults.

(iii)

[4]

[Total 11]

Consider a market where there are two risky assets A and B and a risk free asset. Both

risky assets have the same market capitalisation.

Assume that all the assumptions of the CAPM hold.

(i)

[1]

(ii)

Derive the expressions for the variance of the market portfolio and for the beta

of each asset, in terms of the variance of each asset and of their covariance. [4]

Assume now that the risk-free rate is rf = 10%, the expected return of the market

portfolio is rM =18%, the variance of asset A is 4%, the variance of asset B is 2% and

their covariance is 1%.

(iii)

Derive the value for the expected return on asset A and asset B.

[4]

(iv)

(v)

Derive the corresponding standard deviation using the Capital Market Line. [2]

[Total 13]

CT8 S20124

[2]

10

Let A and B be two investment portfolios taking values in [a,b] with cumulative

probability distribution functions of returns FA and FB respectively, and let the

investors smooth utility function be U.

(i)

Write down the equation that the function U satisfies if the investor prefers

more to less.

[1]

(ii)

dominate portfolio B.

(iii)

if portfolio A first order stochastically dominates portfolio B, then the investor

prefers A to B.

[6]

[Total 9]

END OF PAPER

CT8 S20125

[2]

EXAMINERS REPORT

September 2012 examinations

Core Technical

Introduction

The Examiners Report is written by the Principal Examiner with the aim of helping

candidates, both those who are sitting the examination for the first time and using past papers

as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The

Examiners have access to the Core Reading, which is designed to interpret the syllabus, and

will generally base questions around it but are not required to examine the content of Core

Reading specifically or exclusively.

For numerical questions the Examiners preferred approach to the solution is reproduced in

this report; other valid approaches are given appropriate credit. For essay-style questions,

particularly the open-ended questions in the later subjects, the report may contain more points

than the Examiners will expect from a solution that scores full marks.

D C Bowie

Chairman of the Board of Examiners

December 2012

Subject CT8 introduces the main concepts and principles of financial economics. These are

developed in later subjects in the ST series of exams. This subject combines various types of

skills. In particular, along with CT7, it is one of the first where candidates are expected to

write lengthy passages of reasoned thought, rather than just complete calculations. This is a

skill that will be new to many and candidates are advised to pay particular attention to the

answers to this type of question by studying many past papers.

Comments on the September 2012 paper

The general performance was good and better than on the previous session (April 2012).

Candidates generally found this paper challenging, but well-prepared candidates scored well

across the whole paper and the best candidates scored close to full marks. As in previous

diets, questions that required an element of application of the core reading to situations that

were not immediately familiar proved more challenging to most candidates. The comments

that follow the questions concentrate on areas where candidates could have improved their

performance.

Page 2

(i)

Let the risk neutral default probability for AA be p AA . Consider the equation

of value for a 100 investment in AA:

100 = (1 p AA )

106

+ p AA 0 p AA =1.8868%,

1.04

and similarly

100 = (1 pBB )

(ii)

(a)

108

+ pBB 0 pBB = 3.7037%.

1.04

106 p AA

= 106

p AA

(b)

108 pBB

= 108

pBB

(c)

54 with probability p AA (1 pBB ) = 0.01817

0 with probability p AA pBB = 0.00070

So the 95% VaR is 107 54 = 53.

The 95% TailVaR is

= 55

pBB

(iii)

lower dispersion of returns and hence lower risk.

Portfolio (c) is diversified compared to (a) and (b). However, the 95% VaR

for portfolio (c) is higher than for either (a) or (b) where it is zero. So an

increase in VaR could, in this circumstance, correspond to a decrease in risk.

Zero VaR does not necessarily mean zero risk.

The 95% TailVaR for portfolio (c) is lower than (a) and (b).

Page 3

The question was framed sufficiently openly that candidates could quote values at risk

relative to the maximum return, the expected return or the initial investment. Full marks

were available for any approach if it was followed through correctly although the below sets

out answers relative to the maximum return.

In general, this was poorly answered with candidates struggling to gain more than a few

marks. Some candidates calculated the transition rates in part (i) instead of the probability or

calculated the probabilities assuming a continuous time model. In part (ii), many candidates

calculated VaR and TailVaR using a continuous model instead of the discrete model in the

question. Some candidates confused VaR and variance.

q=

e6% 1/1.2

= 0.62319

1.2 1/1.2

[1]

There are eight possible paths the option could take. The paths, probabilities of those

paths, final stock prices and option payoffs are shown in the following table.

Path

Probability of path

Option payoff

Up up up

q3 = 0.24203

691.2

Nil

Up up down

q 2 (1 q) = 0.14634

480

21.91

Up down up

q 2 (1 q) = 0.14634

480

21.91

Up down down

(1 q)2 q = 0.08848

333.33

18.26

Down up up

q 2 (1 q) = 0.14634

480

Nil

Down up down

(1 q)2 q = 0.08848

333.33

18.26

Down down up

(1 q)2 q = 0.08848

333.33

Nil

(1 q)3 = 0.05350

231.48

Nil

V = e 36%

paths

If candidates worked in units of s rather than p, they will have found an answer of

0.805 (or 80.5p) and full marks were available.

Also, if candidates took a down movement to mean 0.8St rather than St/1.2 then full

marks were available in this case.

Page 4

Largely well answered. Some candidates didnt calculate the price correctly because they

miscalculated the number of paths to the nodes with non-zero payoffs. Some candidates

miscalculated the probability by using e-r rather than er. A few candidates calculated the

probability according to classical probability theory (favourable outcomes / possible

outcomes) rather than risk-neutral.

(i)

(ii)

(a)

That investors select their portfolios on the basis of the expect return

and the variance of that return over a single time horizon.

(b)

Investors are never satiated. At a given level of risk, they will always

prefer a portfolio with a higher return to one with a lower return.

(c)

Investors dislike risk. For a given level of return they will always

prefer a portfolio with lower variance to one with higher variance.

A proportion xi is invested in security Si . The return on the portfolio RP is

N

RP = xi Ri ,

i =1

The expected return on the portfolio E is

N

E = E [ RP ] = xi Ei ,

i =1

The variance is

V = Var [ RP ] =

xi x j Cij ,

i , j =1

where Cij is the covariance of the returns on securities i and j and we write

Cii =Vi .

(iii)

A portfolio is efficient if the investor cannot find a better one in the sense that

it has both a higher expected return and a lower variance.

Page 5

When there are N securities the aim is to choose xi to minimise V subject to the

constraints

i xi = 1

and

E = EP, say,

in order to plot the minimum variance curve.

One way of solving such a minimisation problem is the method of Lagrangian

multipliers.

The Lagrangian function is

W = V (E EP) (i xi 1).

To find the minimum we set the partial derivatives of W with respect to all the xi and

and equal to zero. The result is a set of linear equations that can be solved.

The usual way of representing the results of the above calculations is by plotting the

minimum standard deviation for each value of EP as a curve in expected return

standard deviation (E ) space. In this space, with expected return on the vertical

axis, the efficient frontier is the part of the curve lying above the point of the global

minimum of standard deviation.

Largely well answered. Some candidates forgot the single time period assumption in part

(i) or included simplifying assumptions such as no transaction charges etc. as major

assumptions. Some candidates confused efficient portfolios with optimal portfolios.

Page 6

(i)

S2 = 89.888

q

S 1 = 84.8

S 1 = 76.194

S 0 = 80

S2 = 80.762

S2 = 72.562

Payoff

Call at 82

Put at 82

7.888

1.238

9.438

1

1.05 = 0.55936.

Now q =

1

1.06

1.05

e5%/4

(ii)

(a)

(b)

Similarly, p0 = e

5%

2

5%

2

= p0 + 80

Using the value for the call found in question (i), we get p0 = 2.38248.

(iii)

At time zero, the value of the American put option is at least as great as the

European put option, i.e. greater than 2.38248. The intrinsic value of the

option is 2. Therefore early exercise is not optimal.

Page 7

After three months, if the first move is up the option is out of the money, so

early exercise is not optimal.

After three months, if the first move is down, the intrinsic value of the option

is 82 76.19048 = 5.8095. The value of holding on to the option until 6

months is given by

5%

4

So, it would be optimal to exercise the option early if the first move was

down.

Candidates who calculated a down move as multiplying by 0.95 rather than

dividing by 1.05 were awarded full marks.

Largely well answered with most candidates earning full marks in parts (i) to (iii). The

majority of candidates discussed whether it was optimal to exercise American put options in

general in part (iv), or even American call options, rather than the particular option in the

question.

Interest rates should be positive.

The short rate and other interest rates should exhibit some form of mean-reverting

behaviour.

It should be straightforward to calculate the prices of bonds and certain derivative

contracts.

The model should produce realistic dynamics.

The model should be able to be calibrated easily to current market data.

The model should be flexible enough to cope properly with a range of derivative

contracts.

The model should provide a satisfactory fit to historical data.

Generally well done as straightforward book work. Some candidates answered this with a

series of questions such as "is it easy to calculate? does it fit historical data?... In this

situation marks were awarded according to the extent that the candidates identified the key

points set out below. Some candidates did write other assumptions like constant volatility

or the share follows geometric Brownian motion.

Page 8

(i)

Under the risk neutral measure Q the short rate under the Vasicek model has

the dynamics

dr ( t ) = ( r ( t ) ) dt + dW (t )

The short rate under the Cox-Ingersoll-Ross model has the dynamics

dr ( t ) = ( r ( t ) ) dt + r (t ) dW (t )

(ii)

So, if the short-rate changes, the volatility of the process is unchanged in the

Vasicek model, but it will change in the CIR model (an increase in the short

rate will lead to an increase in the volatility).

Most candidates gained full marks in part (i). Some candidates wrote about how a change in

volatility could affect the short-term rate rather than vice versa. One or two candidates only

included the sigma in the volatility term of the CIR model. Many candidates gave generic

statements about the interest rate models in answer to part (ii), rather than responding to the

question.

(i)

(ii)

Under the risk free measure, the stock price S0.25 = S0 exp( Z0.25

0.52(0.25) + 0.25r)

While the stock price at time 6 months is

S0.5 = S0.25 exp(2(Z0.5 Z0.25 ) 0.5(2)2 (0.25) + 0.25r)

= S0 exp(2(Z0.5 Z0.25 ) + Z0.25 0.52(1.25) + 0.5r)

Full marks were available if candidates provided the formulae under the real

world probability measure.

(iii)

Since Z has stationary independent increments, S0.5 has the same distribution

as

S0 exp((2.5)Z0.5 0.52(1.25) + 0.5r),

which corresponds to the stock price at 6 months with volatility (2.5).

Now, using the Black-Scholes formula, the put price is

p = KrT (d2) S0 (d1).

d1 = 2.4378

d2 = -2.4368,

Page 9

so

p = 120(e.5r (d2) (d1)) = $1.179

In general, this was poorly answered. There was evidence of candidates spending a

significant amount of time in part (i) but many then proceeded with an assumed value for the

volatility and were awarded full marks where they completed parts (ii) and (iii) in a selfconsistent way. Most candidates forgot the volatility doubled between time three and six.

Several candidates managed to calculate a value in part (iii) using their assumed values from

part (i).

(i)

Mertons model assumes that a corporate entity has issued both equity and

debt such that its total value at time t is of F(t).

It is an example of a structural credit risk model.

F(t) varies over time as a result of actions by the corporate entity which does

not pay dividends on its equity or coupons on its bonds. Part of the corporate

entitys value is zero-coupon debt with a promised repayment amount of L at a

future time T. At time T the remainder of the value of the corporate entity will

be distributed amongst the equity holders and the corporate entity will be

wound up.

The corporate entity will default if the total value of its assets, F(T) is less than

the promised debt repayment at time T, i.e. F(T)<L. In this situation, the bond

holders will receive F(T) instead of L and the equity holders will receive

nothing.

This can be regarded as treating the equity holders of the corporate entity as

having a European call option on the assets of the company with maturity T

and a strike price equal to the value of the debt.

The Merton model can be used to estimate either the risk-neutral probability

that the company will default or the credit spread on the debt.

(ii)

where F(t) is the gross value of the company at time t.

Thus the value at time 0 is

e3rE[min(F(3),3200)] = e3rE[F(3) max(F(3) 3200,0)],

where the expectation is under the risk-neutral measure, so equals F(0) C,

where C is a call option on the gross value with strike 3,200m.

(iii)

Page 10

The market value of the equity (i.e. the call option on the companys assets is

then 6,979m 2,963.3m = 4,015.7m.

We can calculate the implied volatility of the companys assets as 29.8%

The risk neutral price for the insurance (ignoring credit risk of the insurer

themselves) is then:

1m e6% (1 (d2)) = 1m e6% 0.085518 = 80,538.2

Whether or not this represents an arbitrate opportunity depends on whether

there is a market (e.g. credit default swaps) where you can trade these

contracts/go short in relation to Risky plc.

Candidates had no major problems in part (i) describing the Merton model. Some

candidates did confuse the facts that shareholders had a call option while bondholders had a

put, although given put-call parity there are various ways to value these options. Only some

candidates managed to answer part (ii) and some did answer it by reference to valuing a put

option rather than the call in the marking schedule for which full marks were awarded.

(i)

(ii)

Let rM denote the return of the market portfolio, rA (resp. rB) denote the return

of asset A (resp. asset B).

Then, V(rM) = V(0.5rA + 0.5rB) = 0.52 * V(rA) + 0.52 * V(rB)

+ 2 * 0.52 cov(rA,rB).

BetaA = cov(rA,rM)/V(rM)

= (0.5 * V(rA) + 0.5 * cov(rA,rB))/ 0.52 * V(rA) + 0.52 * V(rB)

+ 2 * 0.52 cov(rA,rB)

As Cov(rA,rM) = cov(rA,0.5rA+0.5rB) = 0.5 * V(rA) + 0.5 * cov(rA,rB)

Similarly, BetaB = (0.5 * V(rB) + 0.5 * cov(rA,rB)) / 0.52 * V(rA) + 0.52

* V(rB) + 2 * 0.52 cov(rA,rB)

(iii)

ri = rf + Betai (rM rf) where ri is the expected return of asset i (for i = A,B).

Hence, using the numerical values, we get

rA = 0.2 and rB = 0.16

(iv)

Page 11

rP = w0 rf + wM rM

where w0 is the weight of the risk-free asset in the portfolio P and wM is the

weight of the market portfolio in the portfolio P.

Moreover, there is the constraint w0 + wM = 1

Solving the system leads to:

w0 = 0.25 and wM = 1.25

(v)

rP = rf + sigmaP * ((rM rf) / sigmaM)

where sigmaP (resp. sigmaM) is the standard deviation of the portfolio P (resp.

the market portfolio.

So, we get sigmaP = 17.6%

This question posed little difficulty to well-prepared candidates. Some included the risk-free

asset in their answer to part (i). In part (ii), a lot of candidates defined beta in terms of the

market portfolio rather than the risky assets as asked for in the question. Part (iii) posed

little problem for the majority of candidates although some struggled to calculate a

numerical value for beta. Only a handful of candidates included the risk-free asset in part

(iv). The majority only included the risky assets.

10

(i)

U ( w) > 0 .

(ii)

certain value is never less than the probability of portfolio A producing a

return below the same value and exceeds it for at least some value of x .

Alternative answer:

First order stochastic dominance holds if:

FA ( x ) < FB ( x ) , for some value of x .

(iii)

b

Page 12

E [U A ] = U ( w ) dFA ( w ) ,

a

b

E [U B ] = U ( w ) dFB ( w ) .

a

Thus, if A is preferred to B

b

a

b

U ( w) ( FA ( w ) FB ( w ) ) U ( w ) [ FA ( w ) FB ( w )]dw.

a

a

so for the expression to be positive we require the value of the integral to be

negative.

U ( w ) > 0 by assumption, so for the integral to be negative, no matter what

for all values of w with FA < FB for at least one value of w if the value is not

to be zero.

Largely well-answered. However, some candidates appeared to confuse inequality signs. In

part (i), this meant defining non-satiation as having a decreasing utility function while in part

(ii) this meant the distribution function of A was greater than that of B. Fewer candidates

than expected scored well in part (iii) for what appeared to be a textbook proof.

Page 13

EXAMINATION

17 April 2013 (pm)

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1.

Enter all the candidate and examination details as requested on the front of your answer

booklet.

2.

You must not start writing your answers in the booklet until instructed to do so by the

supervisor.

3.

4.

Attempt all 10 questions, beginning your answer to each question on a separate sheet.

5.

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this

question paper.

In addition to this paper you should have available the 2002 edition of the Formulae

and Tables and your own electronic calculator from the approved list.

CT8 A2013

List the key advantages and disadvantages of the following measures of investment

risk in the context of a portfolio of bonds subject to credit risk:

Variance of return

Downside semi-variance of return

Shortfall probability

Value at Risk

Tail Value at Risk

[10]

Consider a mean-variance portfolio model with two securities, SA and SB , where the

expected return and the variance of return for SB are twice the corresponding values

for SA . Suppose the correlation between the returns on the two securities is .

(i)

(ii)

(iii)

(a)

zero-risk portfolio, by calculating the variance of the return on a

portfolio with weights xA and xB invested in the two assets.

(b)

Calculate the portfolio weights that lead to the most efficient zero-risk

portfolio.

(c)

the expected return on SA .

[5]

(a)

(b)

if the investor can short sell at most one unit of either security and the

total he has to invest is one unit.

[2]

covariance between the two securities is 60% of the variance of SA .

[2]

[Total 9]

An analyst states that It is common practice in actuarial modelling to use the same

data set to specify the model structure, to fit the parameters, and to validate the model

choice. A large number of possible model structures are tested, and testing stops

when a model is found which passes a suitable array of tests.

Indicate, giving evidence and examples, why this procedure may be inappropriate.

[5]

CT8 A20132

In a market where the CAPM holds there are five assets with the following attributes.

Asset

Annual return in

State 1

State 2

State 3

Market Capitalisation

(i)

Probability

of being in

state

3%

5%

7%

10m

3%

7%

5%

20m

3%

2%

8%

40m

3%

8%

1%

30m

3%

3%

3%

0.25

0.5

0.25

Calculate the expected annual return on the market portfolio and M, the

standard deviation of the annual return on the market portfolio.

[4]

(ii)

[2]

(iii)

[6]

(iv)

(i)

[3]

[Total 15]

[5]

dX t = Yt dBt + At dt ,

where At is a deterministic process and Yt is a process adapted to the natural

filtration of Bt .

(ii)

(iii)

CT8 A20133

[2]

[2]

[Total 9]

Suppose that at time t we hold the portfolio ( at , bt , ct ) where at, bt and ct represent

the number of units held at time t of securities with respective price processes At , Bt

and Ct . Assume ( at , bt , ct ) are previsible. Let Vt be the value of this portfolio at

time t.

(i)

[1]

(ii)

Write down an equation for the instantaneous change in the value of the

portfolio, including cash inflows and outflows, at time t.

[2]

(iii)

[2]

(iv)

contingent on the path taken by at , bt and ct .

[2]

(v)

used to value the derivative in (iv) at time 0.

[2]

(vi)

[1]

[Total 10]

Over each of the next two years its price will either be multiplied by a factor of 1.2 or

divided by 1.2. The continuously compounded risk-free rate is 1% p.a. The value of

an option on the stock is 50p.

Denote by Puu the value of the payoff if both stock price moves are up, Pud for the

value of the payoff if one move is up and one is down (this is the same whichever

order the price moves occur), and Pdd for the value of the payoff if both stock price

moves are down. The price of the stock is to be modelled using a binomial tree

approach with annual time steps.

(i)

Derive, and simplify an equation for Puu in terms of Pud and Pdd .

(ii)

Calculate, using your answer to part (i), or otherwise, the range of values that

Puu could take.

[2]

(iii)

Determine the value of the option in each of the two cases below, assuming

that Puu takes its maximum possible value:

(a)

(b)

[4]

If the first stock price move is down.

[3]

[Total 9]

CT8 A20134

(i)

[5]

(ii)

Write down, defining all terms and notation used, the two-factor Vasicek

model.

[3]

[Total 8]

2 years on an underlying (non-dividend bearing) stock with price process St. Its

payoff at maturity is $100Max(S2/S1 1;0) if and only if the stock price has not

exceeded $2 by time 1. The volatility of the stock is 25% p.a. and the continuously

compounded risk-free rate is 3% p.a. The initial stock price is $1.

(i)

Calculate Q(Maxt<1St < 2), where Q is the EMM, using the formula in the

actuarial tables and the representation of a geometric Brownian Motion.

[3]

(ii)

(a)

Write down an expression for the price of this option at time 1. You

should consider separately the two cases (Maxt<1St) < 2 and

(Maxt<1St) 2.

(b)

Show that the value of this option at time 1 is $11.348 in the case

(Maxt<1 St )< 2.

(c)

10

(i)

Determine, using the result in (i), the fair price at time 0 for the option.

[9]

[Total 12]

[4]

two zero-coupon bonds in issue, both with a recovery rate of = 60%. Bond 1

matures in one year, bond 2 in two years time. Bond 1 has a continuously

compounded credit spread of 4%, bond 2 has a continuously compounded credit

spread of 5%. The continuously compounded risk-free rate is 1.5% p.a.

(ii)

(iii)

(a)

Calculate the price per $100 nominal of each bond in one year and in

two years time.

(b)

and in two years time.

[6]

Determine the implied values of the default intensities, assuming that they are

constant for each of the two years.

[3]

[Total 13]

END OF PAPER

CT8 A20135

EXAMINERS REPORT

April 2013 examinations

Core Technical

Introduction

The Examiners Report is written by the Principal Examiner with the aim of helping

candidates, both those who are sitting the examination for the first time and using past papers

as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The

Examiners have access to the Core Reading, which is designed to interpret the syllabus, and

will generally base questions around it but are not required to examine the content of Core

Reading specifically or exclusively.

For numerical questions the Examiners preferred approach to the solution is reproduced in

this report; other valid approaches are given appropriate credit. For essay-style questions,

particularly the open-ended questions in the later subjects, the report may contain more points

than the Examiners will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that

the examination was set. Candidates should take into account the possibility that

circumstances may have changed if using these reports for revision.

D C Bowie

Chairman of the Board of Examiners

July 2013

Subject CT8 (Financial Economics Core Technical) April 2013 Examiners Report

Subject CT8 introduces the main concepts and principles of financial economics. These are

developed in later subjects in the ST series of exams. This subject combines various types of

skills. In particular, along with CT7, it is one of the first where candidates are expected to

write lengthy passages of reasoned thought, rather than just complete calculations. This is a

skill that will be new to many, and candidates are advised to pay particular attention to the

answers to this type of question by studying many past papers.

Comments on the April 2013 paper

The general performance was good and better than on the previous session (September 2012).

Candidates generally found this paper challenging, but well-prepared candidates scored well

across the whole paper and the best candidates scored close to full marks. As in previous

diets, questions that required an element of application of the core reading to situations that

were not immediately familiar proved more challenging to most candidates. The comments

that follow the questions concentrate on areas where candidates could have improved their

performance.

Page 2

Subject CT8 (Financial Economics Core Technical) April 2013 Examiners Report

Variance of return

Variance is mathematically tractable.

Variance fits neatly with a mean-variance portfolio construction framework.

Variance is a symmetric measure of risk. The problem of investors is really the

downside part of the distribution.

Credit risky bonds have an asymmetric return distribution and as defaults are often

co-dependent on economic downturns portfolios can have fat tails.

Neither skewness or kurtosis of returns is captured by a variance measure.

Downside semi-variance of return

Semi-variance is not easy to handle mathematically and it takes no account of

variability above the mean.

Furthermore if returns on assets are symmetrically distributed semi-variance is

proportional to variance.

As with variance of return, semi-variance does not capture skewness or kurtosis.

It can be decomposed into systematic and non-systematic risk contributions.

Shortfall probability

The choice of benchmark level is arbitrary.

For a portfolio of bonds, the shortfall probability will not give any information on:

nor the potential downside of returns when the benchmark level is exceeded.

It allows a manager to manage risk where returns are not normally distributed.

Value at Risk (VaR)

VaR generalises the likelihood of underperformance by providing a statistical

measure of downside risk.

Portfolios exposed to credit risk, systematic bias or derivatives may exhibit nonnormal distributions.

Page 3

Subject CT8 (Financial Economics Core Technical) April 2013 Examiners Report

distributions of returns.

The further one gets out into the tails of the distributions, the more lacking the data

and, hence, the more arbitrary the choice of the underlying probability distribution

becomes.

Tail Value at Risk (TailVaR)

Relative to VaR, TailVaR provides much more information on how bad returns can be

when the benchmark level is exceeded.

It has the same modelling issues as VaR in terms of sparse data, but captures more

information on tail of the non-normal distribution.

In general, and given that this was a straightforward question, this was surprisingly poorly

answered with students losing marks for not knowing basic definitions.

Let the expected return on S A be E A and the variance of return be V A . Then the

expected return on S B is 2 E A and the variance of return is 2 V A .

(i)

(a)

The only zero risk portfolio can occur if the correlation is either 1 or

1. By considering diversification, the most efficient portfolio will

occur when it is 1.

The overall portfolio variance is:

V = x 2AVA + 2 xB2VA + 2 2 x A xB VA = VA ( x A 2 xB ) 2

+2 2 x A xB (1 + )V A

this can only be 0 if = 1 .

(b)

x A + xB = 1 yields x A =

(ii)

Page 4

2

1

and xB =

.

2 +1

2 +1

2+2

.

2 +1

(c)

(a)

selling unlimited amounts of security S A to purchase unlimited

amounts of security S B ).

Subject CT8 (Financial Economics Core Technical) April 2013 Examiners Report

(b)

(iii)

unit of S A to purchase two units of S B . The maximum expected

return is then 3 E A .

xA =

2VA 0.6VA 7

2

= = 0.7777 and so xB = = 0.2222

3VA 1.2VA 9

9

11

E A = 1.2222 E A .

9

This question was surprisingly poorly answered with most candidates missing the point of the

question, which was to test their understanding of basic ideas about correlated assets.

We may not be justified in accepting a model simply because it passes the tests. Many

of these tests (for example, tests of stationarity) have notoriously low power, and

therefore may not reject incorrect models.

Indeed, even if the true model was not in the class of models being fitted, we would

still end up with an apparently acceptable fit, because the rules say we keep

generalising until we find one.

This process of generalisation tends to lead to models which wrap themselves around

the data, resulting in an understatement of future risk, and optimism regarding the

accuracy of out-of-sample forecasts.

For example, Huber recently compared the out-of-sample forecasts of the Wilkie

model to a nave same as last time forecast over a 10 year period. The nave

forecasts proved more accurate.

May candidates had not studied basic material covered in this question and answered poorly.

(i)

investor holds risky assets in proportion to that portfolio. Thus the market

portfolio is 0.1A + 0.2B + 0.4C + 0.3D (asset E is the risk-free asset).

Asset

Annual return in

State 1

State 2

State 3

Market Capitalisation

Probability

of being in

state

3%

5%

7%

10m

3%

7%

5%

20m

3%

2%

8%

40m

3%

8%

1%

30m

3%

3%

3%

0.25

0.5

0.25

Page 5

Subject CT8 (Financial Economics Core Technical) April 2013 Examiners Report

and so EM = (105%+205.5%+403.75%+305%)/100 = 4.6%

Now 2M = 0.25(34.6)2+0.5(5.14.6)2+0.25(5.24.6)2 = 0.855%

and M = 0.92466%

(ii)

(iii)

i = Cov(Ri, RM)/Var(RM).

Now Cov(RA, RM) = 0.2533+0.555.1+0.2575.254.6 = 1.1%;

Cov(RB, RM) = 0.2533+0.575.1+0.2555.25.54.6 = 1.3%;

Cov(RC, RM) = 0.2533+0.525.1+0.2585.23.754.6 = 0.5%;

Cov(RD, RM) = 0.2533+0.585.1+0.2515.254.6 = 0.95%

It follows that A = 1.1/0.855=1.2865, B = 1.3/0.855 = 1.5205,

C = 0.5/0.855 = 0.5848 and D = 0.95/0.855 = 1.1111.

OR

Assets all lie on the securities market line, so Ei r = i(EMr), so

A = 2/1.6=1.25, B = 2.5/1.6 = 1.5625

C = 0.75/1.6 = 0.46875 and D = 2/1.6 = 1.25.

(iv)

Empirical studies do not provide strong support for the model. There are

basic problems in testing the model since, in theory, account has to be taken of

the entire investment universe open to investors, not just capital markets.

Regrettably, there was an inconsistency with the CAPM in the question data.

Accordingly candidates could obtain full marks to part (iii) by giving either of the two

answers above.

In general the question was answered well, with most candidates showing good familiarity

with the CAPM.

(i)

whenever s < t.

Bt has stationary increments, i.e. the distribution of Bt Bs depends only on

t s.

Bt has Gaussian increments, i.e. the distribution of Bt Bs is N(0, t s).

Bt has continuous sample paths t Bt.

B0 = 0.

Page 6

Subject CT8 (Financial Economics Core Technical) April 2013 Examiners Report

f f

1 2 f 2

f

Yt dBt + +

At +

Yt dt

x

2 x 2

t x

(ii)

df ( t , X t ) =

(iii)

df ( t , X t ) = 2te 2tX t Yt dBt + 2e 2tX t X t + tAt + t 2Yt 2 dt

This question was very well answered in general, with most candidates fully conversant with

the basic properties of Brownian Motion and with Itos Lemma.

(i)

including time t.

(ii)

dVt = at dAt + dat At + dat dAt + bt dBt + dbt Bt + dbt dBt + ct dCt + dct Ct + dct dCt

(iii)

portfolio is equal to the pure investment gain.

In other words, dVt = at dAt + bt dBt + ct dCt

(iv)

0 t <U

(where U is the payment time for X) such that:

VU = aU AU + bU BU + cU CU = X .

(v)

payment without risk. Hence, by no arbitrage the value of the derivative at

time 0 must be V0.

(vi)

strategy ( at , bt , ct ) .

portfolios and simple stochastic calculus seemed beyond most candidates.

Page 7

Subject CT8 (Financial Economics Core Technical) April 2013 Examiners Report

(i)

1

1.2 = 0.481818

q=

1

1.2

1.2

1.01

50 p =

(q P

2

1.01

uu

So

Puu = 219.70826 p 2.15094 Pud 1.15664 Pdd .

(ii)

takes its maximum value when Pud and Pdd are zero. So

0 < Puu < 219.70826 p.

(iii)

(a)

If Puu takes its maximum value then Pud and Pdd are both zero.

If first stock price move is up then the new value of the option is:

qP

V = uu = 104.8113.

1.01

(b)

As Pud and Pdd are both zero if the first stock price move is down then

the option will expire worthless.

Many candidates seemed uncomfortable with a basic binary tree calculation, despite these

being well-explained in the Core Reading. Those with some familiarity scored very well.

(i)

Firstly, if we look at historical interest rate data we can see that changes in the

prices of bonds with different terms to maturity are not perfectly correlated as

one would expect to see if a one-factor model was correct. Sometimes we even

see, for example, that short-dated bonds fall in price while long-dated bonds

go up.

Recent research has suggested that around three factors, rather than one, are

required to capture most of the randomness in bonds of different durations.

Page 8

Subject CT8 (Financial Economics Core Technical) April 2013 Examiners Report

Secondly, if we look at the long run of historical data we find that there have

been sustained periods of both high and low interest rates with periods of both

high and low volatility. Again these are features which are difficult to capture

without introducing more random factors into a model.

This issue is especially important for two types of problem in insurance: the

pricing and hedging of long-dated insurance contracts with interest-rate

guarantees; and asset-liability modelling and long-term risk-management.

contracts which are more complex than, say, standard European call options.

For example, any contract which makes reference to more than one interest

rate should allow these rates to be less than perfectly correlated in order to

produce realistic pricing formulae.

(ii)

dr ( t ) = r ( m ( t ) r ( t ) ) dt + r1dW1 ( t ) + r 2 dW2 (t )

dm ( t ) = m ( m ( t ) ) dt + m1dW1 ( t )

where r(t) is the short rate, and m(t), the local mean-reversion level for r(t) and

W1 (t ) and W2 (t ) are independent, standard Brownian motions under the riskneutral measure Q.

Answers were mixed. Again, knowledge of basic Core Reading made all the difference to

candidates scores on this question.

(i)

Q(Maxt<1St 2)

= Q(maxt<1Bt + (r 2)t ln 2)

= Q(maxt<1Bt + (r 2)t/ ln 2/)

= ([ln 2 + (r 2)]/) + exp(2(r 2) ln 2/2) ([ln 2 + (r 2)]/)

= (2.7776) + 0.9727 (2.7676)

= 0.00274 + 0.9727 0.00282

= 0.00548

So Q(Maxt<1St < 2) = 0.99452.

Page 9

Subject CT8 (Financial Economics Core Technical) April 2013 Examiners Report

(ii)

(a)

the risk neutral pricing formula gives the following price C1 for the

option at time 1:

C1 = C1 (low) = erEQ[100.Max(S2/S11;0)|F1]

C1 = C1 (up) = 0

(b)

conditional expectation: C1 (low) = erEQ[100.Max(S2/S11;0)|F1]

Since S2/S1 is independent of the values of S up to time 1 under the

EMM Q, the conditional expectation is a simple expectation:

C1 (low) = erEQ[100.Max(S2/S11;0)] = er.100. EQ[Max(S2/S11;0)]

But S2/S1 = exp((r2/2)+.(B2B1)).

Hence, we simply need to compute the price of a standard European

option with strike and initial stock price both equal to 1 and maturity

1 year.

After some simple calculations, we have, in the case {(Maxt<1 St )<2}

C1 (low) = 100.[(d1)exp(3%).(d2)]

with d2 = [r2/2]/ and d1 = d2+.

Hence, C1 (low) = $11.348

(c)

Thus, the fair price at time 0 of the option is C0 = E[er C11{Maxt<1St < 2}]

where 1{Maxt<1St < 2} is the indicator of the event {Maxt<1St < 2}, so takes

the value 1 if {Maxt<1St < 2} occurs and 0 otherwise.

So C0 = 0.99452er C1(low)

C0 = $10.952

This question was very poorly answered, with most candidates unable to cope with pathdependent option, even though the steps to solution were laid out in the question. Familiarity

with the actuarial tables would also have been helpful.

Page 10

Subject CT8 (Financial Economics Core Technical) April 2013 Examiners Report

10

(i)

In the two state model, the company defaults at time-dependent rate (t) if it

has not previously defaulted. Once it defaults it remains permanently in the

default state. It is assumed that after default all bond payments will be reduced

by a known factor (1 ), where is the recovery rate. Now we need to

change to the risk neutral measure, which will change the default rate to (t ) .

This rate is that implied by market prices.

(ii)

Pt = 100etR(t) = 100ert(1(1 )(1- exp( t0 s ds )) )

= 100ert ( + (1 )Q(At)),

where R(t) is the effective rate for a ZCB with redemption at t, s is the risk

neutral default rate at time s and At is the event that there has been no default

by time t.

So, P1 = 100e(.015+.04) = $94.6485

and so Q(A1) = (er P1/100 )/(1 ) = 0.90197

And P2 = 100e2(.015+.05) = $87.8095

and so Q(A2) = (e2r P2/100 )/(1 ) = 0.76209

(iii)

and 02 s ds = 1 + 2 = ln [Q(A2)] = 0.27169 and so 2 = 0.16852.

This was a difficult question and many candidates clearly didnt know the relevant material.

A smaller number did and consequently performed well.

Page 11

EXAMINATION

25 September 2013 (pm)

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1.

Enter all the candidate and examination details as requested on the front of your answer

booklet.

2.

You must not start writing your answers in the booklet until instructed to do so by the

supervisor.

3.

4.

Attempt all 10 questions, beginning your answer to each question on a separate sheet.

5.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this

question paper.

In addition to this paper you should have available the 2002 edition of the Formulae

and Tables and your own electronic calculator from the approved list.

CT8 S2013

(i)

(a)

(b)

State the four axioms from which it can be derived.

[5]

(ii)

Explain of the concepts of non-satiation and risk aversion, showing how they

can be expressed in terms of a utility function.

[2]

absolute risk aversion at a value of wealth of one unit is 0.25

(iii)

Calculate the value of b and the range over which U(.) satisfies the condition

of non-satiation.

[3]

[Total 10]

(i)

Describe the single-index model of security returns, defining any terms used.

[2]

The single-index model is to be used in a particular market.

(ii)

(a)

(b)

(c)

the variance of returns on a security; and

the covariance of returns between two securities

[3]

(iii)

Show that investors can diversify away specific risk in this model by holding

equal weights in an increasing number of securities.

[4]

(iv)

(a)

(b)

in terms of forecasting security returns.

[2]

[Total 11]

(i)

(ii)

[3]

of an earthquake in the capital city of one of its major markets.

Scenario 2: Company Bs share price falls suddenly, when a long-awaited and

publicly negotiated merger is completed.

[3]

[Total 6]

CT8 S20132

In the Wilkie model, the force of inflation in year t, I(t), is modelled as an AR(1)

process as follows:

I(t) = m + a(I(t 1) m) + Z(t),

where, for any t, all Z(t) are independent, identically distributed N(0, 2) random

variables.

Let m = 0.03; a = 0.6 and 2 = 2.5 105. The force of inflation was 3.3% in 2012.

(i)

[3]

A final salary pension fund is assuming inflation of 1% p.a. for the period 1 January

2012 to 31 December 2013.

(ii)

model is correct.

[2]

[Total 5]

The share price in Santa Insurance Co, St , is currently 97p and can be modelled by

the stochastic differential equation:

where Bt is a standard Brownian motion.

(i)

(a)

(b)

price in two years time.

[6]

The share price in Rudolf Financial Services plc, Rt , is also currently at 97p and can

be modelled by the stochastic differential equation:

Let Ut = e0.4t Rt

(ii)

CT8 S20133

(a)

Calculate dUt.

(b)

Services plc share price in two years time.

[6]

[Total 12]

A non-dividend-paying stock has a current price of 300p. Over each of the next two

three-month periods its price will either go up by 30p or down by 30p. Price

movements for each period are independent of each other. An investment in a cash

account returns 2% per quarter. A European call option on the stock pays out in six

months based on a strike price of 290p. The price of the stock is to be modelled using

a binomial tree approach with three-month time steps.

(i)

Calculate the value of the call option today using a risk-neutral pricing

approach.

[3]

Assume that the real world probability of the stock price moving up in each of the

next three month periods is 0.7

(ii)

(a)

Calculate the values of the state price deflator after six months

(b)

Calculate and the value of the call option today using your answers to

part (ii)(a).

(c)

[5]

Assume that the real world probability has now dropped from 0.7 to 0.6.

(iii)

(a)

price deflator would change in value.

(b)

Comment on the impact that this would have on the option price. [2]

[Total 10]

The continuously compounded risk-free rate of interest is r, and a stock, with maturity

T, pays dividends continuously at rate q.

(i)

Determine the forward price at time 0 for a forward contract on the stock. [3]

(ii)

Show that there exists a portfolio that earns the risk free rate r, containing:

the stock

a European call option on the stock

and a European put option on the stock

[4]

[Total 7]

(i)

Write down a stochastic differential equation for the short rate r in the Vasicek

model defining any notation used.

[1]

(ii)

List the desirable and undesirable features of this model for the term structure

of interest rates.

[4]

(iii)

(a)

(b)

CT8 S20134

Solve the stochastic differential equation from your answer to part (i).

Comment on the statistical properties of rT , T > t.

[7]

[Total 12]

has a strike of $150.

The continuously compounded risk-free rate is 2% p.a. The current stock price is

$117.98. Assume that the market follows the assumptions of a Black-Scholes model.

An institutional investor holds a delta-hedged portfolio with 100,000 call options, no

cash and short 18,673 shares of Company ABC.

(i)

[2]

(ii)

[4]

(iii)

Calculate the price of a one-year put on the same stock with a strike of $150.

[2]

The investor retains their holding of call options and trades in the put and the stock to

achieve a delta and gamma-hedged portfolio.

10

(iv)

Calculate the investors new holdings of the put and the stock.

[4]

[Total 12]

(i)

Describe the Merton model for pricing a bond subject to default risk.

[4]

A very highly geared company XYZ plc has issued zero-coupon bonds payable in

four years time. The debt is a nominal $120m.

(ii)

Give expressions for the value of the debt in four years time and today,

adopting a Black-Scholes model for the value of XYZ plc.

[4]

The current gross value of XYZ plc is $180m. The continuously compounded riskfree interest rate is 2% p.a. and the continuously compounded credit spread on the

bond is 4.5% p.a.

(iii)

[1]

(iv)

[3]

(v)

END OF PAPER

CT8 S20135

[3]

[Total 15]

EXAMINERS REPORT

September 2013 examinations

Core Technical

Introduction

The Examiners Report is written by the Principal Examiner with the aim of helping

candidates, both those who are sitting the examination for the first time and using past papers

as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The

Examiners have access to the Core Reading, which is designed to interpret the syllabus, and

will generally base questions around it but are not required to examine the content of Core

Reading specifically or exclusively.

For numerical questions the Examiners preferred approach to the solution is reproduced in

this report; other valid approaches are given appropriate credit. For essay-style questions,

particularly the open-ended questions in the later subjects, the report may contain more points

than the Examiners will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that

the examination was set. Candidates should take into account the possibility that

circumstances may have changed if using these reports for revision.

D C Bowie

Chairman of the Board of Examiners

December 2013

Subject CT8 (Financial Economics Core Technical) September 2013 Examiners Report

Subject CT8 introduces the main concepts and principles of financial economics. These are

developed in later subjects in the ST series of exams. This subject combines various types of

skills. In particular, along with CT7, it is one of the first where candidates are expected to

write passages of reasoned thought, rather than just complete calculations. This is a

skill that will be new to many, and candidates are advised to pay particular attention to the

answers to this type of question by studying many past papers.

Comments on the September 2013 paper

The general performance was good and broadly in line with the previous session (April

2013). Candidates generally found this paper challenging, but well-prepared candidates

scored well across the whole paper and the best candidates scored close to full marks. As in

previous diets, questions that required an element of application of the core reading to

situations that were not immediately familiar proved more challenging to most candidates.

The comments that follow the questions concentrate on areas where candidates could have

improved their performance. Candidates approaching the subject for the first time are advised

to include in their revision these areas and the ability to apply the core reading to similar

situations.

Page 2

Subject CT8 (Financial Economics Core Technical) September 2013 Examiners Report

(i)

(a)

constructed representing an investors utility of wealth, w, at some

future date. Decisions are made on the basis of maximising the

expected value of utility under the investors particular beliefs about

the probability of different outcomes.

(b)

following four axioms.

1. Comparability

An investor can state a preference between all available certain outcomes.

2. Transitivity

If A is preferred to B and B is preferred to C, then A is preferred to C.

3. Independence

If an investor is indifferent between two certain outcomes, A and B, then he is

also indifferent between the following two gambles:

(a)

(b)

B with probability p and C with probability (1 p).

4. Certainty equivalence

Suppose that A is preferred to B and B is preferred to C. Then there is a

unique probability, p, such that the investor is indifferent between B and a

gamble giving A with probability p and C with probability (1 p).

B is known as the certainty equivalent of the above gamble.

(ii)

It is usually assumed that people prefer more wealth to less. This is known as

the principle of non-satiation and can be expressed as:

U(w)>0 or U is strictly increasing.

Attitudes to risk can also be expressed in terms of the properties of utility

functions.

A risk averse investor values an incremental increase in wealth less highly

than an incremental decrease and will reject a fair gamble. The utility function

condition is U ( w) < 0 or U is strictly concave.

(iii)

A( w)

U ( w)

.

U ( w)

Page 3

Subject CT8 (Financial Economics Core Technical) September 2013 Examiners Report

Which for the utility function given can be calculated by taking derivatives as,

2b

.

1 2bw

Non-satiation means U ( w) > 0 <=> 1+2bw > 0 <=> w 5.

This bookwork question was largely well-answered although some candidates appeared to be

unaware that non-satiation and absolute risk aversion do not have identical meanings.

(i)

Ri = i + iRM + i

where: Ri is the return on security i

i and i are constants

RM is the return on the market

The i are independent, zero-mean random variables, uncorrelated with RM,

representing the component of Ri not related to the market.

(ii)

Ei = Ri i i RM i i + i .EM,

where EM is the expected return on the market.

The variance of returns on security i is Vi = Var i i RM i i2VM Vi ,

where VM is the variance of returns on the market, Vi is the variance of the

random variable component of Ri not related to the market and the result holds

because under the model i is uncorrelated with RM.

The covariance of returns between security i and security j is given by

Ci,j = Cov Ri , R j Cov i i RM i , j j RM j i . j .VM ,

all i j.

Page 4

Subject CT8 (Financial Economics Core Technical) September 2013 Examiners Report

(iii)

Using the results from (ii), the variance of portfolio returns on a portfolio of N

equally weighted securities is

V

N 2 Cov Ri , R j

i , j 1

1

N2

(i2VM

i 1

Vi )

i . j .VM

N 2 i , j 1, i j

1 N 2

= i VM plus terms which tend to zero as N .

N

i 1

In other words, the limiting portfolio variance depends on the average value of

the i s and the variance of the market but not the specific risk of any

individual security.

Alternative solution:

The single index model for a portfolio P of N assets held in proportions xi, ,

xN is:

RP = P + PRM + P

where P =

xi i , P =

i 1

xii and P =

i 1

xi i

i 1

VP = 2PVM V P

2

= xii VM var xi i

i 1

i 1

If xi =

1

then:

N

2

1 N

1 N

VP = 2 i VM 2 Vi

N i 1

N i 1

= 2VM

1

V

N

Page 5

Subject CT8 (Financial Economics Core Technical) September 2013 Examiners Report

Vi s.

As N , the second component, which represents the specific risk, tends

to 0.

(iv)

More factors will always improve the fit of a regression to historic data, in

other words reduce the residual errors in relation to the data fitted, although

market correlation typically has the most explanatory power.

There is little evidence that multi-factor models are significantly better at

forecasting the future correlation structure.

Again this was a largely well-answered question, although some candidates didnt define

notation despite the explicit instruction to do so. Surprisingly few candidates used the results

they had derived in part (ii) to prove part (iii). Some candidates confused this model with

CAPM.

(i)

Strong form EMH: market prices incorporate all information, both publicly

available and also that available only to insiders.

Semi-strong form EMH: market prices incorporate all publicly available

information.

Weak form EMH: the market price of an investment incorporates all

information contained in the price history of that investment.

(ii)

Scenario 1: The first event tells us nothing about the EMH-assuming this

earthquake was not predictable, its happening could not have been discounted

in market prices.

A quick adjustment of prices in response to a news announcement suggests

evidence for the semi-strong form (and by implication the weak form) EMH.

However, although the price drop was quick, we have no idea how accurate it

was. It is possible that the market has over or under reacted to the bad news

and will correct itself later. If this is the case, then it suggests markets are not

efficient.

Some earthquake specialists (insiders) may have known about the earthquake

shortly in advance but there is no mention of price movements before the

earthquake, perhaps this suggests the market is also strong form efficient.

Scenario 2: The second event strongly contradicts the strong-form EMH.

Insiders are privy to all information about the merger talks and therefore there

shouldnt be a sudden reaction.

Page 6

Subject CT8 (Financial Economics Core Technical) September 2013 Examiners Report

Indeed, given the public nature of the negotiations, this seems even to

contradict the semi-strong form (and by implication the strong form) of the

EMH although perhaps markets were pricing in a significant probability of the

merger failing or overreacting to the benefits and then correcting themselves.

This question was reasonably answered, although some candidates simply related the same

form of EMH to both scenarios. Many candidates missed the fact that the merger had already

been publicly negotiated and so wasnt new information.

(i)

where N is a standard normal r.v. It follows that a 95% confidence interval is

(0.0318 0.005 1.9600) = (0.0220, 0.0416)

(ii)

Not at all appropriate, since 1% does not lie in the 95% confidence interval for

2013 and it was 3.3% in 2012!

However there may be compensating assumptions which make this divergence

unimportant, for example wage-inflation may also be underestimated.

The pension scheme may have a view that inflation will fall next year, e.g. due to

a forecast recession. The Wilkie model parameters are estimated as averages over

a historic time period (they are longitudinal estimates) and therefore may not

reflect future conditions.

reasonable statement about this assumption.

A surprising number of candidates were unable to calculate a confidence interval, and there

were many calculation slips. The majority of candidates struggled to interpret part (ii) of the

question.

(i)

(a)

dSt

0.4dt 0.5dBt .

St

d log St

(b)

dSt 0.5

2 (dSt ) 2 0.275dt 0.5dBt .

St St

log St = log S0 + 0.275t + 0.5Bt.

Page 7

Subject CT8 (Financial Economics Core Technical) September 2013 Examiners Report

or, finally,

St S0e0.275t 0.5 Bt .

St

has a lognormal distribution with parameters 0.275t and 0.25t,

S0

or equivalently St is lognormally distributed with parameters log S 0

+ 0.275t and 0.25t.

So

and variance of St:

S2 97e0.8 215.877 p

2

(ii)

(a)

dRt 0.4 Rt dt 0.5dBt .

Consider U t Rt e0.4t

dU t 0.4 Rt e0.4t dt e0.4t dRt

0.5e0.4t dBt

t

(b)

0

and hence

Rt R0e

0.4t

0

Now since

t 0.4 s t

0.5 e

dBs

0,

Page 8

Subject CT8 (Financial Economics Core Technical) September 2013 Examiners Report

and

2

Var R2 Var 0.5e0.4 s 2 dBs

0

0.25

1 e 1.6 0.2494 p 2

0.8

Overall well-answered but some candidates did seem to struggle applying Itos Lemma and

with calculating the expectation and variance; Some candidates confused the Normal and

LogNormal distributions, while others simply stated the answer rather than deriving it.

(i)

stock price from each state:

q 300

0.6

330 270

q 330

0.61

360 300

q 270

0.59.

300 240

V =

1.022

= 29.143.

Alternatively, if the candidates misinterpret the question and use 2% as a force

of interest per quarter we get qs = (0.601007, 0.611107, 0.590906), and a

value for V of 29.21234. 2 marks can be awarded for this or any other answer

which has the right working but the wrong interpretation of the interest rate.

(ii)

(a)

Using the results from (i) we can calculate the values of the state-price

deflator:

A 360

A 300

q 300 q 330

0.7 1.02

0.71793

2 0.7 0.3 1.022

1.07559

Page 9

Subject CT8 (Financial Economics Core Technical) September 2013 Examiners Report

A 240

(0.3 1.02) 2

each path:

A(uu) = 0.71793, A(ud) = 1.071017, A(du) = 1.080171 ,

A(dd) = 1.75146.

If candidates have used 2% as a force of interest:

A(uu) = 0.72016, A(ud) = 1.069345, A(du) = 1.078681 ,

A(dd) = 1.742506.

Or if using three nodes the middle node is 1.074013.

(b)

V = EP (A2V2)

0.32 A 240 0

= 29.143.

(iii)

(c)

This is the same answer as under part (i) as expected under a given

model the option price should not vary depending on how we evaluate

the model.

(a)

would shrink as the denominator rises.

(b)

Overall the option price would remain unchanged as it does not depend

on real-world probabilities.

Generally reasonably answered, although some candidates only calculated one risk-neutral

probability instead of three and many struggled to calculate correct state price deflators or

more surprisingly confused real-world and risk-neutral probabilities.

Page 10

Subject CT8 (Financial Economics Core Technical) September 2013 Examiners Report

(i)

Let K be the forward price and denote the stock price at time t by St . Now

compare the setting-up of the following two portfolios at time 0:

Invest dividends in the stock.

At time T portfolio B is worth ST K .

By the principle of no-arbitrage these portfolios must have the same value at

all times before T.

In particular, at time 0, portfolio B has value e qT S0 Ke rT which must equal

the value of the forward contract (which must be zero at time 0).

So K = e( r q )T S0 .

(ii)

and short a European call option both of which expire at time T at strike price

K, whose prices at time t are denoted by St , pt and ct respectively.

At expiry:

If ST K , the put option expires worthless, the call option will be exercised

(or be worthless if ST K ) and the stock will be delivered in return for K.

I.e. the value of the portfolio will be K.

If ST K , the call option will not be exercised, and the stock can be sold via

the put option for K, so the value of the portfolio will be K.

Since the portfolio will be worth a known, fixed amount at time T, by the

principle of no-arbitrage it must earn the risk free rate up to time T.

This question differentiated between the stronger and weaker candidates. Candidates who

knew how to adjust the portfolio construction arguments to forward pricing scored well.

Page 11

Subject CT8 (Financial Economics Core Technical) September 2013 Examiners Report

(i)

drt = ( rt) dt + dBt.

where B is a standard Brownian motion, is the volatility, and and are the

drift parameters.

[1]

(ii)

Desirable:

Arbitrage-free

Instantaneous and other rates mean reverting

Ease of computation/pricing of derivatives and bonds

Undesirable:

Does not generate realistic dynamics/yield curves

e.g. bonds of all durations perfectly correlated

e.g. constant volatility of the short rate

Does not provide good historical fit (even with suitable parameter values)

Is not easy to calibrate

Is not sufficiently flexible e.g. cannot price derivatives whose value depends

on more than one interest rate

(iii)

(a)

drt = ( rt) dt + dBt.

Consider ut rt et

dut rt et dt et drt

et dt et dBt .

so uT ut (e

e ) es dBs

t

and hence rT rt e

(T t )

1 e

T t

e

T

Page 12

(T s )

dBs .

Subject CT8 (Financial Economics Core Technical) September 2013 Examiners Report

(b)

Gaussian distribution

with mean

T t

T t

rt e 1 e

2

2 T t

and variance

1 e .

2

Largely, well-answered bookwork question, although the candidates found the later sections

of this question progressively more difficult.

(i)

The of the call holding must be minus the of the shareholding, which, by

definition is 18673, so the of a call is C = 0.18673.

(ii)

+ 0.02 + 2))/ = 0.22/ + .

Now (d1) = 0.18673 so d1 = 0.89

which implies that

0.22 + 0.89 + 2 = 0 so = -0.89 (0.892 + 0.44).

Rejecting the negative root gives a value of = 22%.

(iii)

= 150er (d2) 117.98(d1) = 147.0298 (d2) 117.98( d1)

= 147.0298 0.8665 117.98 0.81327 = $31.4517

(iv)

Using C to denote the call option, P the put option and S the stock we know

that:

C P = S =1

C P and S 0

So since we hold 100,000 call options, we must be short 100,000 put options

and 100,000 shares to get a gamma and delta neutral portfolio.

Alternative calculation approaches were awarded full marks if candidates

reached the right conclusions.

Candidates found this question difficult, especially the latter part which only the strongest

candidates answered well.

Page 13

Subject CT8 (Financial Economics Core Technical) September 2013 Examiners Report

10

(i)

(ii)

Mertons model assumes that a corporate entity has issued both equity and

debt such that its total value at time t is F(t). F(t) varies over time as a

result of actions by the corporate entity which does not pay dividends on

its equity or coupons on its bonds.

repayment amount of L at a future time T. At time T the remainder of the

value of the corporate entity will be distributed amongst the equity holders

and the corporate entity will be wound up.

The corporate entity will default if the total value of its assets, F(T) is less

than the promised debt repayment at time T i.e. F(T) < L. In this situation,

the bond holders will receive F(T) instead of L and the equity holders will

receive nothing.

This can be regarded as treating the equity holders of the corporate entity

as having a European call option on the assets of the company with

maturity T and a strike price equal to L.

(a)

min(F(4),120) = 120 max(120 F(4),0) = F(4) max(F(4)

120, 0), where F(t) is the gross value of the company at time t.

Thus the value at time 0 is

e4rE[min(F(4),120)] = e4rE[F(4) max(F(4) 120,0)],

[Alternative expressions are fine, as per the first part of (ii) (a).]

where the expectation is under the risk-neutral measure, so equals F(0)

C, where C is a call option on the gross value with strike 120.

[Alternatively = 120e4r P, where P is a call option on the gross

value with strike 120. ]

(iii)

(iv)

This leads to an estimated volatility of 40%.

Try a volatility of 20%. This gives an option price of $72.266.

A volatility of 50% gives a price of $92.293.

Interpolating gives a volatility of:

20 + (87.276 72.266 / (96.06 72.266) 30 = 39%.

Page 14

Subject CT8 (Financial Economics Core Technical) September 2013 Examiners Report

Interpolating again gives a volatility of 40%.

For reference when marking:

volatility = 30%, c = $78.985, vol = 40%, c = $87.275, vol = 45%,

c = $91.645

(v)

= 1 (d2) = 1 (0.206831)

= 1 0.58192 = 0.41808 = 42%

Candidates struggled to gain many marks on this question, and many seemed to be short of

time reflecting the importance of time management in these exams.

Page 15

EXAMINATION

24 April 2014 (am)

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1.

Enter all the candidate and examination details as requested on the front of your answer

booklet.

2.

You must not start writing your answers in the booklet until instructed to do so by the

supervisor.

3.

4.

Attempt all 10 questions, beginning your answer to each question on a new page.

5.

Graph paper is NOT required for this paper.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this

question paper.

In addition to this paper you should have available the 2002 edition of the Formulae

and Tables and your own electronic calculator from the approved list.

CT8 A2014

(i)

State the expression for the return on a security, i, in the single-index model,

defining all terms used.

[2]

(ii)

Explain the difference between the single-index model and the Capital Asset

Pricing Model.

[1]

[10]

Suppose the market has expected return 6% and standard deviation 10%. Two

securities have expected returns 8% and 10%, and standard deviations 15% and 20%.

The correlation between these two securities and the market is 0.25 and 0.4

respectively. Assume the single-index model described in (i) holds.

(iii)

Calculate the constant parameters in the expression for the return of these two

securities.

[5]

(iv)

single-index model in terms of fitting data and predicting future security price

moves.

[2]

[Total 10]

(i)

the terms used.

[2]

(ii)

(a)

Brownian filtration.

Hint: E (Wt2Fs ) = Ws2 + t s for all t s.

(b)

Use Itos lemma to show that f (t , Wt2 ) is a process with zero drift.

[4]

(iii)

CT8 A20142

motion.

[6]

[Total 12]

Consider the following long position in European and American call options written

on a stock, with strikes and times to expiry as set out in the table below.

Option

European/American

Strike price

Time to expiry

A

B

C

D

E

American

American

American

European

European

400

400

420

400

400

3 years

2 years

3 years

3 years

2 years

Rank these options in order of value to the extent that this is possible.

[5]

drt = rt dt + dZt

where and are fixed parameters and Z is a standard Brownian motion.

(i)

[4]

drt = a ( rt )dt + dZt .

(ii)

[6]

(iii)

[1]

[Total 11]

(i)

State the equation for the capital market line in the Capital Asset Pricing

Model (CAPM), defining all the terms used.

[3]

In a market where the CAPM is assumed to hold, the expected annual return on the

market portfolio is 12%, the variance is 4%% and the effective risk-free annual rate is

4%. An Agent wants an expected annual return of 18% on a portfolio worth

1,200,000.

(ii)

portfolio.

[2]

(iii)

portfolio.

[3]

[Total 8]

CT8 A20143

derivative written on S, with maturity T, where Dt = g(t, St) for any t < T and

g(T, x) = f(x).

(i)

Write down the partial differential equation (PDE) that g must satisfy,

including the boundary condition for time T.

[3]

Suppose that the derivative pays STn / S0n1 at time T, where n is an integer greater

than 1.

(ii)

(i)

Show, using (i), that the price of the derivative at time t is given by

Dt = (Stn / S0n1)e(Tt) for some which you should determine.

[6]

[Total 9]

State and prove the put-call parity for a stock paying no dividends.

[5]

strike price $120 and expiry T = 1 year is priced at $10.09. The continuously

compounded risk-free rate is 2% p.a. and the stock is currently priced at $110.

(ii)

[4]

A European put option on the same stock has strike price $121 and the same maturity.

An investor holds a portfolio which is long one call and short one put.

(iii)

Sketch a graph of the payoff at maturity of the portfolio against the stock price

[2]

(iv)

(a)

maturity.

(b)

(v)

[3]

[2]

[Total 16]

CT8 A20144

[8]

10

A company has two zero-coupon bonds in issue. Bond A redeems in 1 year and the

current price of 100 nominal is 92.50. Bond C redeems in 2 years and the current

price of 100 nominal is 74.72.

The continuously compounded risk-free rate is 2.5% p.a. for the next two years.

(i)

Write down the formula for the general zero-coupon bond price in the twostate model for credit ratings, defining all the terms used.

[2]

(ii)

this model holds, and a recovery rate of 50% for bond A.

[3]

If bond A defaults then bond C automatically defaults with a recovery rate of zero,

whereas if bond A does not default then bond C may still default in the second year,

but with a recovery rate of 50%.

(iii)

Modify your answer to (i) to give a formula for the current price of bond C.

[3]

(iv)

END OF PAPER

CT8 A20145

[3]

[Total 11]

EXAMINERS REPORT

April 2014 examinations

Core Technical

Introduction

The Examiners Report is written by the Principal Examiner with the aim of helping

candidates, both those who are sitting the examination for the first time and using past papers

as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The

Examiners have access to the Core Reading, which is designed to interpret the syllabus, and

will generally base questions around it but are not required to examine the content of Core

Reading specifically or exclusively.

For numerical questions the Examiners preferred approach to the solution is reproduced in

this report; other valid approaches are given appropriate credit. For essay-style questions,

particularly the open-ended questions in the later subjects, the report may contain more points

than the Examiners will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context pertaining to the date that

the examination was set. Candidates should take into account the possibility that

circumstances may have changed if using these reports for revision.

D C Bowie

Chairman of the Board of Examiners

June 2014

Subject CT8 (Financial Economics Core Technical) April 2014 Examiners Report

Subject CT8 introduces the main concepts and principles of financial economics. These are

developed in later subjects in the ST series of exams. This subject combines various types of

skills. In particular, along with CT7, it is one of the first where candidates are expected to

write lengthy passages of reasoned thought, rather than just complete calculations. This is a

skill that will be new to many, and candidates are advised to pay particular attention to the

answers to this type of question by studying many past papers.

Comments on the April 2014 paper

The general performance was good. Candidates generally found this paper challenging, but

well-prepared candidates scored well across the whole paper and the best candidates scored

close to full marks. As in previous diets, questions that required an element of application of

the core reading to situations that were not immediately familiar proved more challenging to

most candidates.

Page 2

Subject CT8 (Financial Economics Core Technical) April 2014 Examiners Report

Anchoring is a term used to explain how people will produce estimates. They then

adjust away from this initial anchor to arrive at their final judgement.

Prospect theory

A theory of how people make decisions when faced with risk and uncertainty. It

replaces the conventional risk averse / risk seeking decreasing marginal utility theory.

Prospect theory is associated with the concept of:

Framing (and question wording)

The way a choice is presented (framed) and, particularly, the wording of a question

in terms of gains and losses, can have an enormous impact on the answer given or the

decision made.

Myopic loss aversion

This is similar to prospect theory, but considers repeated choices rather than a single

gamble.

Estimating probabilities

Issues (other than anchoring) which might affect probability estimates include:

is considered as negative or positive) has an enormous influence on the probability

estimates of its likely occurrence.

Representative Heuristics people find more probable that which they find easier

to imagine. As the amount of detail increases, its apparent likelihood may

increase (although the true probability can only decrease steadily).

Availability people are influenced by the ease with which something can be

brought to mind. This can lead to biased judgements when examples of one event

are inherently more difficult to imagine than examples of another.

Overconfidence

People tend to overestimate their own abilities, knowledge and skills. This may be a

result of:

Hindsight bias events that happen will be thought of as having been predictable

prior to the event, events that do not happen will be thought of as having been

unlikely prior to the event.

Confirmation bias people will tend to look for evidence that confirms their point

of view (and will tend to dismiss evidence that does not justify it).

Page 3

Subject CT8 (Financial Economics Core Technical) April 2014 Examiners Report

Mental accounting

People show a tendency to separate related events and decisions and find it difficult

to aggregate events.

Effect of options

Other issues include:

Primary effect people are more likely to choose the first option presented, but

Recency effect in some instances, the final option that is discussed may be

preferred! (The gap in time between the presentation of the options and the

decision may influence this dichotomy.)

Other research suggests that people are more likely to choose an intermediate

option than one at either end!

hand, a higher probability is attributed to options explicitly stated than when

included in a broader category.

Status Quo bias people have a marked preference for keeping things as they are.

possibility of regret (the pain associated with feeling responsible for a loss).

This question was generally well answered by candidates who knew the 8 key findings of

behavioural finance. A surprising number of candidates confused this question with the

Efficient Market Hypothesis. Some candidates discussed the shortcomings of assuming that

consumers are rational.

(i)

Ri= i + iRM+ i

where Ri is the return on security i,

i and i are constants,

RM is the return on the market,

i is a random variable representing the component of Ri not related to

the market.

Page 4

Subject CT8 (Financial Economics Core Technical) April 2014 Examiners Report

(ii)

The single-index model is purely empirical and is not based on any theoretical

relationships between i and the other variables, which are assumed in CAPM.

(iii)

The i are the ratio of the covariances of the securities with the market divided

by the variance of the market.

So, 1 =

15 0.25 10

20 0.4 10

= 0.375 and 2 =

= 0.8.

100

100

(iv)

As you are fitting more parameters, in-sample results should give a better fit

(although not necessary a higher information criterion).

In terms of prediction, adding additional indices are unlikely to improve

predictions, assuming the market is reasonably efficient.

Part (i) was well answered by most candidates. Part (ii) was poorly answered by most

candidates. Part (iii) was well answered by most candidates. Some candidates failed to

derive both alpha and beta, but instead only provided a single set of parameters. Part (iv)

was well answered by most candidates. Several candidates failed to answer both parts of the

question (i.e. fitting the data and predicting future security prices). A number of candidates

also concluded that the multi-factor model would be better at predicting future security

prices.

St = S0 exp(t + Wt)

Where is the drift

and is the volatility

Using the hint, we see that E Wt2 t | Fs = Ws2 s for all s < t.

(and E(|( Wt2 t ) | ) < ) .

Then using Itos lemma we can see that

d (Wt2 t ) = 2Wt dWt ,

so indeed the process has zero drift and is a martingale.

For X to be a Brownian Motion we need

( )

t = Var(Xt) = t 2 Var Wt = t 2+ 2 + = 1

Page 5

Subject CT8 (Financial Economics Core Technical) April 2014 Examiners Report

We can then consider the increment in the process from t = 1(when the value of Xt is

simplified). So suppose that t > 1:

( )

E ( t Wt W1 )2 = t 2+ + 1 2t min t ,1 .

But for Xt to be a standard Brownian motion we must also have:

E ( t Wt W1 )2 = t 1

( )

This is not the only solution.

If < 0 then t t = 1and so + = 0 and thus = 1 and = 1 also works.

You may recognise the second solution to this problem as the time inversion property

of standard Brownian motion.

Alternatively:

The law of any Gaussian stochastic process is completely determined by its

expectation and its covariance function.

For Xt to be standard Brownian motion, we require:

E Xt = 0 and cov (Xs, Xt ) min(s, t).

Now Cov(Xs , Xt) = Cov(sXs, tXt) = s tmin(s, t)

Setting this equal to min(s, t) gives the two pairs of solutions required: = 0, = 1

and = 1, = 1.

Part (i) was well answered by most candidates. Part (ii) was well answered by most

candidates. Part (iii) was very poorly answered in general. Few if any considered the finite

moment condition. Only a few students managed to score more than a couple of marks in

part (iii) because they didnt try to check the relevant Gaussian parameters.

Page 6

Subject CT8 (Financial Economics Core Technical) April 2014 Examiners Report

Call options with lower strike prices are more valuable, so A > C.

American call options are more valuable than European call options so A > D and

B > E.

American call options with longer time to expiry are more valuable so A > B.

So, A is the most valuable, B is more valuable than E, and we cannot pass comment

on the relative value of other pairs with the information available.

Most managed this quite well, though a lot of students who found the correct inequalities also

derived some spurious ones as well. The most common mistake seemed to be not

understanding American options and not noticing that dividends might be payable.

(i)

Interest rates do not display mean reversion.

This model is computationally tractable.

This model wont give a realistic range of yield curves.

It wont fit historical data well.

It cannot be calibrated to current market data.

It is not very flexible (single factor model).

It is arbitrage-free.

(ii)

SDE for the short rate to get:

r (u ) = r (t ) e

a ( u t )

+ 1 e

a( u t )

) + e

au

as

dZ s .

Hence

T

r ( u ) du = r ( t ) e

a ( u t )

a u t

du + 1 e ( ) du + e au eas dZ s du

Page 7

Subject CT8 (Financial Economics Core Technical) April 2014 Examiners Report

T

r ( u ) du = ( t t ) + r ( t )

t

T

a T t

a T s

1 e ( )

1 e ( )

+

dZ s

a

a

t

So,

t

Students scored well on part (i) which was standard bookwork. In part (ii) many students

only solved the Vasicek SDE rather than deriving an expression for the integral as asked.

(i)

rP r0 = P / M(rM r0),

where

rP is the expected return on an efficient portfolio, P;

rM is the expected return on the market portfolio;

r0 is the risk-free rate;

P is the standard deviation of the return on the portfolio, P;

M is the standard deviation of the return on the market portfolio.

(ii)

rP is 18% and so

14 = 8P / 2, thus P = 0.035 = 3.5%.

(iii)

The efficient portfolio is a mix of the market portfolio and the risk-free asset.

If the weights (which sum to 1) are wM and w0 then the expected return is

12wM + 4 w0 so 8 wM = 14 and wM = 1.75, wM = 0.75.

Thus the efficient portfolio has 2,100,000 in the market portfolio and is short

900,000 in cash.

Some weaker students confused the variance with the standard deviation when applying the

formula for CAPM. Others lost marks for minor calculation errors.

Page 8

Subject CT8 (Financial Economics Core Technical) April 2014 Examiners Report

(i)

2x2gxx+ (r q)xgx rg + gt = 0

with boundary condition as above: g(T, x) = f(x).

(ii)

The proposed solution implies that for this derivative the function g is given

by g(t, x) = (xn / S0n1)e(Tt), where n is an integer great than 1.

This gives xgx = ng, x2gxx = n(n 1)g and gt = g.

Thus, to solve the PDE we need = 2n(n 1) + (n 1)r nq.

A quick check shows that g satisfies the boundary condition:

g(T, x) = xn/S0n1.

Not generally well-answered. Most students managed part (i) but few got any marks for part

(ii). A surprising number of students answered part (i) correctly but failed to try the obvious

route of substituting the equation from part (ii) into the formula from part (i).

Students were not penalised if they took the dividend rate q to be 0.

(i)

Consider the portfolio which is long one call plus cash of Ker(Tt) and short

one put.

The portfolio has a payoff at the time of expiry of ST.

Since this is the value of the stock at time T, the stock price should be the

value at any time t < T: that is

Ct + Ker(Tt) Pt = St.

(ii)

The Black-Scholes formula gives us that S0 (d1) KerT (d2),

with

S0 = 110, K = 120, r = .02, T = 1

so that

d1 = (log(S0 / K) + r + 2T) / T = (log(11/12) + .02 + 2) / ,

d2 = d1 .

Guessing and repeated interpolation gives = 30%.

Page 9

Subject CT8 (Financial Economics Core Technical) April 2014 Examiners Report

(iii)

(iv)

(a)

S1 121 D S1 120.

It follows that the initial price, V, of the portfolio should satisfy

S0 121er V S0 120 er,

i.e. 8.604 V 7.624.

(b)

(v)

Most students scored highly with the proof of the put-call parity.

Part (ii): a lot of students checked two trial values, and then interpolated to get something at

or near 30%. They didn't always check that their answer gave the right answer.

Part (iii): few students managed to sketch the graph correctly. There was often confusion

over the payoff profile between 120$ and 121$.

Part (iv): few students understood the question, mainly because they hadnt sketched the

graph in part (iii).

Part (v): a common mistake was using put-call parity to work out the value of the put and not

spotting that it had a different strike.

Page 10

Subject CT8 (Financial Economics Core Technical) April 2014 Examiners Report

market returns. In particular,

market crashes appear more often than one would expect from a normal

distribution. While the random walk produces continuous price paths, jumps or

discontinuities seem to be an important feature of real markets.

Furthermore, days with no change, or very small change, also happen more often

than the normal distribution suggests. This would seem to justify the consideration

of Levy processes.

Q-Q plots of the observed changes in the FTSE All Share index against those

which would be expected if the returns were lognormally distributed show

substantial differences. This demonstrates that the actual returns have many more

extreme events, both on the upside and downside, than is consistent with the

lognormal model.

a quintic polynomial distribution whose parameters have been chosen to give the

best fit to the data, clearly provides an improved description of the returns

observed, in particular more extreme events are observed than is the case with the

lognormal model. The rolling volatilities of a simulation from the non-normal

distribution show significant differences over different periods. This volatility

process has the same characteristics as the observed volatility from the equity

market.

This question was very poorly answered by most candidates, with very few candidates

scoring more than 4/8. Several candidates scored zero marks for providing a discussion on

the normal distribution itself, as opposed to the assumption of normality in market returns.

Candidates were generally able to generate the first two points (market crashes occur more

often than expected, jumps, etc. and that there are a larger number of days with little or no

movement). Almost no one discussed the use of Q-Q plots or a quintic polynomial. Again,

some candidates noted the points highlighted by Anna Bishop around the Hausdorff fractal

dimension.

10

(i)

is the risk-neutral default rate, is the recovery rate, and r is the risk-free rate.

(ii)

so that

Q(bond A defaults) = (1 exp( 10 s ds )) = 0.10317

(iii)

Page 11

Subject CT8 (Financial Economics Core Technical) April 2014 Examiners Report

Thus

C0 = 0.7472 = e0.05 [exp( 02 s ds) + 0.5(1 exp( 12 s ds )) exp( 10 s ds)]

= e0.05[0.5 exp( 02 s ds) + 0.5 exp( 10 s ds)]

(iv)

From the second expression in (iii) and the answer to (ii) we obtain

Q(bond C defaults) = 1 exp( 02 s ds)

= (1 2e0.05.7472 + (1 .10317)) = 0.32581.

Most struggled on part (iii).

A small number of students managed to work out the non-conditional probability of C

defaulting with only a handful coming to the full answer.

Page 12

EXAMINATION

30 September 2014 (am)

Core Technical

Time allowed: Three hours

INSTRUCTIONS TO THE CANDIDATE

1.

Enter all the candidate and examination details as requested on the front of your answer

booklet.

2.

You must not start writing your answers in the booklet until instructed to do so by the

supervisor.

3.

4.

Attempt all 10 questions, beginning your answer to each question on a new page.

5.

AT THE END OF THE EXAMINATION

Hand in BOTH your answer booklet, with any additional sheets firmly attached, and this

question paper.

In addition to this paper you should have available the 2002 edition of the Formulae

and Tables and your own electronic calculator from the approved list.

CT8 S2014

CT8exampaperSeptember2014

Pleasenote,regardingQuestion9:Thefivemarksforpart(v)of

Question9shouldhavebeensplitastwomarksforpart(iv)and

threemarksforpart(v).

manufacturing company M. The investor believes that returns on shares in S have

mean 10% and variance 16%% while returns on shares in M have mean 8% and

variance 25%%. The correlation between the two companies is 0.3.

[9]

theory.

(i)

[2]

function.

(ii)

[1]

(iii)

Calculate the expected return and the standard deviation of a portfolio which is

invested three quarters in S and one quarter in M.

[2]

(iv)

[2]

A new study suggests that in the future, S will make more sales to M, when M is

delivering strong profits.

(v)

including the minimum-variance portfolio.

[3]

[Total 10]

(i)

[5]

distributed N(0,1) random variables.

(ii)

(iii)

Explain why the standard Brownian motion is less suitable than the geometric

Brownian motion as a model of stock prices.

[2]

[Total 8]

CT8 S20142

[1]

A non-dividend paying stock currently trades at $65. Every two years the stock price

either increases by a multiplicative factor 1.3, or decreases by a multiplicative factor

0.8. The effective risk-free rate is 4% p.a.

Calculate the price of an American put option written on the stock with strike price

$70 and maturity four years, using a two period binomial model.

[9]

Let S be the price of a non-dividend paying share, and let r be the continuously

compounded risk-free rate.

(i)

Derive the forward price at time zero for the forward contract on S with

maturity T.

[4]

Assume that, at time zero, the share price is 500, and that the forward contract has

maturity two years. The share pays a dividend of 5% of the share price every six

months with the next dividend due in two months, and the continuously compounded

risk-free rate is 3% p.a.

(ii)

[4]

(iii)

Comment on whether the high dividend yield relative to the risk-free rate

offers an arbitrage opportunity.

[2]

[Total 10]

(i)

arbitrage-free model.

[2]

Consider a specific bond with maturity T1, suppose its price satisfies the following

Stochastic Differential Equation (SDE) under the real-world probability measure P:

dB(t,T1) = B(t,T1)[m(t,T1)dt + S(t,T1)dW(t)]

where W is a standard Brownian Motion, m(t, T1) is the drift and S(t, T1) is the

volatility.

(ii)

(a)

(b)

(c)

Show how it can be used in transforming the SDE above from the realworld probability measure P to a risk-neutral probability measure Q.

[4]

(iii)

Show how the above results would be used in calculating zero-coupon bond

prices.

[3]

(iv)

CT8 S20143

[2]

[Total 11]

(i)

constant, using the formula in section 7.2 of the Actuarial Formulae and

Tables.

[3]

(ii)

Give the expression for the fair price at time t of a derivative written on S

paying an amount DT at time T, defining any terms you use.

[3]

Suppose that S has an initial price of S0 = 1.20 and a volatility = 30% p.a. and that

the continuously compounded risk-free rate is r = 3% p.a.

(iii)

if and only if max0sT (Bs + s) > 1.44.

[4]

[Total 10]

(i)

Define delta.

[1]

Suppose that the stock price at time zero is S0 = $100, the continuously compounded

risk-free rate is 3% and that a European call option written on S with strike price

$109.42 and maturity t = 1 year has a delta of = 0.42074.

(ii)

[3]

An exotic option written on S with strike prices K1 and K2 and exercise times and T

is defined as follows:

The option may be exercised at time in which case the holder receives $100 if

and only if the price of the underlying, S is at least K1.

If the option is not exercised at time , then the holder will receive an amount c if

and only if the price at expiry T, ST, satisfies ST / S K2.

(iii)

Explain why, if c $100, the option will always be exercised at time when

S is at least K1.

[2]

(iv)

Give a formula for the value of the option just after the first exercise time

(i.e. just after the first exercise option has expired).

[2]

(v)

Explain why this value does not depend on the stock price at time .

[2]

(vi)

CT8 S20144

Determine the fair price of the exotic option just after time one and hence at

time one and at time zero.

[3]

[Total 13]

A company has issued a loan in the form of a zero-coupon bond which redeems in one

year from now. The bond is priced at 92.78 per 100 nominal and the recovery rate

in the event of a default is assumed to be 50%. The continuously compounded riskfree rate for one year is 3% p.a.

(i)

Write down the formula for the bond price under the two-state model, defining

all the terms used.

[2]

(ii)

[3]

Assume that the Merton model holds and that the annual volatility of the companys

total assets is 13%.

10

(iii)

Give an expression for the risk-neutral probability that the company defaults,

defining any other terms you use.

[3]

(iv)

Calculate the ratio of nominal loan to total asset value, assuming that the riskneutral default probability is the same as calculated in (ii).

(v)

Calculate the ratio of loan value to total asset value and hence determine the

percentage of total assets represented by equity value at time zero.

[5]

[Total 13]

(i)

(a)

definition of the parameters used.

(b)

State the corresponding mean and variance for the security price.

[4]

S0 = 200. The expected price at time 1 (in years) is E(S1) = 200e0.4 and the variance

is Var(S1) = 40000e0.4.

(ii)

Determine the parameter values for the corresponding lognormal model. [3]

[Total 7]

END OF PAPER

CT8 S20145

EXAMINERS REPORT

September 2014 examinations

Core Technical

Introduction

The Examiners Report is written by the Principal Examiner with the aim of helping

candidates, both those who are sitting the examination for the first time and using past papers

as a revision aid and also those who have previously failed the subject.

The Examiners are charged by Council with examining the published syllabus. The

Examiners have access to the Core Reading, which is designed to interpret the syllabus, and

will generally base questions around it but are not required to examine the content of Core

Reading specifically or exclusively.

For numerical questions the Examiners preferred approach to the solution is reproduced in

this report; other valid approaches are given appropriate credit. For essay-style questions,

particularly the open-ended questions in the later subjects, the report may contain more points

than the Examiners will expect from a solution that scores full marks.

The report is written based on the legislative and regulatory context at the date the

examination was set. Candidates should take into account the possibility that circumstances

may have changed if using these reports for revision.

F Layton

Chairman of the Board of Examiners

November 2014

Subject CT8 (Financial Economics Core Technical) September 2014 Examiners Report

Subject CT8 introduces the main concepts and principles of financial economics. These are

developed in later subjects in the ST series of exams. This subject combines various types of

skills. In particular, along with CT7, it is one of the first where candidates are expected to

write lengthy passages of reasoned thought, rather than just complete calculations. This is a

skill that will be new to many, and candidates are advised to pay particular attention to the

answers to this type of question by studying many past papers.

Comments on the September 2014 paper

The general performance was good. Candidates found some questions challenging, but wellprepared candidates scored consistently across the whole paper. As in previous diets,

questions that required an element of application of the core reading to situations that were

not immediately familiar proved more challenging to most candidates. A significant number

of candidates failed to read some questions carefully enough to identify the relevant section

of the course being examined.

Page 2

Subject CT8 (Financial Economics Core Technical) September 2014 Examiners Report

(i)

(ii)

(iii)

the budget constraint

how the consumer decides which consumption bundle to choose

(i)

Definitions

Utility is the satisfaction that a consumer obtains from a particular course of

action.

The amount of one good that a consumer is prepared to swap for one extra unit

of another good is known as the marginal rate of substitution.

An indifference curve joins all the consumption bundles of equal utility.

The slope of a consumers indifference curves will depend on his or her

individual preferences and is equal to the marginal rate of substitution.

A given combination of goods (e.g. two apples and five bananas) is called a

consumption bundle.

Assumptions and results

(a)

A consumer can rank different bundles, and therefore can pick a set of

consumption bundles that give the same utility.

(b)

Therefore indifference curves slope downwards from left to right and

indifference curves further from the origin give higher utility.

(c)

(ii)

substitution.

The assumptions

(a)

(b)

The consumers income is fixed.

The budget line joins all points that a consumer can afford, assuming that all

income is spent.

Page 3

Subject CT8 (Financial Economics Core Technical) September 2014 Examiners Report

(iii)

Economists assume that consumers choices exhibit rational behaviour. A

rational consumer will choose the consumption bundle that maximises his own

utility. This is the concept of utility maximisation.

Implications

Combining the budget line with indifference curves, we can determine the

consumption bundle which a consumer will choose. A rational consumer will

choose a consumption bundle such that the marginal rate of substitution is

equal to the slope of the budget line that is, where the ratios of marginal

utilities equal the ratios of prices.

[9]

This question was generally well answered by candidates who knew the bookwork on

consumer choice theory. A significant minority of candidates wrote about behavioural

finance (sometimes many pages) and scored few, if any, marks.

(i)

framework.

[2]

(ii)

You can relax the assumption that investors solely select their portfolios on the

basis of the expected return and variance of that return.

[1]

(iii)

Var(P) = 0.752 Var(S) + 0.252 Var(M) + 2 0.75 0.25 4 5 0.3

= 12.8125%%

So standard deviation (P) =

(iv)

(12.8125) = 3.57945%

xS

VM CSM

25 4 5 0.3

0.655173

VS 2CSM VM 16 2 4 5 0.3 25

(v)

[2]

[2]

The study suggests that the correlation between M and S will increase.

This means that portfolios containing positive amounts of M and S will have a

higher variance.

Page 4

Subject CT8 (Financial Economics Core Technical) September 2014 Examiners Report

If the correlation increases, then the minimum variance portfolio will contain

relatively higher amounts of S and relatively lower amounts of M.

[3]

[Total 10]

Generally well answered. A surprising number of candidates went about deriving the

proportion of assets in the minimum variance portfolio from first principles. A number of

candidates also werent able to calculate the variance of a linear combination of correlated

random variables. Part (v) required thinking beyond the core reading, and the better

candidates scored here.

(i)

One possible answer is as follows (other acceptable proofs could score full

marks):

We need:

W 0 ,

W X 0 X 0 and abs( X ) abs(W )

The probability of each of these inequalities is 0.5,

and they are all independent.

Therefore the overall probability is 1/8.

(ii)

[5]

St e At Zt

Where A, and are constants and Z t is the standard Brownian motion. [1]

(iii)

However successful the Brownian motion model may be for describing the

movement of market indices in the short run, it is useless in the long run, if

only for the reason that a standard Brownian motion is certain to become

negative eventually.

It could also be pointed out that the Brownian model predicts that daily

movements of size 100 or more would occur just as frequently when the

process is at level 100 as when it is at level 10,000.

[2]

[Total 8]

Many candidates found part (i) challenging, and skipped to other questions without having a

go at parts (ii) and (iii), which presented an opportunity for some relatively easy marks.

As the option is an American put, it may be optimal to exercise early and we have to

test at each node on the binomial tree.

First let us calculate the value of the European put option at each node starting from

expiry (the value of the American option is then the maximum of the value of the

European option and the intrinsic value at any node).

Page 5

Subject CT8 (Financial Economics Core Technical) September 2014 Examiners Report

q

1.042 0.8

0.5632 .

1.3 0.8

The value of the option payoff for the European options at t = 4 is given by:

Stock price

Option payoff

SUD = SDU = 65 1.03 * 0.8 = 67.6

SDD = 65 0.82 = 41.6

0

$2.40

$28.40

The value of the European option, and hence American options at time t = 2 are then:

Stock price

at t = 2

t=2

SU = 65*1.03 = 84.5

SD = 65* 0.8 = 52

0

$18

$0.97

$12.71

Finally, the value at time zero is

Max($5, (0.5632 $0.97 + (1 0.5632) $18)/1.042) = $7.77

[9]

Generally well answered. Most candidates realised that you can exercise an American

option early, but few managed to adjust the option price appropriately to allow for

this. Some candidates also slipped up over the two-year time steps.

(i)

One possible answer is as follows (other acceptable proofs could score full

marks):

Let K be the forward price. Now compare the setting up of the following

portfolios at time 0:

A: one long forward contract.

B: borrow K exp(rT) cash and buy one share at S0.

If we hold both of these portfolios up to time T then both have a value of

ST K at T.

Page 6

Subject CT8 (Financial Economics Core Technical) September 2014 Examiners Report

By the principle of no-arbitrage these portfolios must have the same value at

all times before T.

In particular, at time 0, portfolio B has value S0 K exp(rT) which must

equal the value of the forward contract.

This can only be zero (the value of the forward contract at t = 0) if

K = S0 exp(rT).

(ii)

[4]

A: one long forward contract

B: long 1.054 units of the share and short K * exp(0.06) in cash

Following similar logic to part (i), with the dividend being reinvested in the

share at each dividend date we find that no arbitrage implies that the fair

forward price K = 500 exp(0.06) 1.054 = 436.79.

[4]

(iii)

This does not provide an arbitrage opportunity since the dividend is not riskfree (and if the share price dropped significantly so would the dividend

amount, even if the yield remained the same).

[2]

[Total 10]

Part (i) was well answered. In part (ii) many candidates made a decent attempt at allowing

for dividends, but few got to the right answer. A surprising number of candidates thought

that a high dividend yield presented an arbitrage opportunity, failing to appreciate that

dividends are not risk-free.

(i)

We have started off with a process for r(t) which is not a tradable asset. An

arbitrage opportunity must relate to trading an asset, therefore arbitrage-free

models must allow for trading.

[2]

(ii)

(a)

(t , T1 )

m(t , T1 ) r (t )

.

S (t , T1 )

(b)

(t,T1) represents the excess expected return over the risk-free rate per

unit of volatility in return for an investor taking on this volatility.

(c)

dB(t, T) = B(t,T)[m(t,T)dt + S(t,T)dW(t)]

= B(t,T)[(r(t) + (t)S(t,T))dt + S(t,T)dW(t)]

= B(t,T)[r(t)dt + S(t,T)(dW(t) + (t)dt)]

Page 7

Subject CT8 (Financial Economics Core Technical) September 2014 Examiners Report

= B(t,T) r (t ) dt S (t , T )dW (t )

under Q.

(iii)

[4]

For a one-factor model we have seen above the broad principal which

transforms from P to Q. In order to say more about the basic price processes

we must look at the effect of this transformation on r(t).

Thus

dr(t) = a(t,r(t))dt + b(t,r(t))dW(t) under P

= a(t,r(t))dt + b(t,r(t)) dW (t ) (t ) dt

= (a(t,r(t)) (t)b(t,r(t)))dt + b(t,r(t)) dW (t )

= a(t , r (t ))dt b(t , r (t ))dW (t )

where a(t , r (t )) = a(t,r(t)) (t)b(t,r(t)).

The final two lines give us the dynamics of r(t) under the artificial measure Q.

We then use this to determine:

T

t

(iv)

[3]

When modellers use this approach to pricing, from the practical point of view

they normally start by specifying the dynamics of r(t) under Q in order to

calculate bond prices. Second, they specify the market price of risk as a

component of the model, and this allows us to determine the dynamics of r(t)

under P.

[2]

[Total 11]

Part (i) was generally well answered, but very few candidates managed parts (iii) and (iv)

which were largely bookwork. Quite a few candidates tried solving the SDE for the log of the

ZCB price with no mention of transforming to the risk neutral probability measure.

Page 8

Subject CT8 (Financial Economics Core Technical) September 2014 Examiners Report

(i)

P(M > y) = ((t y)/t) + e2y ((y t)/t).

It follows that M has density f given by

f(y) = f/y

= ((t y)/t)/t 2 e2y ((y t)/t) + e2y ((t y)/t)/t,

where is the standard normal density: it follows after a little algebra that

f(y) = 2((t y)/t)/t 2 e2y ((y t)/t).

(ii)

[3]

where Q is the unique risk-neutral (or equivalent martingale) measure, r is the

risk-free rate and is the filtration.

[3]

(iii)

St /S0 log N(r 0.52)t,2t)

and

P max( Bs s ) 1.44

0 st

Comparing the Bs + s part of this expression with the expression inside the

share price formula, we might take:

=

r 0.52

= 0.5

(although the value of was not given in the question so we award full marks

to any student who has derived the correct answer in terms of )

= 10e0.06P[max0s2(Bs + s) > 1.44]

1.44 2 21.44

1.44 2

2

2

= 10e0.06

Page 9

Subject CT8 (Financial Economics Core Technical) September 2014 Examiners Report

[4]

[Total 10]

Many candidates found this question tough and scored few marks. A number of candidates

were seemingly put off by part (i) and didnt attempt the potentially easier marks available in

later parts.

(i)

(ii)

is the first partial derivative of the option price with respect to the

underlying asset price.

[1]

Using the formula for the , we see that (d1) = 0.42074 and hence d1 = 0.2.

Thus 0.2 = 0.0600 + 2 or 2 + 0.2 0.06 = 0.

Solving the quadratic gives = 20% or 60% and rejecting the negative value

gives = 20%.

[3]

(iii)

When S is at least K1 then the holder is presented with a choice between $100

now and the possibility of $c later. Clearly if c 100, the holder will always

choose to exercise immediately.

[2]

(iv)

Just after , the optional element has expired and the holder is entitled to $c at

time T if and only if (ST/S K2). And so the fair price after time is

cer(T) Q(ST/S K2|F),

where Q is the EMM.

(v)

[2]

Since, under

Q, ST/S = exp( (BT B) + (r 2)(T )),

where B is a Brownian motion under Q, and since BM has independent

increments, ST/S is independent of F and so the value of the option just after

[2]

time does not depend on S.

(vi)

200e0.03(1 (0.5)) = $134.20.

Since this is greater than $100, the holder will never exercise the option at

time 1 and so

V0 = e0.03V1 = $130.24.

Page 10

[3]

[Total 13]

Subject CT8 (Financial Economics Core Technical) September 2014 Examiners Report

Reasonably well answered. Many candidates tried to find the volatility by trial and error,

which was time-consuming compared to deriving and solving the quadratic equation. Some

candidates derived the quadratic equation then still solved it by trial and error. Several

candidates tried to determine the price of the exotic option as a call option for part (vi).

(i)

where B is the bond price, is the risk-neutral default rate, is the recovery

rate, and r is the risk-free rate.

[2]

(ii)

0.9278 = e0.03[1 0.5 (1 exp( 10 s ds )]

= e0.03[1 0.5p],

where p is the default probability.

Hence p = 0.08789.

(iii)

[3]

Under the Merton model, Q(default) = Q(FT < L), where L is the nominal loan

amount, and Ft is the gross asset value of the company at time t and Q is the

EMM.

Hence

Q(default) = Q(F0 exp( BT + (r 2)T) < L)

= Q(BT < (ln(L/F0) (r 2)T)/)

= (ln(L/F0) (r 2)T)/T)

(iv)

[3]

Thus

([ln(L/F0) 0.02155]/0.13) = 0.08789

so

ln(L/F0) = 0.131(0.08789) + 0.02155 = 0.154457

and so

L/F0 = 0.85688.

[2]

Page 11

Subject CT8 (Financial Economics Core Technical) September 2014 Examiners Report

(v)

Thus,

L0/F0 = 0.9278*0.85688 = 0.79501

and so

E0/F0 = 1 0.79501 = 20.5%,

where Et is the net equity value at time t and Lt is the loan value at time t. [5]

[Total 15]

Candidates scored well on parts (i), (ii) and (iii). Well prepared candidates scored full

marks but many did not attempt parts (iv) and (v). Many candidates thought that lambda was

the probability of default (rather than the integral of lambda) and tried to find lambda

without success.

10

(i)

(a)

for the log of the asset price.

Thus, if Su denotes the stock price at time u, then

log(St/Ss) ~ N((t s),2(t s))

where is the drift and is the volatility parameter.

(b)

It follows that

E(St) = S0exp(t+ 2t)

and the variance is

Var(St) = S02 exp(2t + 2t)(exp(2t) 1).

[Alternative: if students use Geometric BM as the foundation for the

lognormal model then they will model

log(St/Ss) ~ N((t s) 2(t s),2(t s)).

The formulae for mean and variance will then change to:

E(St) = S0exp(t)

and

Var(St) = S02 exp(2t)(exp(2t) 1).]

Page 12

[4]

Subject CT8 (Financial Economics Core Technical) September 2014 Examiners Report

(ii)

exp(+2) = e0.4 and exp(2 + 2)(exp(2) 1) = e0.4,

so that exp(2) 1 = e1.2.

It follows that

2 = log (1 + e1.2) = 0.2633

and

= log(e0.4) log (1 + e1.2) = 0.2684.

[Alternative: if students use Geometric BM then they should obtain

exp() = e0.4 and exp(2)(exp(2) 1) = e0.4,

so that exp(2) 1 = e1.2.

It follows that

2 = log(1 + e1.2) = 0.2633, as before, and = log(e0.4) = 0.4.]

[3]

[Total 7]

Generally very well answered, with most students recalling and applying the bookwork

correctly.

Page 13

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