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Faculty of Actuaries

Institute of Actuaries

EXAMINATION
28 April 2010 (am)

Subject CT8 Financial Economics


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.

Mark allocations are shown in brackets.

4.

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

5.

Candidates should show calculations where this is appropriate.

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 A2010

Faculty of Actuaries
Institute of Actuaries

Let ( X t ; t 0 ) be a stochastic process satisfying:


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)

State the stochastic differential equation for f ( t , X t ) .

[2]

Let dX t = X t dt + dWt .
(ii)

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

X t = X 0 exp ( t ) + exp ( ( s t ) ) dWs

[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

the continuously compounded risk-free rate is r = 5% per six-month period

(i)

(a)
(b)

Prove that there is no arbitrage in the market.


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

Its solution is given by:


t

r ( t ) = r0 exp ( at ) + b (1 exp ( at ) ) + exp ( at ) exp ( as ) dWs


0

You may also use the fact that for T > t:


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)

Derive the price at time t of a zero-coupon bond with maturity T.

[10]

(ii)

(a)

State the main drawback of such a model for the short-rate.

(b)

State the name and stochastic differential equation of an alternative


model for the short-rate that is not subject to the drawback.
[2]
[Total 12]

CT8 A20103

PLEASE TURN OVER

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)

Calculate the fair price for this derivative security.


[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)

Explain how the two state model is generalised in the Jarrow-Lando-Turnbull


model.
[3]
[Total 12]

(i)

State the Cameron-Martin-Girsanov Theorem.

(ii)

Derive the value of a which makes exp(Bt at) a martingale when B is a


standard Brownian Motion.
[3]

[3]

In a Black-Scholes market, the stock price is given by:


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)

Calculate the value of c such that Bt + ct is a standard Brownian


Motion under the Equivalent Martingale Measure.

(b)

Calculate the risk-free rate of interest.


[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

Subject CT8 Financial Economics


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)

Write down Itos formula for f(t,Xt) when dX t = t dt + t dWt


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.

Portfolio B: buying a fraction exp ( (T t ) ) of the underlying asset for

St exp ( (T t ) ) and borrowing K exp ( r (T t ) ) at time t. Its value at time t

is then K exp ( r (T t ) ) St exp ( (T t ) ) . Its value at maturity is then

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.

At time 1, we get in the upper state,


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

The price of the option is obtained as

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

(i)

) = 8.744 .

The price of a zero-coupon bond can be written as

T

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

Since

r ( u )du is a Gaussian random variable, we can compute explicitly the


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

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


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 = 10%. Black Sholes formula gives a price of p10 = 44.05.


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

and D is an absorbing state.


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.

Another correct answer will be:


T

PrP(X(T) = N | X(t) = N) = exp s ds

PrP(X(T) = D | X(t) = N) = 1 exp s ds

If is a stopping time defined as:


= 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

The formula for the zero-coupon bond price is

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)

(The Cameron-Martin-Girsanov theorem)


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

equivalent to P and where Z t = Zt + s ds is a standard Brownian motion


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

Z t = Zt + s ds is a Brownian motion under Q .


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!).

3 forms of EMH defining what type of information is available: weak for


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

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

Although illegal, insider information appears to enable investors to make money.


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 define publicly available information might be that some very


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.

Conflicting empirical evidence from supporters and detractors.

Difficult to determine when, precisely, information arrives.

(i)

Let J be the return to the investor in the junior loan.


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(J < 50) = 0.25


Pr(S < 50) = 0.125

END OF EXAMINERS REPORT

Page 10

Faculty of Actuaries

Institute of Actuaries

EXAMINATION
8 October 2010 (am)

Subject CT8 Financial Economics


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.

Mark allocations are shown in brackets.

4.

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

5.

Candidates should show calculations where this is appropriate.

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 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)

Calculate the mean and variance of R.

(ii)

Calculate the shortfall probabilities for R and for S using:


(a)
(b)

a benchmark rate of return of


0%
a benchmark rate of return of 10%

[3]

[4]

(iii)

Comment on what the variance and shortfall probabilities at both benchmark


levels illustrate about the asset returns, by referring to the calculations in (i)
and (ii).
[3]
[Total 10]

(i)

Explain what is meant by excessive volatility of share prices.

(ii)

State two examples of empirical evidence of the under-reaction of share


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)

In the context of credit risk for defaultable bonds:


(a)

(b)
(c)
(ii)

give three examples of a credit event


give three examples of an outcome of a default
define the recovery rate

Describe the two-state model for credit ratings.

[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:

a continuously compounded risk free rate of interest of 3% p.a.


the issue of bond A is priced at 1.6m
the issue of bond B is priced at 2.2m

(iii)

Evaluate the two default rates (under a risk-neutral measure).

[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)

State an expression for the price of a derivative security in a Black-Scholes


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

PLEASE TURN OVER

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)

Prove, using Itos formula, that t is a martingale.

(b)

Show that E[exp(mWt )]= exp(1/2m2t).


[5]

(ii)

(a)

Derive an expression for p0 when f(x) = x.

(b)

Show that there is an arbitrage in the market unless m = (r )/.


[5]
[Total 10]

(i)

Define delta, gamma and vega for an individual derivative.

[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

the continuously compounded risk-free rate is r = 6% per period

(i)

(ii)

(a)

Prove that there is no arbitrage in the market.

(b)

Construct the binomial tree for the model.

[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)

Calculate the initial price of this call option.

(b)

Comment on the relationship between the price of the special call


option and the option in (ii).
[4]
[Total 11]

END OF PAPER

CT8 S20105

INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS REPORT
September 2010 examinations

Subject CT8 Financial Economics


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

Institute and Faculty of Actuaries

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

(i)

E[R] = 0.8 * 0% + 0.2 * 30% = 6%


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

(ii)

Var(R) = 0.028 0.062 = 0.0244 = 0.15622


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)

Variance suggests risks are the same


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

(Note: candidate answers may differ slightly because approximations required in


standard normal lookups from tables.)

(i)

Excessive volatility is when the change in market value of stocks (observed


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)

There are also well-documented examples of under-reaction to events (any


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)

failure to pay either capital or a coupon


loss event
bankruptcy
rating downgrade of the bond by a rating agency such as Standard
and Poors or Moodys

The outcome of a default may be that the contracted payment stream


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)

We seek a portfolio consisting of a units of 100 nominal of bond A, b


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

Solving gives a = b = 2.5, c = 500 and d = 1.


(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)

The unique fair price is V = EP[erTD], where P is the EMM

(ii)

Standard interpolation using the Black-Scholes formula gives r = 14.55% or


14.5%

(iii)

The price of the security is given in (i) so equals


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)

Set g(x,t) = exp(kx (1/2)k2t), then t = g(Wt , t).


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)).

Now the price at time 0 of a unit of stock is S0 , so unless p0 = S0 ,


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)

Denote the individual derivative by f and assume this is written on an


underlying security S

f f
(t, St ).
s s
2 f
s 2

= f

(Marks should also be awarded if these are defined in words.)


(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.

Portfolio B: buying the underlying asset for St and borrowing

K exp ( r (T t ) ) + D exp ( r (T ' t ) ) at time t. Its value at time t is then:

( K exp ( r (T t ) ) + D exp ( r (T ' t ) ) St ). At time T ' , the dividend D is paid


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)

Key calculation in demonstrating no arbitrage is


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

(b)

The binomial tree is:


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

= 44 ; Cud = ( udS0 K ) = 0 ; Cdd = d 2 S0 K

= 0.

At time 1, we get in the upper state,


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

C1 ( d ) = exp qCud + (1 q ) Cdd = 0 where the risk-neutral probability of an


upward move is q =

exp ( r ) d
ud

= 0.6545 .

At time 0, C0 = exp ( r ) qC1 (u ) + (1 q ) C1 (d ) .


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.

END OF EXAMINERS REPORT

Page 7

INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION
20 April 2011 (am)

Subject CT8 Financial Economics


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.

Mark allocations are shown in brackets.

4.

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

5.

Candidates should show calculations where this is appropriate.

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 A2011

Institute and Faculty of Actuaries

(i)

State the six assumptions underlying the Black-Scholes market.

(ii)

Give the four defining characteristics of a Brownian Motion Z, such that


Z0 = 0.
[5]

(i)

State the main assumptions of modern portfolio theory.

[2]

Three assets have the following characteristics:


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)

State the Lagrangian function that can be minimised to find the


minimum variance portfolio associated with a given expected return,
defining any notation used.

(b)

By taking five partial derivatives of this function, calculate the


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 assumptions of the Capital Asset Pricing Model hold


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)

Calculate M, the standard deviation of the annual return on the market


portfolio. Quote any results that you use.

[1]

(ii)

Calculate rB, the expected annual return on asset B.

[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)

Outline the three forms of the efficient market hypothesis.

[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)

Comment on this statement.

[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)

Derive expressions for x and y in terms of r, u, d, and .

(ii)

Derive an expression for the risk-neutral probability of the security having


value St u at time t + 1 in terms of (x + y), r, and .
[2]

[4]

Assume St = 100, u = 1.25, d = 0.8 and r = 0.


(iii)

(a)
(b)

Calculate the prices of at-the-money call and put options.


Check that the put-call parity holds for this model.
[4]
[Total 10]

CT8 A20113

PLEASE TURN OVER

(i)

Describe the lognormal model for security prices.

[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)

Calculate, as at this date, the probability, p, that (S1 > 2.20).

[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)

Explain whether or not you would buy this option.

[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)

Specify the distribution of .


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)

Comment on this in the light of your answer to part (iv)(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

Assume the Black-Scholes model applies.


(i)

State an expression for the price of a derivative security with payoff D at


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)

Estimate the implied volatility to within 1% per annum.

(b)

Calculate the corresponding hedging portfolio in shares and cash for


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

(c)

Calculate the options Vega.


[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)

State the value of the senior debt at maturity.


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)

Calculate the theoretical price of 100 nominal of the junior debt.

CT8 A20115

[6]
[Total 10]

PLEASE TURN OVER

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)

Solve the SDE for the short rate rt from (ii).

(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]

INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS REPORT
April 2011 examinations

Subject CT8 Financial Economics


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

Institute and Faculty of Actuaries

Subject CT8 (Financial Economics) Examiners Report, April 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.

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.

[Unit 8 p3 para 1]
A Brownian Motion Z has the following properties:
(1)

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


{Zr, r s} whenever s < t.

(2)

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


only on t s.

(3)

Z has Gaussian increments, i.e. the distribution of Zt Zs is N(0, t s).

(4)

Z has continuous sample paths t Zt

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

Page 2

(i)

It is assumed that investors select their portfolios on the basis of the


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

It is assumed that the expected returns, variance of returns and covariance


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.

Subject CT8 (Financial Economics) Examiners Report, April 2011

(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=

xi2Vi + 21212 x1x2 ( E1x1 + E2 x2 + E3 x3 E ) ( x1 + x2 + x3 1)


i =1

= 36 x12 + 144 x22 + 324 x32 + 108 x1 x2 (4 x1 + 6 x2 + 8 x3 E ) ( x1 + x2 + x3 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

Solving this set of simultaneous equations gives x1 = 0.7125,


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

Subject CT8 (Financial Economics) Examiners Report, April 2011


(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)

The market portfolio is in proportion to the market capitalisation since every


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.

Generally well-answered by most candidates.

(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

Subject CT8 (Financial Economics) Examiners Report, April 2011


(ii)

Any reasonable comments:-the market was expecting more and reacted


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)

Consider an investment of x in cash and y in the stock at time t. Equating the


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)

For the call option we have:


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

For the put option we have:


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

(b)

The strike price (for the at-the-money option) is just St = 100.


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

Subject CT8 (Financial Economics) Examiners Report, April 2011

(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)

p = P(S1 > 2.20) = P(log(S1/S0) > log(2.2/1.83)) = P(N(0,1) > (log(2.2/1.83)


.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)

is N(, 2/10) so ~ N(0, 0.00144).

(b)

A priori, therefore, P( > 0.03) = 1 (.03/.00144)


= 1 (.79057) = .21459.

(a)

If the true value of is <0.0128 then p is smaller than p and so the


option is a bargain!

(b)

The probability of this level of error in the estimate of is relatively


large even though we have 10 years of data.

(v)

In fact, this shows the difficulty in estimating drifts in market models


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 decrease as the underlying share price increased.


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.

A very well answered question.

Page 6

Subject CT8 (Financial Economics) Examiners Report, April 2011

(i)

The unique fair price is V = EQ[erTD], where Q is the EMM

(ii)

(a)

Standard interpolation using the Black-Scholes formula gives = 20%


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)

The calls Delta = C = f/S = (d1), where


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)

Vega = VC = f/ = /(S(d1) KerT (d2))


= (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)]

The put price is p = KerT (d2) S(d1), where


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

Subject CT8 (Financial Economics) Examiners Report, April 2011


(iv)

If we have a portfolio of a shares, b puts and m cash we require to match the


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 (3) gives b = 1.18506;


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)).

Using a Black-Scholes approach, the current value of the senior debt is V1 =


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.

(d1) = 0.68819 and (d2) = 0.48848 and so


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

Subject CT8 (Financial Economics) Examiners Report, April 2011

10

(i)

Risk-neutral approach:
T

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

State-price deflator approach:


B (t , T ) =

E P { A(T )Ft }
A(t )

Where A(t) is the deflator.


(ii)

The dynamics of the short rate rt under Q for the Vasicek model are:
drt = ( rt )dt + dZt,

where Z is a Q-Brownian motion.


This is an Ornstein-Uhlenbeck process.
(iii)

Consider st = etrt. Then


dst = etrtdt + et drt
= etdt + et dZt
t

Thus st = s0 + (et 1) + eu dZu


0

and consequently
t

rt = etr0 + (1 et) + e (u t ) dZu


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.

END OF EXAMINERS REPORT

Page 9

INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION
28 September 2011 (am)

Subject CT8 Financial Economics


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.

Mark allocations are shown in brackets.

4.

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

5.

Candidates should show calculations where this is appropriate.

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 S2011

Institute and Faculty of Actuaries

(i)

Define an efficient portfolio in the context of modern portfolio theory.

[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

The correlation between the returns on the two assets is 0.25.


(ii)

(a)

Calculate the proportion that would be invested in each of the two


assets in a minimum variance portfolio.

(b)

Calculate the expected return of that portfolio.


[3]
[Total 4]

Consider the following three-factor model of security returns:


Ri = i + i1I1 + i2I2 + i3I3 + i
Where:

Ri is the return on security i


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:

Zt is a standard Brownian motion


= 12%
= 25%
t is the time from now measured in years; and
S0 = 1

(i)

(ii)

(a)

Derive the distribution of St.

(b)

Calculate the amount, A, that the investor would need to invest in


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

PLEASE TURN OVER

Assume that there is no arbitrage in the market. A forward contract is available on a


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)

Derive an expression for the market price of risk.

[4]

(iii)

Deduce the stochastic differential equation for rt under the risk-neutral


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)

Calculate the state-price deflator after one year.

[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]

A non-standard derivative is written on a stock with current price S0 = $2 and is


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)

Explain how the option should be priced after t = 1 (assuming that it is


not exercised at t = 1).

(b)

Give an expression for the corresponding price, pt.


[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)

Show that a holder should exercise the option at t = 1 if S1 > k for a


suitable value of k.

(b)

Calculate the value of k.


[4]
[Total 10]

CT8 S20115

PLEASE TURN OVER

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]

Assume the Black-Scholes model applies.

10

(ii)

Calculate the implied volatility of the stock.

(iii)

Construct the corresponding hedging portfolio in shares and cash for 5000 of
the call options.
[2]
[Total 9]

(i)

In the Wilkie model, the force of inflation, I(t), is a mean-reverting AR(1)


process.
(a)

Explain what the statement above means.

(b)

Show that the mean of I(t) converges to m, using the formula:

[4]

I(t) = m + a(I(t 1) m) + Z(t),


where the Z(t)s are iid N(0, 2) random variables and 0 < a < 1.
[4]
(ii)

Discuss the differences between and suitability of mean-reverting and random


walk models for share prices, interest rates and inflation.
[5]
[Total 9]

CT8 S20116

11

(i)

Draw a diagram to illustrate the Jarrow-Lando-Turnbull model for credit


default, defining any notation used.

[4]

A model was proposed for a countrys sovereign debt as follows:


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)

Derive a similar equation for k defined by k(t) = 2p1(t) + p2(t).


[2]

Suppose that this countrys economy is in state 2 at time 0.


(iii)

Find the probability that it is in default at time 2.

[4]

Assume a continuously compounded risk-free interest rate of 2% per annum and a


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)

Calculate the credit spread.


[3]
[Total 13]

END OF PAPER

CT8 S20117

INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS REPORT
September 2011 examinations

Subject CT8 Financial Economics


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

Institute and Faculty of Actuaries

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)

Macroeconomic factor models

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

These are closely related to macroeconomic models but instead of (or, in


addition to) macroeconomic variables the factors used are company specific
variables. These may include such fundamental factors as:

the level of gearing;


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

These do not rely on specifying the factors independently of the historical


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)

There are many acceptable answers, but for example:


Macroeconomic factor model

I1 = annual inflation; I2 = annual GDP; I3 = equity dividend yield


Fundamental factor model

I1 = quick ratio; I2 = book value; I2 = industry group to which the company


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)

Using Itos Lemma:


d log St =

1
1
dSt + 2 (dSt ) 2
St
2 St

2
=
dt + dZt

Written in integral form, this reads

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

Var( St ) = e2t (e t 1) or equivalently,

Var( ASt ) = 100, 0002 e

(e

2t

So the variance of the investment is:


41,1682Var(S10) = 41,1682 e2.4(e0.625 1)
= 41,1682 9.571
= 16,220,971,227.90
(b)

As St has a lognormal distribution


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

= P((log S10 0.8875)/


(c)

0.625 < 0.1333) = 0.4470

The 99th percentile of the Normal distribution is given by Zt = 2.3263.


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

2 2 at time zero. Its value at maturity is S F T by taking account


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)

drt = (t rt)dt + dZt or alternatively dr = [ (t ) ar ] dt + dz


Where in both cases Z is a Brownian motion under

(iii)

Arbitrage free. Yes


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

The market price of risk, t, is defined as:


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

So, using Its lemma, we have


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

rt
.

t =
(iii)

The stochastic differential equation for rt under the risk-neutral measure


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)

First we calculate the risk-neutral probability of an upwards movement in the


share price from each state:
q(200) =

1.03 200 170


= 0.6
230 170

q(230) =

1.03 230 200


= 0.738
250 200

q(170) =

1.03 170 150


= 0.502
200 150

We can use these to calculate the state-price deflators:


A2(250) =

A2(200) =

A2(150) =

(ii)

q (200)q (230)
(0.75 1.03) 2

= 0.742

q (200)[1 q (230)] + [1 q (200)]q (170)


2 0.75 0.25 1.032
[1 q (200)][1 q (170)]
(0.25 1.03) 2

= 0.900

= 3.004

The option premium, V, can be calculated as


V = EP (A2V2)

= p2 A2(250) log(70) + 2p(1 p) A2(200) log(20) + (1 p)2 A2(150) 0


= 2.784
(iii)

It would not change at all.

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],

where C is the claim value at t = 2 and Q is the risk-neutral probability


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)

At the critical value the holder should be indifferent i.e. we should


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 {log(2/k) + .025}/.3 =.02531


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)

Using put-call parity, 0 = S KerT, so K = SerT = 306.06p


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)

(d1) = 0.52 so the hedge is 5000 0.52 = 2600 shares


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)

The n states represent

1 credit ratings plus default.

ij (t ) are the deterministic transition intensities from state i to state j at time t

under the real world measure P.


(ii)

(a)

h(t ) = 2 p1 (t) p2 (t) = 3p1(t) + 3/2p2(t) = 3/2h(t).


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

(b)

Solving these linear differential equations with initial conditions


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)

The bond price is thus e.04 (1 p3(2))100 + p3(2)60) = 68.729.

(b)

The equivalent no-default interest rate is log(100/68.729) = 18.75%.


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.

END OF EXAMINERS REPORT

Page 12

INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION
25 April 2012 (am)

Subject CT8 Financial Economics


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.

Mark allocations are shown in brackets.

4.

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

5.

Candidates should show calculations where this is appropriate.

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 A2012

Institute and Faculty of Actuaries

(i)

State the assumptions underlying the Black-Scholes market.

[3]

(ii)

State the defining characteristics of Brownian Motion.

[2]

(iii)

Explain what an examination of past option prices tell us about the


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)

Calculate the expected return on the market portfolio.

[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]

Assume that r takes the value 20% p.a.


(ii)

CT8 A20122

Calculate the price at time 0 of a non-standard derivative which pays off


( 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)

Calculate the price c of the call option exactly.

[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)

Define VaR ( X ) with [ 0,1] .

(ii)

Show that:

VaR = + 1 ( )

[1]

where denotes the cumulative Normal distribution function.


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

[4]

Derive an expression for TailVaR ( X ) given that:

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

Calculate the VaR and TailVaR of this investment when = 0.01.

[2]
[Total 11]

PLEASE TURN OVER

(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)

Solve the stochastic differential equation in (i).

[5]

(iv)

State the distribution of r(t) for t given.

[1]

(v)

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

[3]

(vi)

Outline the main drawback of the Vasicek model.

[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)

Explain the bonus in terms of an option on the share price.

[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]

(Hint: Consider the different situations depending on whether one or both


options are exercised).
(b)

CT8 A20124

Calculate the amount this transaction will save the company.

[2]
[Total 12]

In a Black-Scholes market, a special option with strike price a and maturity T on an


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

the fact that max(xk,0) = I a ( x ) da .

[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)

Calculate the implied risk-neutral default intensities A and B, assuming that


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

Calculate the implied risk neutral probability of a double-default and the


corresponding constant rate.

[2]

Calculate the maximum price for this derivative, by considering the maximum
possible double-default rate.
[4]
[Total 14]

PLEASE TURN OVER

10

(i)

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

(ii)

State the two major weaknesses of APT.

END OF PAPER

CT8 A20126

[2]
[Total 6]

INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS REPORT
April 2012 examinations

Subject CT8 Financial Economics


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

Institute and Faculty of Actuaries

Subject CT8 (Financial Economics) April 2012 Examiners Report

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 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

Subject CT8 (Financial Economics) April 2012 Examiners Report

(i)

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


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)

A Brownian Motion Z has the following properties


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)

The Black-Scholes formula describes option prices in terms of anticipated


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

Subject CT8 (Financial Economics) April 2012 Examiners Report

(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)

The no arbitrage condition implies that d < 1 + r < u .


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)

The model can be drawn as follows:


q2

q1

S 0 = 150

S 1 = 280

S 1 = 120

S2 = 420, payoff is 3202 = 102, 400 .

S2 = 322, payoff is 2222 = 49, 284 .


q3

S 2 = 168, payoff is 682 = 4, 624 .

S2 = 112, payoff is 122 = 144 .

Page 4

Subject CT8 (Financial Economics) April 2012 Examiners Report

Then we can calculate

and

q1 =

180 120
336 322
= 0.375 , q2 =
= 0.14286
280 120
420 322

q3 =

144 112
= 0.57143.
168 112

The value of the option is therefore

V=

(1 + r )2

102, 400q1q2 + 49, 284q1 (1 q2 ) + 4, 624 (1 q1 ) q3 + 144 (1 q1 ) (1 q3 )

= 15, 984.

Generally candidates scored well on this question.

(i)

Consider a portfolio, A , consisting of a European call on the share and a sum


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

Subject CT8 (Financial Economics) April 2012 Examiners Report

(ii)

Consider the following two portfolios:

A: one call option plus cash of $30e 3 + $0.50e


B: one put option plus one share
After four months both portfolios have value

max {$30, S4 months } + $0.50e

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)

VaR ( X ) = t where P ( X < t ) = .

(ii)

Following the hint in the question:

= P ( X < VaR )

X VaR
= P
<

VaR

= P Z <

where Z is a standard Normal random variable.

VaR
Therefore =

VaR
1 ( ) =
,

and so VaR = ( + 1 ( )).

Page 6

Subject CT8 (Financial Economics) April 2012 Examiners Report

(iii)

As the loss distribution is continuous, we have


TailVaR = E ( X |X < VaR )

1
=

VaR

x, ( x ) dx

1( )

x0,1 ( x ) dx

1( )

0,1 ( x )

1 ( )

(iv)

VaR = 350m [10% 25% 2.32635] = 168.56m

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)

dr ( t ) = ( r ( t ) ) dt + dW ( t ) where W is a standard Brownian motion.

(ii)

This process is an Ornstein-Uhlenbeck process.

(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

Subject CT8 (Financial Economics) April 2012 Examiners Report

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)

For t given, r(t) is normally distributed.

(v)

For t given, the expected value of r(t) is given by:


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 )

The second moment of r(t) is given by:

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)

The process may become negative which is undesirable in a nominal interest


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)

Thus C = S(d1) KerT (d2),


with

S = 90, K = 100, d1 = .43978, d2 = .61978, so (d1) = 0.33005

and

(d2) = .26770

so that C = 3.2009p.

Page 8

Subject CT8 (Financial Economics) April 2012 Examiners Report

Then C = C/S = (d1) =.33005,


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)

For 120 > S > 100, we need a and b to satisfy


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)

D0(a) = erT E[Ia(ST)]

(ii)

Since C0(K) = erTE[max(ST K,0)] = e rT E[ I a ( ST )da ], we see that

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

Subject CT8 (Financial Economics) April 2012 Examiners Report

Now (dd1/dK) = 1/(KT) = (dd2/dK),


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)

The risk-neutral prices are given by


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)

Let p denote the risk-neutral double-default probability, then if V is the price


of the derivative security we have
V = 100,000 e.75rp,

Page 10

Subject CT8 (Financial Economics) April 2012 Examiners Report

So
P = (7900/100000) * e.75r = 0.07989,
the corresponding constant rate is log (1 p) / .75 = 0.111016.
(iv)

Now we get a double-default when both companies default, so this cant


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.

Few candidates failed to score well on this exercise.

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

Subject CT8 (Financial Economics) April 2012 Examiners Report

(ii)

Weaknesses:
(1)

In order to apply APT, we need to define a suitable multi-index model.

(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.

END OF EXAMINERS REPORT

Page 12

INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION
4 October 2012 (am)

Subject CT8 Financial Economics


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.

Mark allocations are shown in brackets.

4.

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

5.

Candidates should show calculations where this is appropriate.

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 S2012

Institute and Faculty of Actuaries

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)

Calculate the risk neutral implied default probability of each bond.

(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 AA bonds.


100 invested in BB bonds.
50 invested in AA bonds and 50 invested in BB bonds.
[6]

(iii)

Comment on your answers to (ii).

[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

S3 after three years, provided that at some point

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.

Calculate the current price of this non-standard derivative.

[8]

(i)

[3]

State the three main assumptions of Modern Portfolio Theory.

Assume Modern Portfolio Theory holds true.


(ii)

Write down equations for the expected return, E and variance, V of a portfolio
of N securities, defining any notation used.
[3]

(iii)

Describe how an efficient portfolio can be found.

CT8 S20122

[4]
[Total 10]

A non-dividend paying stock is currently priced at S0 = 80 . Over each of the next


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]

State eight desirable characteristics of a term-structure model.

(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]

A three-month European call option on a non-dividend paying stock in Universal


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

PLEASE TURN OVER

(i)

Describe the Merton model for pricing a defaultable bond.

[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)

Derive an expression for the value of the debt.

[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)

Discuss whether there is an arbitrage opportunity.

[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)

State the composition of the market portfolio.

[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]

An investor wants an expected return of 20%.


(iv)

Calculate the composition of the corresponding portfolio.

(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)

Explain what it would mean for portfolio A to first order stochastically


dominate portfolio B.

(iii)

Prove, by considering the expected utility of investments in either A or B, that


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]

INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS REPORT
September 2012 examinations

Subject CT8 Financial Economics


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

Institute and Faculty of Actuaries

Subject CT8 (Financial Economics) September 2012 Examiners Report

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 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

Subject CT8 (Financial Economics) September 2012 Examiners Report

(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

The 95% VaR is zero. The 95% TailVar is

106 p AA
= 106
p AA
(b)

The 95% VaR is zero. The 95% TailVar is:


108 pBB
= 108
pBB

(c)

The distribution of returns is:

107 with probability (1 p AA )(1 pBB ) = 0.94479


54 with probability p AA (1 pBB ) = 0.01817

53 with probability pBB (1 p AA ) = 0.03634


0 with probability p AA pBB = 0.00070
So the 95% VaR is 107 54 = 53.
The 95% TailVaR is

107 p AA pBB + 54(1 p AA ) pBB


= 55
pBB
(iii)

Investing in diversified (i.e. not perfectly correlated) assets generally leads to a


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

Subject CT8 (Financial Economics) September 2012 Examiners Report

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.

The risk-neutral probability of an up jump at any time is:


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

Final stock price

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

Down down down

(1 q)3 = 0.05350

231.48

Nil

The price of the option is then


V = e 36%

probability of path option payoff = 8.05p

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

Subject CT8 (Financial Economics) September 2012 Examiners Report

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)

The key assumptions are:


(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.

Suppose an investor can invest an any of N securities, i = 1, , N .


A proportion xi is invested in security Si . The return on the portfolio RP is
N

RP = xi Ri ,
i =1

where Ri is the return on security i .


The expected return on the portfolio E is
N

E = E [ RP ] = xi Ei ,
i =1

where Ei is the expected return on security i .


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

Subject CT8 (Financial Economics) September 2012 Examiners Report


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

Subject CT8 (Financial Economics) September 2012 Examiners Report

(i)

The model can be drawn as follows:


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

So, c0 = e5%/2 q 2 7.888 + 0 = 2.40707

(ii)

(a)

(b)

Similarly, p0 = e

5%
2

(1 q )2 9.438 + 2q (1 q ) 1.238 = 2.38248

The put-call parity entails c0 + 82e

5%
2

= p0 + 80

Using the value for the call found in question (i), we get p0 = 2.38248.
(iii)

Early exercise would happen at time zero or after three months.


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

Subject CT8 (Financial Economics) September 2012 Examiners Report

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

( q 1.238 + (1 q ) 9.438) = 4.7909.

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.

The model should be arbitrage free.


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

Subject CT8 (Financial Economics) September 2012 Examiners Report

(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)

Standard interpolation gives a volatility of = 436%

(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

Subject CT8 (Financial Economics) September 2012 Examiners Report

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)

Under the Merton model, the value at redemption is min(F(T), 3,200m),


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 debt is 3,200 92.603/100 = 2,963.3m

Subject CT8 (Financial Economics) September 2012 Examiners Report

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)

Since equal market capitalisation: wA = 0.5 and wB = 0.5.

(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)

The equation of the Security Market line gives:


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)

Using the separation theorem, we have:

Page 11

Subject CT8 (Financial Economics) September 2012 Examiners Report

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)

The Capital Market Line equation is:


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)

This means that the probability of portfolio B producing a return below a


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 all x , and


FA ( x ) < FB ( x ) , for some value of x .
(iii)

The expected utility of A is


b

Page 12

E [U A ] = U ( w ) dFA ( w ) ,
a

Subject CT8 (Financial Economics) September 2012 Examiners Report

and the expected utility of an investment in portfolio B is


b

E [U B ] = U ( w ) dFB ( w ) .
a

Thus, if A is preferred to B

U ( w) dFA ( w) U ( w) dFB ( w) > 0.

Now, the left hand side can be written as


b

U ( w)[dFA ( w) dFB ( w)]


a

and integrating by parts yields


b

U ( w) ( FA ( w ) FB ( w ) ) U ( w ) [ FA ( w ) FB ( w )]dw.

a
a

Now, FA ( a ) = FB ( a ) = 0 by definition, and FA ( b ) = FB ( b ) = 1 by definition


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

the exact form of U ( w ) , FA ( w ) FB ( w ) must be less than or equal to zero


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.

END OF EXAMINERS REPORT

Page 13

INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION
17 April 2013 (pm)

Subject CT8 Financial Economics


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.

Mark allocations are shown in brackets.

4.

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

5.

Candidates should show calculations where this is appropriate.

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 A2013

Institute and Faculty of Actuaries

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)

Determine the values of which allow the possibility of constructing 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)

Calculate the expected return on the portfolio in part (i)(b) in terms of


the expected return on SA .
[5]

Calculate the maximum expected return for an investor:


(a)

if portfolio weights are unlimited.

(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]

Calculate the expected return on the minimum variance portfolio if the


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)

Calculate the market price of risk under CAPM.

[2]

(iii)

Calculate the beta of each asset.

[6]

(iv)

Outline the limitations of the CAPM.

(i)

State the five key features of a standard Brownian motion Bt .

[3]
[Total 15]

[5]

Consider a stochastic differential equation


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)

Write down Itos lemma for f (t , X t ) , where f is a suitable function.

(iii)

Determine df (t , X t ) where f (t , X t ) = e 2tX t .

CT8 A20133

[2]
[2]
[Total 9]

PLEASE TURN OVER

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)

Explain what it means for (at , bt , ct ) to be previsible.

[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)

Give the condition for this portfolio to be self-financing.

[2]

(iv)

Define a replicating strategy for a derivative with payoff X at a future time U,


contingent on the path taken by at , bt and ct .
[2]

(v)

Describe how the no-arbitrage condition and a self-financing strategy can be


used to value the derivative in (iv) at time 0.
[2]

(vi)

Give a condition for the market to be complete.

[1]
[Total 10]

A non-dividend-paying stock in an arbitrage-free market has a current price of 150p.


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 up.


If the first stock price move is down.
[3]
[Total 9]

CT8 A20134

(i)

Describe three limitations of one-factor term structure models.

[5]

(ii)

Write down, defining all terms and notation used, the two-factor Vasicek
model.
[3]
[Total 8]

In a Black-Scholes market, we consider a special option with strike K and expiry in


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.

Hint: S2/S1 is independent of the values of St up to time 1 under the EMM.


(c)

10

(i)

Determine, using the result in (i), the fair price at time 0 for the option.
[9]
[Total 12]

Describe the two-state model for credit defaults.

[4]

Company As bonds are modelled according to a two-state model. Company A has


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)

Deduce the implied risk-neutral probabilities of no default in one year


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

INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS REPORT
April 2013 examinations

Subject CT8 Financial Economics


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

Institute and Faculty of Actuaries

Subject CT8 (Financial Economics Core Technical) April 2013 Examiners Report

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 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 takes into account the risk of lower returns.


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:

upside returns above the benchmark level


nor the potential downside of returns when the benchmark level is exceeded.

It gives an indication of the possibility of loss below a certain level.


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

The usefulness of VaR in these situations depends on modelling skewed or fat-tailed


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

Since 1 1 and VA > 0


this can only be 0 if = 1 .
(b)

Then, V = 0 x A = 2 xB and the overall portfolio constrain


x A + xB = 1 yields x A =

(ii)

Page 4

2
1
and xB =
.
2 +1
2 +1
2+2
.
2 +1

(c)

So the expected return on the overall portfolio E = E A .

(a)

In this case the maximum expected return is infinite (obtained by


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)

In this case the maximum expected return is obtained by selling one


unit of S A to purchase two units of S B . The maximum expected
return is then 3 E A .

In this case we have, using results from the core reading,


xA =

2VA 0.6VA 7
2
= = 0.7777 and so xB = = 0.2222
3VA 1.2VA 9
9

And so the expected return is

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)

The market portfolio is in proportion to the market capitalisation since every


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

EA = 5%; EB = 5.5%; EC = 3.75%; ED = 5%


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)

market price of risk is (EMr)/M = (4.6 3)/0.92466 = 173%

(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)

Most of the assumptions of the basic model can be attacked as unrealistic.


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)

Bt has independent increments, i.e. Bt Bs is independent of {Br , r s}


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)

Using Itos lemma above we have:


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)

It means that at , bt and ct are known based on information up to but not


including time t.

(ii)

The instantaneous change in the value of the portfolio is given by:

dVt = at dAt + dat At + dat dAt + bt dBt + dbt Bt + dbt dBt + ct dCt + dct Ct + dct dCt

(iii)

The portfolio is self-financing if the instantaneous change in the value of the


portfolio is equal to the pure investment gain.
In other words, dVt = at dAt + bt dBt + ct dCt

(iv)

A replicating strategy is a self-financing strategy ( at , bt , ct ) defined for


0 t <U
(where U is the payment time for X) such that:
VU = aU AU + bU BU + cU CU = X .

(v)

An initial investment of V0 = a0 A0 + b0 B0 + c0C0 at time 0, if we follow the

self-financing portfolio strategy ( at , bt , ct ) , will reproduce the derivative


payment without risk. Hence, by no arbitrage the value of the derivative at
time 0 must be V0.
(vi)

The market is complete if for any contingent claim X there is a replicating


strategy ( at , bt , ct ) .

In contrast to question 5, the slightly more advanced knowledge about self-financing


portfolios and simple stochastic calculus seemed beyond most candidates.

Page 7

Subject CT8 (Financial Economics Core Technical) April 2013 Examiners Report

(i)

First we calculate the risk neutral probability of an up-jump q:


1
1.2 = 0.481818
q=
1
1.2
1.2
1.01

Then the equation of value for the option price is,

50 p =

(q P
2

1.01

uu

+ 2q(1 q ) Pud + (1 q)2 Pdd

So
Puu = 219.70826 p 2.15094 Pud 1.15664 Pdd .
(ii)

Puu represents the payoff from an option so cannot be negative. Likewise, it


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)

Not perfect correlation across maturities.

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

Different volatility phases.

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.

Pricing complex derivatives.

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


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)

This models two processes which satisfy the equations:


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)

Denoting by Q the EMM and by F1 the information available at time 1,


the risk neutral pricing formula gives the following price C1 for the
option at time 1:

if the event {Maxt<1St < 2} occurs:


C1 = C1 (low) = erEQ[100.Max(S2/S11;0)|F1]

if the event {Maxt<1St 2} occurs:


C1 = C1 (up) = 0

(b)

In the case {(Maxt<1 St )< 2}, we need to compute the following


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)

The risk-neutral prices are given by


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)

Thus 10 s ds = 1 = ln [Q(A1)] = 0.10317


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.

END OF EXAMINERS REPORTS

Page 11

INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION
25 September 2013 (pm)

Subject CT8 Financial Economics


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.

Mark allocations are shown in brackets.

4.

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

5.

Candidates should show calculations where this is appropriate.


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

Institute and Faculty of Actuaries

(i)

(a)
(b)

State the expected utility theorem.


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]

A quadratic utility function is given by the equation U ( w) = w + bw2 . The value of


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)

Determine the following results:


(a)
(b)
(c)

the expected return on a security


the variance of returns on a security; and
the covariance of returns between two securities

in the market, using the parameters described in part (i).

[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)

State the potential impact of adding additional indices to the model:


(a)
(b)

in terms of explaining historic data.


in terms of forecasting security returns.
[2]
[Total 11]

(i)

Outline the three forms of the Efficient Markets Hypothesis (EMH).

(ii)

Discuss the following two scenarios in the light of the EMH:

[3]

Scenario 1: Company As share price falls suddenly, immediately after news


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)

Calculate a 95% confidence interval for the force of inflation in 2013.

[3]

A final salary pension fund is assuming inflation of 1% p.a. for the period 1 January
2012 to 31 December 2013.
(ii)

Comment on the appropriateness of this assumption assuming that the Wilkie


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:

dSt = 0.4St dt + 0.5St dBt


where Bt is a standard Brownian motion.
(i)

(a)

Determine dlog St , using Itos Lemma.

(b)

Calculate the expectation and variance of the Santa Insurance Co share


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:

dRt = 0.4Rt dt + 0.5dBt


Let Ut = e0.4t Rt
(ii)

CT8 S20133

(a)

Calculate dUt.

(b)

Calculate the expectation and variance of the Rudolf Financial


Services plc share price in two years time.
[6]
[Total 12]

PLEASE TURN OVER

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)

Compare this to your answer to part (i).

[5]

Assume that the real world probability has now dropped from 0.7 to 0.6.
(iii)

(a)

Explain, without performing any further calculations, how the state


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]

A one-year European call option on a non-dividend paying stock in Company ABC


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)

Calculate the delta of the call option.

[2]

(ii)

Calculate the implied volatility for the underlying.

[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)

Calculate the price of the bond today.

[1]

(iv)

Estimate to the nearest 1% the implied volatility of the value of XYZ.

[3]

(v)

Determine the implied risk-neutral probability of default.

END OF PAPER

CT8 S20135

[3]
[Total 15]

INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS REPORT
September 2013 examinations

Subject CT8 Financial Economics


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

Institute and Faculty of Actuaries

Subject CT8 (Financial Economics Core Technical) September 2013 Examiners Report

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 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)

The expected utility theorem states that a function, U(w) can be


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)

The expected utility theorem can be derived formally from the


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)

A with probability p and C with probability (1 p); and


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)

The absolute risk aversion A is given by:


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

Now, given the condition A(1) = 0.25 yields b = 0.1.


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)

The single-index model expresses the return on a security as:


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)

The expected return on security i is


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 ,

since under the model i is uncorrelated with RM and i is independent of j for


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

So that (by the result in part (ii)):


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

Where is the average of the individual is and V is the average of the


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)

I(2013) = 0.03 + 0.6(I(2012) 0.03) + 0.005N = 0.0318 + 0.005N,


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.

Candidates will be rewarded for making any other self-consistent and


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)

Divide by St to separate variables:


dSt
0.4dt 0.5dBt .
St

Use Its Lemma to calculate d log St:


d log St

(b)

dSt 0.5
2 (dSt ) 2 0.275dt 0.5dBt .
St St

Written in integral form, this reads:


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

The properties of the lognormal distribution give us the expectation


and variance of St:

S2 97e0.8 215.877 p

Var S2 97 2 (e0.55 ) 2 Var e0.5 B2

= 97 2 (e0.55 ) 2 e0.5 e0.5 1


2

=30,232.41p = (173.87)2 = (173.87)2 = 2 3.0232


(ii)

(a)

We wish to solve the stochastic differential equation:


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)

so U t U 0 0.5 e0.4 s dBs


0

and hence
Rt R0e

0.4t

0.5 e0.4( s t ) dBs .


0

Now since
t 0.4 s t
0.5 e
dBs

0,

E R2 97 e 0.8 p 43.584 p 0.43584

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

(0.499 p) 2 2 0.00002494 (0.00499) 2


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)

First we calculate the risk-neutral probability of an upwards movement in the


stock price from each state:
q 300

1.02 300 270


0.6
330 270

q 330

1.02 330 300


0.61
360 300

q 270

1.02 270 240


0.59.
300 240

Then the option price V is:


V =

q 300 q 330 70 q 300 1 q 330 10 1 q 300 q 270 10 0

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

q 300 1 q 330 1 q 300 q 270


2 0.7 0.3 1.022

1.07559

Page 9

Subject CT8 (Financial Economics Core Technical) September 2013 Examiners Report

A 240

1 q 300 1 q 270 1.75146.


(0.3 1.02) 2

Alternatively candidates may have calculated four deflators, one for


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)

Then the option premium V can be calculated as:


V = EP (A2V2)

= 0.7 2 A 360 70 2 0.7 0.3 A 300 10

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)

A(360) would rise as the denominator decreases; A(240) and A(300)


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:

A: one long forward contract.

B: borrow Ke rT in cash and buy e qT units of the stock priced at S0 .


Invest dividends in the stock.

At time T portfolio A is worth ST K .


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)

Consider a portfolio consisting of e qT units of stock, a European put option


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)

The stochastic differential equation for the short rate r is:


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:

Short rate not necessarily positive


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)

We wish to solve the stochastic differential equation:


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)

From this we see that under the risk-neutral measure rT follows a


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)

C for a call is (d1), where d1 = (ln(S0/k) + r + 2))/ = (ln(1.1798/1.5)


+ 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)

d2 = d1 T = 1.11. Thus P = KerT (d2) S0 (d1)


= 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.

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 L.

(a)

Under the Merton model, the value at redemption is


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)

The bond price is 120 e4(r+.045) = $92.5262m.

(iv)

The call price is $87.474 with T = 4, r = 0.02, S0 = 180, K = 120.


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

This gives a price of $86.413.


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)

Q(default ) = Q(F(4) < 120)


= 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.

END OF EXAMINERS REPORT

Page 15

INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION
24 April 2014 (am)

Subject CT8 Financial Economics


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.

Mark allocations are shown in brackets.

4.

Attempt all 10 questions, beginning your answer to each question on a new page.

5.

Candidates should show calculations where this is appropriate.


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

Institute and Faculty of Actuaries

Outline the key findings in behavioural finance.

(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)

Explain how a multi-index model would be expected to perform relative to the


single-index model in terms of fitting data and predicting future security price
moves.
[2]
[Total 10]

Let W be a standard Brownian motion.


(i)

State the continuous-time log-normal model of a security price S, defining all


the terms used.
[2]

Let f be a function of t and Wt2 .


(ii)

(a)

Find a function f such that f (t , Wt2 ) is a Ft-martingale, with F the


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]

Let X be the process defined as X t = t Wt .


(iii)

CT8 A20142

Derive the values of and for which X t defines a standard Brownian


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]

Consider the following model for the short-rate r:


drt = rt dt + dZt
where and are fixed parameters and Z is a standard Brownian motion.
(i)

Comment on the suitability of this model for the short-rate.

[4]

An alternative model for the short-rate is the Vasicek model:


drt = a ( rt )dt + dZt .
(ii)

Derive an expression for Tt r (u )du .

[6]

(iii)

State the distribution of Tt r (u )du .

[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)

Calculate the standard deviation of the return on the corresponding efficient


portfolio.
[2]

(iii)

Calculate the amount of money invested in each component of the Agents


portfolio.
[3]
[Total 8]

CT8 A20143

PLEASE TURN OVER

In a Black-Scholes market, let S be the price of a stock and D be the price of a


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]

In a Black-Scholes market, a European call option on the dividend-free stock, with


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)

Estimate the implied volatility of the stock to the nearest 1%.

[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)

Determine an upper and a lower bound on the value of the portfolio at


maturity.

(b)

Deduce bounds for the current put price.

(v)

Determine the fair price of the put.

[3]
[2]
[Total 16]

Outline the evidence against normality assumptions in models of market returns.

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)

Determine the implied risk-neutral probability of default for bond A, assuming


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)

Calculate the risk-neutral probability of default for bond C.

END OF PAPER

CT8 A20145

[3]
[Total 11]

INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS REPORT
April 2014 examinations

Subject CT8 Financial Economics


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

Institute and Faculty of Actuaries

Subject CT8 (Financial Economics Core Technical) April 2014 Examiners Report

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 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 and adjustment


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:

Dislike of negative events the valence of an outcome (the degree to which it


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!

A greater range of options tends to discourage decision-making. On the other


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.

Regret aversion by retaining the existing arrangements, people minimise the


possibility of regret (the pain associated with feeling responsible for a loss).

Ambiguity aversion people are prepared to pay a premium for rules.

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)

The single-index model expresses the return on a security as


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

Hence, 1 = 8 0.375 6 = 5.75 and 2 = 10 0.8 6 = 5.2.


(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

( )

Since t 2+ = t we must have t min t ,1 = 1, so = 0 whence = 1 if > 0.


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 may not be positive.


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)

Since the Vasicek model is an Ornstein-Uhlenbeck process we can solve the


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

and so, carrying out the deterministic integrals, we find:


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,

r ( u ) du is a Gaussian random variable.


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)

The capital market line is given by


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.

The majority of students scored full marks on a straight-forward question.


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)

The PDE is the Black-Scholes PDE:


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)

This relationship is known as put-call parity.


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)

The payoff from the portfolio, D, satisfies


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)

And this implies that 17.714 P0 18.694.

The Black-Scholes price (using the formula in the tables) is $18.35.

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

A strand of empirical research questions the use of the normality assumptions in


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)

B(t,T) = er(Tt)[1 (1 )(1 exp( Tt s ds))] , where B is the bond price,


is the risk-neutral default rate, is the recovery rate, and r is the risk-free rate.

(ii)

Using the formula, 0.925 = e0.025[1 0.5(1 exp( 10 s ds ))]


so that
Q(bond A defaults) = (1 exp( 10 s ds )) = 0.10317

(iii)

Now bond C pays:

nothing with probability (1 exp( 10 s ds ))


Page 11

Subject CT8 (Financial Economics Core Technical) April 2014 Examiners Report

50% with probability (1 exp( 12 s ds )) exp( 10 s ds)

100% with probability exp( 02 s ds)

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 students scored highly on part (i), part (ii).


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.

END OF EXAMINERS REPORT

Page 12

INSTITUTE AND FACULTY OF ACTUARIES

EXAMINATION
30 September 2014 (am)

Subject CT8 Financial Economics


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.

Mark allocations are shown in brackets.

4.

Attempt all 10 questions, beginning your answer to each question on a new page.

5.

Candidates should show calculations where this is appropriate.

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 S2014

Institute and Faculty of Actuaries

CT8exampaperSeptember2014

Pleasenote,regardingQuestion9:Thefivemarksforpart(v)of
Question9shouldhavebeensplitastwomarksforpart(iv)and
threemarksforpart(v).

Outline consumer choice theory.

An investor wishes to allocate her capital between a service company S and a


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]

Assume the investor chooses their investments according to mean-variance portfolio


theory.
(i)

Explain which companys share she would prefer.

[2]

Assume the investors preferences are described by a standard quadratic utility


function.
(ii)

State which assumption of the mean-variance portfolio theory can be relaxed.


[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)

Calculate the minimum variance portfolio.

[2]

A new study suggests that in the future, S will make more sales to M, when M is
delivering strong profits.
(v)

Describe the effect this will have on portfolios composed of M and S,


including the minimum-variance portfolio.
[3]
[Total 10]

Let (Zt ; t 0) be a standard Brownian motion.


(i)

Calculate the probability of the event that Z1 > 0 and Z 2 < 0.

[5]

Hint: Write Z1 = W, Z2 = W + X, where W and X are both independent, identically


distributed N(0,1) random variables.
(ii)

State the model for geometric Brownian motion.

(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)

Determine the forward price for this contract.

[4]

(iii)

Comment on whether the high dividend yield relative to the risk-free rate
offers an arbitrage opportunity.
[2]
[Total 10]

Consider a one-factor model for the short- rate r.


(i)

Explain why a tradeable asset has to be introduced in order to build an


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)

State the market price of risk.

(b)

Explain what it represents.

(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)

Explain how this is typically done in practice.

CT8 S20143

[2]
[Total 11]

PLEASE TURN OVER

Let B be a standard Brownian motion.


(i)

Derive the probability density function of max0st (Bs+ s), where is a


constant, using the formula in section 7.2 of the Actuarial Formulae and
Tables.

[3]

In a Black-Scholes market, let S be the stock price.


(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)

Calculate the fair-price at time zero of the derivative paying 10 at time T = 2


if and only if max0sT (Bs + s) > 1.44.
[4]
[Total 10]

In a Black-Scholes model, the delta of a call option is = (d1).


(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)

Find the implied volatility of the stock to the nearest 1%.

[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]

Suppose that K1 = $10, K2 = e0.09, = 1 year, T = 2 years and c = $200.


(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)

Calculate the risk-neutral probability that the bond defaults.

[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)

Describe the lognormal model for securities prices including the


definition of the parameters used.

(b)

State the corresponding mean and variance for the security price.

[4]

A security price S is assumed to follow a lognormal model. The price now is


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

INSTITUTE AND FACULTY OF ACTUARIES

EXAMINERS REPORT
September 2014 examinations

Subject CT8 Financial Economics


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

Institute and Faculty of Actuaries

Subject CT8 (Financial Economics Core Technical) September 2014 Examiners Report

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 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

The traditional theory of consumer choice has three main elements:


(i)
(ii)
(iii)

the consumers preferences


the budget constraint
how the consumer decides which consumption bundle to choose

(i)

The consumers preferences


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 any two bundles.


A consumer can rank different bundles, and therefore can pick a set of
consumption bundles that give the same utility.

(b)

Consumers prefer more of a good to less of it.


Therefore indifference curves slope downwards from left to right and
indifference curves further from the origin give higher utility.

(c)
(ii)

Consumer preferences exhibit diminishing marginal rates of


substitution.

The budget constraint


The assumptions
(a)
(b)

The prices of the goods are fixed.


The consumers income is fixed.

These two assumptions determine which consumption bundles are affordable.


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)

How consumers choose


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)

S has a higher return and a lower variance so is preferable in a mean-variance


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)

E[P] = 0.75 E[S] + 0.25 E[M] = 9.5%


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%

The amount invested in S, xS , will be,


xS

VM CSM
25 4 5 0.3

0.655173
VS 2CSM VM 16 2 4 5 0.3 25

invested in S, and so 0.344828 invested in M.


(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

The risk-neutral probability of an up-jump is:


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

SUU = 65 1.032 = 109.85


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

American option payoff


at t = 2

Value of European option at


t=2

SU = 65*1.03 = 84.5
SD = 65* 0.8 = 52

0
$18

$0.97
$12.71

So if the first jump is down, the option should be exercised early.


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]

Similarly consider two portfolios:


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)

The market price of risk is defined as:


(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)

With this identity we find that for all t < T


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 )

where dW (t ) = dW(t) + (t)dt is the standard Brownian motion


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

B(t,T) = EQ exp r (u )du t


t

for specific models.


(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)

Let M = max0st (Bs+ s), then


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]

The fair price is er(Tt) EQ [Dt t ] ,


where Q is the unique risk-neutral (or equivalent martingale) measure, r is the
risk-free rate and is the filtration.
[3]

(iii)

Under the EMM, Q, we have:


St /S0 log N(r 0.52)t,2t)
and

St /S0= exp((r 0.52)t + Bt)

The value of the derivative is contingent on:

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)

Inserting the parameter values, the value after time 1 is


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)

B(t,T) = er(Tt)[1 (1 ) (1 exp Tt s ds ))] ,


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)

Using the formula,


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)

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.

(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)

From (i), we see that


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.

END OF EXAMINERS REPORT

Page 13